Competition, Asymmetric Information, and the Annuity Puzzle: Evidence from a Government-Run Exchange in Chile

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Purchasing an annuity insures an individual against the risk of outliving their money, by promising a steady stream of income until death.  The value of annuities is high in theory, but in practice annuity markets tend to function poorly, with low annuitization rates and high markups. Chile provides an interesting counterexample to this phenomenon, as over 60 percent of eligible retirees purchase annuities from the private market and observed markups are low.  This paper shows that Chilean Social Security policy promotes private annuitization, in contrast to U.S. Social Security policy.  To study this effect, we build a lifecycle consumption-savings model and show through calibrations that the Chilean setting is likely to have lower welfare loss from adverse selection and is more robust to markets unraveling than the U.S.  We then use a novel administrative dataset on all annuity offers made to Chilean retirees between 2004 and 2013 to estimate a flexible demand system built on top of the consumption-savings model.  The model estimates allow us to simulate how the Chilean equilibrium would shift under alternative regulatory regimes.  We find that reforming the Chilean system to more closely resemble the U.S. Social Security system would likely make the annuity market fully unravel.  This result highlights the impact of the rules governing how retirees can access their pension balances on the annuity market equilibrium.

The paper found that:

  • Chile has a high rate of voluntary annuity purchase at low prices, despite the existence of adverse selection;
  • Standard U.S.-style public Social Security crowds out private annuity purchase by lowering retirees’ demand for annuities and making them more price sensitive;
  • Equilibrium levels of annuitization are highly sensitive to the perceived bankruptcy risk of insurance companies;
  • Estimates of retiree preferences show high levels of heterogeneity in mortality risk and correlated risk aversion, bequest motives, and private savings.

The policy implications of the findings are:

  • Retirees have highly heterogeneous preferences about retirement income, with some benefiting from free access to wealth and others preferring to spread income over many years;
  • Government can encourage the sale of private annuities by partially insuring against insurance company risk;
  • U.S. public pension systems may better serve heterogeneous retirees and increase annuitization rates by allowing pension buyouts from private companies, similar to the Chilean system.