The US and Latin American annuity markets could learn from each other's experiences, and help each other take advantage of their opportunities, says Jim Backus.
Judging from the headlines, an annuity is one of the most interesting financial products available in today's insurance markets. US headlines regularly announce new annuity products and new features for existing products. Latin American media reflect the large and highly competitive annuity markets that exist in many countries. However, a comparison of the US and Latin American annuity markets, suggests there are still opportunities for annuity writers in both regions.
Annuities in Latin America are primarily a result of the social reforms that began in 1981 in Chile, the first Western nation to privatise its social security system.1 Since then, seven other Latin American countries - Peru, Argentina, Colombia, Uruguay, Bolivia, Mexico and El Salvador - have adopted the Chilean model to some degree.
Most annuity contracts issued in Latin America are immediate (payout) annuities. Chile is one of the few countries in Latin America to offer a deferred annuity (accumulation) contract. The deferred annuity option enables Chilean retirees to use a portion of their accumulated pension balance for a specified length of time and leave the remainder invested. Once the particular date is reached, the retiree uses the invested funds to buy a payout annuity.
Both the Latin American and US markets address the same needs for retirement income. In Latin America, the national programme is administered privately and funded in advance. Some Latin American governments also supplement worker savings upon retirement so that the poorest retirees may purchase annuities. In the US, the federal government administers the national programme on a pay-as-you-go basis, and private annuities are fully funded and looked upon as savings mechanisms. Consequently, the opportunities and experiences of insurers differ significantly between these markets.
Aging populations and increased life expectancies in developed countries are perhaps the single biggest influence on their annuity markets. In the US, for example, the number of retirees will balloon over the next two decades as the active workforce continues to shrink. The population in Latin America is generally younger than that of the US, but the citizens of both regions have long life expectancies, and the risk of outliving resources makes annuities an attractive retirement option.2
The potential for growth in Latin America's private annuity market is significant for a number of reasons. Economic and demographic conditions are favourable. Regulatory policies progressively protect benefits and promote solvency. Workers saving more than what is required by their social security system have created a market for long-term funds in private annuities.
Primarily a complement to other sources of retirement income, private annuities in most Latin American countries are less attractive to employees with access to relatively high levels of retirement income from government-sponsored defined benefit pensions. However, many Latin American countries require participation in the privatised systems, and defined benefit pensions have been losing ground to the privatised systems.
Economic fluctuations within some of the countries in the region - currency devaluations, recessions, rising national debts and declining commodity markets - have created opportunities for global companies. To address these issues, Latin American governments have focused on developing their financial markets and regulations to promote solvency and protect benefits. Improved tax treatment of annuities has also helped the annuity market to grow.
The purchase of payout annuities is required by some pension plans (Bolivia) and nearly compulsory in other countries (Argentina). Annuities in other Latin American countries simply provide a more attractive alternative than other savings products, with higher returns, better investment control and more choices.3 Generally, payout annuities offer a retirement alternative to monthly withdrawals against the accumulated retirement account. The amount of the payments may change each year, because they are based on a retiree's mortality assessment, which is recalculated annually. Annuities provide a guaranteed amount - and the potential for higher payments in variable contracts - for the life of the retiree.
The capital market influence
Fluctuations in the economy create inconsistent investment yields for both Latin American and US annuity markets. Whether from annuitisation of deferred contracts or sales of immediate annuities, companies in both regions face the possibility of inadequate reserves due to low investment income. However, the largest share of the US market is for annuities during the deferral period, and the risks are accordingly different.
For deferred annuities, the main competitive challenge for the insurer is to credit an attractive rate. When earned rates are high, an insurer may offer policyholders a high crediting rate. Lower rates later may spell trouble for the insurer that has limited its ability to adjust the crediting rate by providing minimum rate guarantees.
US fixed annuities also face risks in the opposite economic environment, when low interest rates are followed by high rates. In those circumstances, an insurer may need to increase its crediting rate to limit surrenders but may be constrained by low yields on its existing investments purchased earlier. The insurer may thus have a choice of losing money immediately, by liquidating its investments at a loss, or losing money gradually, by crediting more than it can afford.
Variable products pose special problems for both US and Latin American companies. Variable products permit the insurer to transfer investment risks to policyholders, earning service fees rather than margins between earned and crediting rates. As a result, the risk of losses by insurers on variable products is small. However, the value of the insurer to its owners may reflect the expected continuation of a high volume of new business and a high level of service fees. Annuity service fees directly correlate to account value, and an equity market decline lowers annuity account values, thereby diminishing annuity profitability. Profitability is further strained in those annuities that promise minimum payout guarantees, regardless of actual equity market performance. Sustained negative pressure on sales and earnings ultimately affects financial stability.
Product features - Latin America
Social security annuities in Latin America - called provisional life annuities in Chile - are purchased with retirement funds accumulated by a worker. A result of the privatisation of government-backed pension plans, social annuities are strictly regulated by the laws of individual countries. These are all annuities that immediately begin paying a periodic benefit.
The US and Latin America offer both fixed and variable immediate annuities, but variable annuities in Latin America pay a contracted amount or more - decreasing payments in social annuities do not exist. The annuity is a variable contract, because the annuity owner may receive a payment increase if the fund administrator achieves a higher yield than the contracted rate. Fixed annuities create benefits for the annuity owner which do not depend on the insurer's investment experience.
Private annuities, which are not yet available in every Latin American country, may be purchased by anyone with the money and the desire. They may offer a variety of features, but product design is still in the early stages of development. As the market matures, asset management tools characteristic of US products - such as dollar-cost averaging, automatic account rebalancing and online services - are likely to emerge. As the regional market matures and competition increases, the region may face challenges similar to those of the current US market.
Product features - US
US annuity products offer a number of features that make them attractive savings vehicles and allow them to compete favourably with other products. The most important of these is the lack of income tax on the build-up of values over time. Policyholders are taxed only when funds are withdrawn. In addition, some products are qualified according to the US tax code, meaning that contributions to them are immediately tax-deductible. For these reasons, most annuities written in the US market are deferred annuities - they allow for the accumulation of funds, but do not immediately begin payment of benefits, unless the policyholder so chooses.
Beyond these basic features, there are benefits that determine the competitive position of the annuity. Fixed annuity benefits generally include partial withdrawal provisions that permit the policyholder to withdraw small amounts each year, without paying a surrender charge. Death benefits are also generally free from penalties. And while the terms-fixed annuity generally applies to any annuity funded in an insurer's general account, insurers may pass along some specific elements of investment risk by writing variations on the fixed annuity, such as modified guaranteed annuities, two-tiered annuities and direct recognition annuities.
Variable annuities involve even more features. The most important competitive feature is the availability of popular funds. As a result of market demand in this area, many US annuity writers have teamed up with popular mutual fund companies to offer customised products. In addition to the choice of funds, variable annuities may also guarantee a range of benefits:
The combination of insurance and investment features that makes US annuities unique retirement products also creates complex products that are hard to illustrate realistically, difficult to explain and expensive to administer. The mix of `bells and whistles' may help annuity writers establish competitive differentiation and attract new customers, but consumer advocates in the US complain that the sheer number of sub-accounts, riders, penalties and fees confuse potential buyers, particularly older consumers generally targeted by distributors. In the chase to have the newest twist or biggest returns, products have shorter shelf lives, which in turn creates speed-to-market concerns for the US annuity market.
Regulation is near the top of every published worry list of US insurance executives, and the US annuity market is heavily regulated by the Securities and Exchange Commission, the National Association of Securities Dealers and 50 state insurance commissioners. Regulation proliferation from these overlapping entities adds significant expense and compliance complexity to annuity products.
Distributors also express concern about product complexity. Many of the most popular annuity products contain more than 50 investment funds, and it's easy to understand that producers would be challenged to completely comprehend the nuances of every sub-account - the fund managers, investment style and characteristics.
Product complexity not only creates confusion but also costs money, and annuity expenses are significantly higher than those of other investments. Fees on mutual funds, for example, average less than 1.4% of assets, while annuity fees average around 2.1% of assets for insurance - charges include mortality, administrative, distribution and management fees.4
Annuities in Latin America are typically distributed by insurance company agents with specialised knowledge of the products. However, banks play an important role in Latin American economies and may become an important player in the private annuity market as well.
As US demand for annuities has grown, so has supply through a proliferation of annuity providers, significant development of new products and widening distribution channels. LIMRA, an independent service that tracks the insurance industry, reported roughly $70bn in individual annuity considerations in 1993.5 Ten years later, LIMRA shows that total industry annuity considerations for the first six months of 2002 exceeded $110bn. Distribution channels have expanded from insurance agents and brokers to include bank sales, direct response and web sites - both proprietary sites and aggregator supermarkets.
The popularity of distribution channels varies according to product features and economic conditions. While the internet continues to provide a wealth of previously unavailable information to consumers, it has yet to become a successful channel for US annuity sales, which have been limited to products with low charges. Conversely, banks and other financial service companies have become important distribution channels for annuities and other insurance products. Securities brokers, because of their specialised knowledge, are generally permitted to sell variable annuities, and when equity markets are rising, sales through the brokerage channel are high.
Bank sales challenge the traditional processes of insurance sales and delivery because they demand simplified products that can be delivered at the time of sale - just as money market accounts and certificates of deposit are handled. At the same time, selling costs are lower because existing bank operations have already covered the fixed costs of maintaining a storefront, and fixed annuity sales do not require a securities licence. While every distribution channel posted increases in the sale of fixed annuities last year, bank sales grew an impressive 63% in 2001, compared to 2000, according to LIMRA. This reflects the weak performance of equity markets and the shift by consumers into simpler products with more guarantees. Interestingly, annuities sold through banks have higher surrender rates.6
The last 20 years have seen the emergence of a large market for annuity products in most Latin American countries. The success of these products, combined with favourable regulatory and demographic factors, will continue to promote growth in this important market.
Meanwhile, the numbers and kinds of annuity features in the US have changed dramatically in response to market conditions and consumer demands. Recent US stock market declines, for example, have driven customers to the security of fixed annuities and spawned new variable products with stronger guarantees to entice customers who want investment certainty. Shorter surrender periods - three years on some products rather than the typical five or seven years - appeal to investors who desire flexibility to change their investments should market conditions improve. Enhanced earnings benefits help offset deferred taxes that become due when an annuity expires. A host of riders - long-term care, living income benefits and guaranteed minimum death benefits - offer additional account customisation to meet consumer needs.
Innovations in US annuities over the past several years have largely been in the accumulation phase of the products. These include:
Analysts predict that US product features in the coming years will be on the payout side of the products, including adjustable payments, flexible payment schedules, commutation options and stepped-up death benefits, as well as guaranteed rates for options such as joint and survivor or joint and contingent annuities.7
There are still many opportunities for each company to increase its annuity portfolio. Latin American companies may find the experience of US companies, especially with deferred annuities, useful in developing their own strategies. It is also likely that the significant experience of Latin America with immediate annuities will influence US product design.
1 National Center for Policy Analysis, Privatising Social Security in Latin America, 1999.
2 Organisation for Economic Co-operation and Development, Insurance and Private Pensions Compendium for Emerging Economies, 2000.
3 National Center for Policy Analysis, 1999.
4 Bank Investment Marketing, As Investment Vehicles, Vas Trump Mutual Funds, May 1, 2002.
5 LIMRA, The 1993 Individual Annuity Market Study, April 1, 1994.
6 LIMRA, 2002 Annual Persistency Study.
7 BestWire, October 18, 2001
By Jim Backus
Jim Backus is an actuary in the International Division of Transamerica Reinsurance.