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Selection Effects in the Market for Individual Annuities: New Evidence from the United Kingdom

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  • Amy Finkelstein
  • James Poterba

Abstract

This paper presents new evidence on the importance of adverse selection in individual annuity markets. It focuses on the individual annuity market in the United Kingdom, which provides an excellent empirical setting for studying selection effects. In addition to a voluntary annuity market, the U.K. also has a compulsory annuity market in which individuals in some types of retirement plans are effectively required to purchase retirement annuities. Two empirical regularities support standard models of adverse selection. First, annuitants as a group are longer-lived than randomly selected individuals in the population at large. The expected present value of the annuity payout stream from a typical voluntary annuity is thirteen percent higher for a typical 65-year-old male voluntary annuitant than for a typical 65-year-old male in the U.K. population. This is simply the result of differential mortality between the annuitant population and the population at large. Selection effects are more pronounced in the voluntary than in the compulsory annuity market, but even compulsory annuitants are not a random sample from the U.K. population. In the compulsory annuity market, the cost of adverse selection is between one third and one half of that in the voluntary annuity market. Second, annuitants select across different types of annuity products with different payout profiles, even within the compulsory market. The expected present values of payouts from inflation-indexed annuities and from nominal escalating annuities are lower than those from nominal annuities. This is consistent with longer-lived individuals choosing annuity products with greater payouts in the distant future. We find some puzzling evidence, however, in the relative pricing of nominal escalating annuities and inflation-indexed annuities. In addition to providing evidence on adverse selection, the U.K. annuity market can also be used to study how the price of an insurance product is related to the quantity of insurance purchased. Prices per annuity unit are lower for larger annuity policies than for smaller policies. Some theoretical models of insurance demand, which suggest that poorer risks should purchase more insurance and do not consider the fixed costs of issuing annuity or insurance policies, are inconsistent with this result.

Suggested Citation

  • Amy Finkelstein & James Poterba, 1999. "Selection Effects in the Market for Individual Annuities: New Evidence from the United Kingdom," NBER Working Papers 7168, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:7168
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    References listed on IDEAS

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    1. Olivia S. Mitchell, 1999. "New Evidence on the Money's Worth of Individual Annuities," American Economic Review, American Economic Association, vol. 89(5), pages 1299-1318, December.
    2. James M. Poterba & Mark Warshawsky, 2000. "The Costs of Annuitizing Retirement Payouts from Individual Accounts," NBER Chapters, in: Administrative Aspects of Investment-Based Social Security Reform, pages 173-206, National Bureau of Economic Research, Inc.
    3. Jeffrey R. Brown & Olivia S. Mitchell & James M. Poterba, 2001. "The Role of Real Annuities and Indexed Bonds in an Individual Accounts Retirement Program," NBER Chapters, in: Risk Aspects of Investment-Based Social Security Reform, pages 321-370, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Knox, David, 2000. "The Australian annuity market," Policy Research Working Paper Series 2495, The World Bank.
    2. Jeffrey Brown, 2002. "Differential Mortality and the Value of Individual Account Retirement Annuities," NBER Chapters, in: The Distributional Aspects of Social Security and Social Security Reform, pages 401-446, National Bureau of Economic Research, Inc.
    3. Amy Finkelstein & James Poterba, 2004. "Adverse Selection in Insurance Markets: Policyholder Evidence from the U.K. Annuity Market," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 183-208, February.
    4. Estelle James & Guillermo Martinez & Augusto Iglesias, 2005. "The Payout Stage in Chile: Who Annuitizes and Why?," Working Papers 14, Superintendencia de Pensiones, revised May 2007.
    5. Thorburn, Craig & Rocha, Roberto & Morales, Marco, 2007. "An analysis of money's worth ratios in Chile," Journal of Pension Economics and Finance, Cambridge University Press, vol. 6(3), pages 287-312, November.
    6. Finkelstein, Amy & Poterba, James & Rothschild, Casey, 2009. "Redistribution by insurance market regulation: Analyzing a ban on gender-based retirement annuities," Journal of Financial Economics, Elsevier, vol. 91(1), pages 38-58, January.
    7. Jean Philippe Gaudemet, 2001. "Les dispositifs d'acquisition à titre facultatif d'annuités viagères en vue de la retraite : une diffusion limitée," Économie et Statistique, Programme National Persée, vol. 348(1), pages 81-106.
    8. Johann K. Brunner & Susanne Pech, 2000. "Adverse selection in the annuity market when payoffs vary over the time of retirement," Economics working papers 2000-30, Department of Economics, Johannes Kepler University Linz, Austria.
    9. Jeffrey R. Brown & Olivia S. Mitchell & James M. Poterba, 2000. "Mortality Risk, Inflation Risk, and Annuity Products," NBER Working Papers 7812, National Bureau of Economic Research, Inc.
    10. Pecchenino, R.A. & Pollard, P.S., 1999. "Government Mandated Private Pensions: A Dependable Foundation for Retirement Security?," Papers 9902, Michigan State - Econometrics and Economic Theory.
    11. Paula Lopes, 2003. "(UBS Pensions series 19) Are Annuities Value for Money? Who Can Afford Them?," FMG Discussion Papers dp473, Financial Markets Group.
    12. Monika Bütler, 2002. "Flexibility and Redistribution in Old Age Insurance," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 138(IV), pages 427-437, December.
    13. Estelle James & Guillermo Martinez & Augusto Iglesias, 2004. "Payout Choices by Retirees in Chile: What Are They and Why?," Working Papers wp068, University of Michigan, Michigan Retirement Research Center.
    14. James Banks & Carl Emmerson, 2000. "Public and private pension spending: principles, practice and the need for reform," Fiscal Studies, Institute for Fiscal Studies, vol. 21(1), pages 1-63, March.
    15. Francis Breedon & Jagjit S. Chadha, 2003. "Investigating Excess Returns from Nominal Bonds," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 65(1), pages 73-90, February.
    16. James, Estelle & Vittas, Dimitri, 2000. "Annuity markets in comparative perspective : do consumers get their money's wotrth?," Policy Research Working Paper Series 2493, The World Bank.
    17. Lopes, Paula, 2003. "Are annuities value for money?: who can afford them?," LSE Research Online Documents on Economics 24899, London School of Economics and Political Science, LSE Library.
    18. Jeffrey R. Brown, 2000. "How Should We Insure Longevity Risk In Pensions And Social Security?," Issues in Brief ib-4, Center for Retirement Research.
    19. Suzanne Doyle & Olivia S. Mitchell & John Piggott, 2001. "Annuity Values in Defined Contribution Retirement Systems: The Case of Singapore and Australia," NBER Working Papers 8091, National Bureau of Economic Research, Inc.

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    JEL classification:

    • H5 - Public Economics - - National Government Expenditures and Related Policies
    • J2 - Labor and Demographic Economics - - Demand and Supply of Labor

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