DEVELOPING THE MARKET FOR RETIREMENT PRODUCTS: THE CASE OF CHILE

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DEVELOPING THE MARKET FOR RETIREMENT
PRODUCTSTHE CASE OF CHILE

• Washington DC
• April, 2005

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INTRODUCTION

• The need to understand better annuities markets
  and the roadmap for development
• Pension reforms involving greater reliance on
  private sector and defined contribution (DC)
  schemes
• Payout phase emerging
• Some research on annuities, but excessively
  focused on specific topics and countries
• Basic questions not yet addressed
• The World Bank annuities project
• The first case study Chile

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Basic Questions Being Addressed by Project

• Can a market for retirement products be created
  from a low initial base?
• Can the insurance sector in emerging countries
  deliver retirement products, especially
  annuities?
• Do companies have internal capacity to manage
  risk?
• Do companies have access to financial instruments
  to manage risk?
• What are the weak/strong aspects of different
  institutional/regulatory arrangements?
• Arrangements competitive, risk-sharing, monopoly
• Product regulation product menu, design,
  marketing rules
• Provider regulation entry, investment, capital,
  exit rules

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VARIETY OF COUNTRY EXPERIENCES EXAMINED TO
ADDRESS THESE QUESTIONS

• Competitive model, many private providers
• Chile, Switzerland,
• Australia, UK, Selected Emerging Countries
• Risk-sharing arrangements
• Denmark, TIAA-CREF
• Single Provider
• Sweden

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THE CHILEAN CASE

• Importance of the Chilean Case
• Overview of the Chilean Annuities Market
• Growth
• Structure
• Performance
• Identifying the Risks
• Internal Risk Management by Providers
• Product Regulation
• Provider Regulation
• Conclusions and Lessons for Other Countries

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AN OVERVIEW OF THE CHILEAN MARKET Growth
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AN OVERVIEW OF THE CHILEAN MARKET Growth
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Insurance Premiums in Chile and Other Regions
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AN OVERVIEW OF THE CHILEAN MARKET Retirement
Conditions

• Normal Age Retirement
• 65 for men, 60 for women
• Early Retirement
• Balance has to be at least equal to 70 of
  average real wage and 150 of MPG
• Disability
• Certification by medical committee
• Survivorship
• Death of main beneficiary

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AN OVERVIEW OF THE CHILEAN MARKET Types of
Pensioners
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AN OVERVIEW OF THE CHILEAN MARKET Menu of
Products

• Lump-sums
• Access conditions restrictive
• Phased Withdrawals (PWs)
• Regulated formula based on life expectancy
• Provided by AFPs
• Annuities
• Freely priced, but fixed, indexed, joint for
  married
• Provided by LICOs
• Temporary Withdrawals
• Withdrawal with deferred annuity
• Provided by AFPs and LICOs

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AN OVERVIEW OF THE CHILEAN MARKET Demand for
Retirement Products
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AN OVERVIEW OF THE CHILEAN MARKET Demand for
Retirement Products

• High degree of annuitization More than 60 of
  all retirees annuitize
• Higher percentage excluding disability and
  survivorship pensions
• Early stagesdisabled and survivors jumpstarted
  the annuities market
• 1990s and 2000s close connection between early
  retirement and annuitization

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AN OVERVIEW OF THE CHILEAN MARKET Pattern of
Annuitization
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AN OVERVIEW OF THE CHILEAN MARKET Market
Structure

• Very concentrated pension fund sector
• Very competitive insurance sector
• Differences in market structure reflected
• in measures of market performance

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AN OVERVIEW OF THE CHILEAN ANNUITIES MARKET
MARKET STRUCTURE
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AN OVERVIEW OF THE CHILEAN ANNUITIES MARKET
MARKET STRUCTURE
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AN OVERVIEW OF THE CHILEAN MARKET Market
Performance

• Performance of the AFP Sector
• High average returns
• Costs and fees have declined but are still too
  high
• Performance has been better for PW holders
• Performance of the LICO/Annuities Sector
• High MWRs in recent years
• Questions about sustainability very thin spreads
• Strong capital buffer from initial years
  partially eroded, some decline in MWRs expected
• MWRs will probably remain comparatively
  attractive if industry does not become very
  concentrated

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Market Performance MWRs
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Market Performance MWRs
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Main Determinants of Individual MWRs
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Dispersion of MWRs for Different Premiums
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MWRs of Nominal Annuities in Other Countries
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MWRs of Indexed Annuities in Other Countries
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MWR Conclusions

• High by international comparison
• Wider supply of indexed instruments, other
  factors
• Lower for shorter durations (young ages, joint)
• Higher longevity and market/investment risks for
  provider
• Higher for larger premiums, suggesting
• Lower unit costs dominate over mortality
  differentials
• More competitive market at higher premiums
  (reflecting higher income and education levels)
• Wide dispersion for smaller premium levels
• Poor market search by prospective annuitants with
  lower income and education levels

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Market Performance Spreads (1)
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Market Performance Portfolio Composition
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Market Performance Commissions
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Market Performance Spreads (2)
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Market Performance ROEs
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Market Performance Estimation of the Average
Annuity Rate Fixed Effects with Robust Standard
Errors Total Panel Observations 693 R2
0.7995 Adj. R2 0.7890 F-Statistic 76.2162
P-Value(F-Statistic) 0.0000
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Market Performance Main Conclusions

• Chilean annuitants getting today better deal for
  their premiums than annuitants in most countries
• Performance was probably worse in the 1990s
• High MWRs of indexed annuities can be partly
  explained by wider supply of indexed instruments
• Inflation hedge with higher yield instruments
• Question is whether these high MWRs can be
  sustained.
• Probably not. Some decline of MWRs likely.

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Market Performance Can the behavior of annuity
providers be explained?

• Both measures of performance reveal aggressive
  pricing by providers
• Use of outdated tables by providers unlikely
• Serious governance problems unlikely
• Maybe providers counting on future interest rate
  increases
• Maybe providers are adopting deliberately
  aggressive pricing policies to gain market share
• Industry solvent, due to strong capital build-up
  in the first 15 years, but some market
  adjustments, lower MWRs likely

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Internal Risk Management

• Mixed success in coping with underwriting risks
• Structure of annuity prices seems reasonable,
  overall levels seem excessively high
• Reasonable strategies to address market risks
• Matching fixed indexed liabilities with portfolio
  of fixed income indexed assets
• Efforts to reduce duration gap, although
  constrained by limitations in the supply of
  instruments
• Reasonable strategies to address credit,
  pre-paymt risks
• Investment in high grade corporate bonds switch
  from mortgages
• Strategies to address operational risks not
  assessed Liquidity risks not important,

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Product Regulation The Menu of Products

• Conservative menu, designed to avoid inadequate
  retirement incomes, excessive recourse to MPG
• Lump-sums restricted
• Annuities have been fixed, indexed, joint for
  married males
• PW formula rules out total exhaustion of funds
• Although menu is relatively restricted, it is
  consistent with the central role played by the
  Chilean second pillar, provides reasonable range
  of choices

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Product Regulation Marketing Rules

• Some rules in the 1990s designed to ensure
  transparency and minimum market search (minimum
  of quotes) did not work very well
• Excessive dispersion of annuities
• Excessive abuse with cash rebates
• New Pensions Law passed in 2004
• Introduces caps on commissions
• Introduces innovative quotation system
• Should lead to more transparency, less dispersion
• Some problems still remain

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Provider Regulation Capital Rules

• Minimum capital and maximum
  leverage
• Regulated valuation of technical provisions
• Additional CALCE provision penalizing mismatching
  due to duration gap, currency, indexation,
  fixed/variable

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Assessment of Capital Rules

• Rules have served well, were innovative when
  introduced
• Provisions based on outdated table but with
  conservative interest rate, but are now low when
  considered in isolation.
• Increasing provisions to an economic valuation
  would reduce equity levels and increase reported
  leverage
• Refinement to regulation should be pursued to
  better reflect the current realities

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Capacity to absorb provisioning increases
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CONCLUSIONS

• The growth of the market for retirement products,
  especially annuities, has been impressive
• The high degree of annuitization is explained by
  institutional/regulatory arramgements
• pension reform, restrictions on lump-sums,
  absence of a front-ended DB scheme, level of the
  MPG, influence of brokers
• Adverse selection cannot be tested, but it does
  not seem to have been strong enough to disrupt
  market development

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CONCLUSIONS

• Market has performed well for consumers, as
  indicated by the high MWRs, higher than ratios in
  other countries, especially indexed annuities
• High MWRs can be partly explained by access to a
  diversified supply of indexed instruments, and
  very competitive environment
• However, it is questionable that MWRs can be
  sustained at current levels for a long period.
  Some decline to be expected
• Excessive dispersion for smaller premiums

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CONCLUSIONS

• Regulatory framework has been generally
  reasonable, and has evolved positively
• Product regulation restrictive but adequate for
  Chile.
• Marketing regulation has evolved in response to
  questionable practices New quotation system.
• Intermediary regulation reasonable. Capital
  rules penalizing mismatching were innovative,
  provided initial strong buffer, although were
  weakened over time by the use of an outdated
  mortality table.
• Longevity and investment risks remain challenging
  for participants and regulators.

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LESSONS FOR OTHER COUNTRIES

• Feasibility of building the market for retirement
  products from a low initial base
• High MWRs to a good extent due to diversified
  supply of indexed annuities, with reasonable
  durations
• Need to develop capital market
• Need for fiscal discipline, to open room for
  private instruments
• Need for pro-active regulatory approach to
  develop securities markets

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LESSONS FOR OTHER COUNTRIES

• Chilean approach to product regulation is
  appropriate for countries that assign a central
  role for second pillar may be relaxed in other
  cases
• Chilean experience with marketing regulation
  provides valuable lessons. Outcomes of the new
  quotation system should be monitored
• Strict capital rules that penalize mismatching
  are a valuable tool to build a strong capital
  buffer in the early stages of market development

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LESSONS FOR OTHER COUNTRIES

• Even good product and intermediary rules can
  weakened by failure to update key parameters,
  especially mortality tables
• Guarantees are maybe inevitable in a system like
  the Chilean. Offsetting the possible moral
  hazard requires a minimum of co-insurance, strong
  capital, intervention, and resolution rules,
  strict enforcement
• Need to evolve to a risk-based supervision system
  over time, as market develops