Media Briefings

ANNUITIES LESS ATTRACTIVE IN CASE OF POTENTIAL HEALTH COSTS: New evidence on how to allocate pension wealth on retirement

  • Published Date: August 2017

Many people at or nearing retirement require much better advice on what to do with their pension savings. In many countries, they need to think through how to balance the risk that putting all their wealth in an annuity leaves them short of funds in a medical emergency versus the risk of drawing down their wealth in full and potentially outliving their assets.

These are among the conclusions of research by Kim Peijnenburg, Theo Nijman and Bas Werker, which is published in the August 2017 issue of the Economic Journal. Their study shows that full annuitisation of pension wealth on retirement is no longer optimal if sizable ‘liquidity shocks’ can hit in the early years of retirement.

The researchers use the example of the liquidity shocks generated by out-of-pocket costs in the US healthcare system. They show that partial annuitisation – say of 50% of the capital in occupational and private pensions – is more attractive than full annuitisation. But the welfare losses of not annuitising pension wealth at all are substantial: easily more than 3% per year, which exceeds the welfare costs of full annuitisation.

Whether or not to allow individuals to access their pension wealth at or before retirement is a big policy issue in many countries. The Netherlands, for example, has mandated lifelong income (annuities); in Denmark, income streams are usually at least for more than 15 years; while Australia, the UK and the United States offer full freedom of choice for individuals. All these countries are currently considering whether or not to adjust the existing legislation.

Pensions aim to provide income in retirement. State pensions are paid as long as an individual lives but they provide limited income in most countries. In many countries historically, occupational and private pensions were intended to be lifelong as well.

But in April 2015, this legislation was changed in the UK and pension wealth can be drawn down as of the age of 55. This implies more freedom of choice for individuals but also implies the risk of outliving one’s assets – that is, to have much lower income in later years in retirement. This can also be a cost for society because individuals that outlive their assets will claim means-tested benefits for housing or healthcare at later ages.

Standard economic theory suggests that lifelong income offers very significant welfare gains. Annuitising private or occupational pensions implies a welfare effect of more than 10% in standard models if they are of equal size as the state pension.

One of the reasons though not to select, nudge or mandate lifelong income insurance of private and occupational pension is that annuitised funds cannot be accessed if they are needed for liquidity reasons. For example, the out-of-pocket costs of healthcare can be quite substantial and are hard to account for if someone faces an unexpected health shock and all wealth is annuitised.

Optimal annuity demand depends on the probability of liquidity shocks. For people with bad health status, annuitisation is less attractive if the individual is to pay substantial out-of-pocket costs of healthcare. These findings suggest an important role for financial advisors, pension providers, regulators or government to inform individuals how to balance the risks of liquidity needs and that of outliving their assets.

The results of the study are robust to the assumption whether or not pension wealth is annuitised at retirement or at a later age. Moreover, the results are much more in line with observed annuitisation choices than the implications of models that ignore liquidity shocks.

Both in Denmark and the Netherlands, the legislation has recently been adjusted to enable lifelong income insurance while still taking adequate investment risks. This new legislation avoids another often-heard argument against lifelong income: that it would require reliance on guaranteed income streams, which are unattractive because of low interest rates.

ENDS


Notes for editors: ‘Health Cost Risk: A Potential Solution to the Annuity Puzzle’ by Kim Peijnenburg, Theo Nijman and Bas Werker is published in the August 2017 issue of the Economic Journal.

Kim Peijnenburg is at HEC Paris. Theo Nijman is scientific director of Netspar (Network for Studies on Pensions, Aging and Retirement). He and Bas Werker are at Tilburg University.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh); Kim Peijnenburg via email: peijnenburg@hec.fr; Theo Nijman via email: Nyman@uvt.nl; or Bas Werker via email: B.J.M.Werker@uvt.nl