When the Annuity Puzzle Doesn’t Exist: Evidence from the Chile

by Manisha Padi, Massachusetts Institute of Technology

Chile has one of the highest voluntary annuitization rates in the world, with more than 60 percent of retirees purchasing a private annuity. In contrast, less than 5 percent of U.S. retirees purchase annuities, despite theoretical predictions that annuity value is high. Novel individual-firm level data on annuity prices and individual level data on choices and deaths from Chile shed light on this divergence. We calibrate a life cycle model and estimate the value and cost of annuities relative to the baseline private social security offered in Chile. We propose that two effects, with opposite welfare implications, may be driving Chilean retirees to annuitize at a higher rate than U.S. retirees. On one hand, the government-mandated ‘outside option’ to annuitization has relatively low value, which may promote over-optimal annuitization. On the other, the design of the annuity market intensifies competition, decreases search costs and encourages price discrimination, resulting in lower levels of adverse selection and low equilibrium prices. We investigate the welfare effects of redesigning the outside option and of regulatory intervention common in public social security systems across the world. Finally, we set up a structural model that allows us to separately investigate in detail three specific phenomena within the annuity market. First, we investigate individuals’ decisions to limit their own choice set to a specific subset of contract types, prior to soliciting bids from firms. Second, we model firm’s bidding behavior and model the interaction between the auction mechanism and individuals’ private information. Third, we study the aggregate risk incurred by each firm, and the resulting possibility of bankruptcy, and the role of regulation in limiting this effect.

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