http://pluto.moneyadviceservice.org.uk/annuities

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http//pluto.moneyadviceservice.org.uk/annuities
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Annuity and inflation

• The main rationale for life annuities is to
  protect retirees from outliving their savings.
  Fixed nominal annuities provide protection
  against the longevity and investment risks but
  are exposed to inflation risk.
• Even a low rate of inflation of 1 per year will
  lower the real value of annuity payments by 18
  after 20 years. With 3 inflation, the reduction
  amounts to 45 and with 5 to 62.
• The average life expectancy of retirees is
  between 15 and 20 years. This implies that
  between one half and one third of retired workers
  will still be alive 20 years after retirement.
  They will suffer heavily even with moderate
  inflation if they buy fixed nominal annuities.
• Fixed nominal annuities fail to provide effective
  protection. Nevertheless, workers who have a
  short life expectancy or who underestimate their
  longevity prefer fixed nominal annuities because
  early payments are higher than with alternative
  annuity products.

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Annuity and inflation
Rate\Years 10 20 30
10 61 85 94
5 39 62 77
3 26 45 59
1 9 18 26
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• Four broad types of annuity products address the
  inflation risk
• escalating nominal annuities
• fixed real annuities
• dollarized or euroized annuities and
• variable annuities.

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escalating nominal annuities

• Escalating nominal annuities provide partial
  protection against inflation risk. This depends
  on the rate of escalation (which is usually set
  at 3 or 5 percent) and the inflation rate.
• If the rate of escalation is higher than the rate
  of inflation, the real value of annuity payments
  increases. In contrast, escalating nominal
  annuities suffer a decline in real value when the
  rate of inflation exceeds the rate of escalation.
• In principle, escalating annuities should appeal
  to people with longer life expectancy. This
  creates a selection bias which providers of
  annuities must take into account in their pricing
  and reserving policies.
• Despite their attractions and simplicity,
  escalating annuities have not been actively
  promoted and do not seem to play a significant
  part in any national annuity market.

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fixed real annuities

• Fixed real annuities provide protection against
  longevity, investment and inflation risks.
• They start with lower payments than nominal
  annuities but exceed nominal annuity payments in
  later years. For this reason, they appeal to
  people with longer life expectancies.
• This self-selection bias explains in part the
  higher load charge that fixed real annuities
  entail.
• In the absence of inflation-linked securities,
  annuity providers also charge an inflation risk
  premium that raises their cost.

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fixed real annuities

• The main disadvantage of fixed real annuities is
  their high cost relative to nominal and variable
  annuities.
• In most advanced countries, inflation-protected
  securities earn on average lower real rates of
  return than nominal securities, corporate
  equities and real estate, although their returns
  suffer from lower volatility.
• A second major shortcoming is that insurance
  companies and pension funds assume the inflation
  risk. They need to have access to
  inflation-protected securities to be able to
  hedge their risks.

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dollarized or euroized annuities

• These are annuities that are linked to a stronger
  and more stable foreign currency, like the US
  dollar or the euro.
• They protect against runaway inflation and large
  currency depreciation in small, poorly managed,
  economies.
• But unless they are linked to inflation-protected
  instruments they fail to provide effective
  protection, especially over the long run.
• US inflation averaged more than 3 per year over
  the past 30 years.

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variable annuities

• The main attraction of variable annuities is that
  they enable retirees to participate in the
  normally higher investment returns of equities,
  real estate and commodities
• Their main weakness is that pensioners assume the
  investment and inflation risks.
• With variable annuities, annuitants also usually
  share in the longevity risk. This is not a
  disadvantage but a different way of coping with
  this risk.
• Variable annuities require a robust system of
  regulation and supervision and a high level of
  transparency and integrity on the part of annuity
  providers.

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