NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

How will the Woodstock generation, the roughly 76 million baby boom

"...variable annuity premiums increased five fold between 1991 and 1994."

How will the Woodstock generation, the roughly 76 million baby boomers born from 1946 to 1964, fare financially in retirement? Are boomers putting aside enough money for their retirement? With the debate over Social Security reform percolating, and employers expecting their workers to take more responsibility for their retirement funding, questions like these are increasingly driving scholarly agendas and policy discussions. One financial market garnering much more research attention these days is the market for annuities, since the "principal insurance role of annuities is to indemnify individuals against the risk of outliving their resources," says NBER Research Associate James Poterba in The History of Annuities in the United States (NBER Working Paper No. 6001).

Annuities are a complex and remarkably flexible financial product. Most annuity contracts have an accumulation or savings phase when capital builds up; the money is then dispersed during the liquidation or payout phase. Variable annuities, essentially mutual funds wrapped in a tax-deferred insurance company account, are a product that can reduce the risk that rising prices will erode benefits--assuming that the investment option picked by the annuity holder provides a hedge against inflation. Insurance company sales of variable annuities have soared in recent years. In 1951, life insurance premiums were more than seven times greater than annuity premiums. In 1993, life insurance premiums were roughly 60 percent of annuity premium income.

Annuities have been available in the United States for more than two centuries. Yet they remained a sliver of the U.S. insurance market until the financial and economic trauma of the Great Depression. Two developments conspired to boost annuity sales in the 1930s. Since insurance companies were seen as stable financial institutions, many individuals bought flexible-payment deferred annuities, a product that combined savings and insurance features. The group annuity market also began to develop. Yet insurers sustained losses on both types of contracts during the 1930s, squeezed between falling rates of return and the rising longevity of annuitants, relative to the assumptions that insurers had used in pricing their contracts.

The group annuity market, which was linked closely to the market for defined benefit pension plans, expanded rapidly during the first few decades of the post World War II era. But sales of individual annuity contracts have surged in recent years, largely driven by the popularity of variable annuities in the late 1980s and 1990s. For instance, variable annuity premiums increased five fold between 1991 and 1994. While many factors have undoubtedly played a role in the rising demand for variable annuities, the aging of the baby boom generation, a strong desire for tax-sheltered savings, and the sharp increase in stock prices in the 1990s have probably been the main contributory factors.

Still, why haven't more people bought annuities? After all, many people face the real risk of outliving their financial resources. The standard economic explanation for the relatively small size of the individual annuity market is adverse selection: the people who buy annuities tend to live longer than average, so insurance premiums must be high enough to compensate insurers for the long life of annuitants. Olivia Mitchell, Poterba, and Mark Warshawsky take another look in New Evidence on the Money's Worth of Individual Annuities (NBER Working Paper No. 6002). Specifically, they focus on a particular kind of individual annuity: the nonparticipating, single premium immediate annuity (SPIA). With a nonparticipating SPIA, an insurance company guarantees principal and a fixed nominal return. The average SPIA premium in 1995 was $79,600, and these policies are typically bought with aftertax dollars -- that is, they are not part of a tax deferred retirement account, such as an IRA.

The researchers estimate the expected present discounted value of payments for annuity policies under a wide range of assumptions and conditions, and compare these to the cost of buying an SPIA contract. "The central finding is that the average annuity policy delivered payouts valued at between 80 and 85 cents per dollar of annuity premium in 1995," say the authors. The rest of the money went to cover marketing expenses, corporate overhead, income taxes, contingency reserves, and the cost of adverse selection. They also find that prices for an SPIA vary significantly, with the difference between premiums charged for the 10 highest payout insurers and the 10 lowest close to 20 percent. The expected payout on annuity policies has increased significantly, however, in the last decade and a half. The payout value per premium dollar has risen by roughly 13 percentage points since the beginning of the 1980s.


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