Academic journal article Journal of Risk and Insurance

On the Cost of Adverse Selection in Individual Annuity Markets: Evidence from Singapore

Academic journal article Journal of Risk and Insurance

On the Cost of Adverse Selection in Individual Annuity Markets: Evidence from Singapore

Article excerpt

ABSTRACT

New evidence is presented on the cost of adverse selection in individual annuity markets using Singapore data. The Singapore annuity market is an interesting setting to examine the cost of adverse selection for three reasons. First, unlike many Western countries, the Singapore government provides very limited public financial assistance for retirees. Second, while social security contributions mandated under the Central Provident Fund (CPF) result in a high forced savings rate, a large proportion of CPF savings, are used up for housing. Third, to ensure that retirees have sufficient funds to meet basic needs, individuals who reach age 55 are required to set aside a minimum amount of their CPF savings, which can be withdrawn at age 62. The CPF Board allows various options for investing the minimum sum, but the most attractive option is to purchase an annuity. The institutional setting in Singapore in effect provides insurers with a large captive market for annuities. It is conjectured that this should be refle cted in a significantly lower cost of adverse selection for annuities sold in Singapore as compared with other countries. The results herein, using data for CPF-approved insurers, are strongly consistent with this conjecture. On average, money's worth of annuities is higher than annuities sold to a similar age-gender mix in the United States, United Kingdom, and Australia. Adverse selection accounts for less than 13 percent of the cost of longevity insurance compared to 30-50 percent documented in many previous studies. These results suggest that one way to resolve the adverse selection problem is to adopt a universal individual defined contribution pension scheme that mandates or provides strong incentives for retirees to purchase annuities.

INTRODUCTION

Many countries are now facing the problem of a rapidly aging population. A key policy concern is how to ensure that both current and future cohorts of retirees have sufficient resources to fund their retirement needs. Extensive discussions have centered around the idea of replacing or supplementing existing state-funded, defined benefit pension schemes with defined contribution accounts with a greater emphasis on self-reliance in the retirement plan (see, e.g., Mitchell, Myers, and Young, 1999; Bodie and Davis, 2000). This development is likely to increase the demand for retirement products such as annuities.

An annuity is an insurance contract whereby the insured is promised a regular sum for life, in exchange for a premium paid to the insurer. The main attraction of annuities is the guarantee of lifetime income. Thus, annuities help retirees cope with the risk of outliving their own financial resources. Despite their appeal, many studies report that only a small percentage of retirees in most countries purchase annuities. For example, historically, only 2 percent of the elderly population in the United States owns individual annuities of any type (Friedman and Sjogren, 1980). Recent studies, e.g., Mitchell et al. (1999) show that this percentage has not increased significantly over the years. The market for annuities in the United Kingdom shows a similar pattern (Blake, 1999). Data from the Australian Treasury show that only 3 percent of the estimated 100,000 Australians retiring each year purchase annuities (Doyle, Mitchell, and Piggott, 2001).

The reasons why most retirees do not purchase annuities are varied and complex. One reason is that retirees have strong bequest motives (Friedman and Warshawsky, 1988, 1990). Second, older people may feel that they need to hold liquid assets to cope with large expenses such as the cost of medical and long-term disability care. Third, the family may serve as a partial substitute for annuities (see Kotlikoff and Spivak, 1981). Fourth, in many countries, retirees receive a guaranteed social security income for life, representing another substitute for individual annuities. …

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