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Annuity Markets: Problems and Solutions

David Blake

Pensions Institute, Birkbeck College


The main problems facing annuity providers relate to adverse selection
and mortality risk, the risk associated with mortality improvements, and
interest rate and inflation risk. Annuity providers hedge these risks,
wherever possible, by holding suitable matching assets against their
annuity liabilities: for example, riskless (government) fixed-income bonds
are used to provide the payments on level annuities, and index-linked bonds
are needed if index-linked annuities are to be serviced effectively. However,
in the absence of suitable matching assets, providers are unable to hedge
the risks associated with mortality effectively and compensate for this by
imposing substantial cost loadings. Annuitants face interest rate risk prior
to purchase and, since most of them prefer the higher initial income from a
level annuity compared with an indexed annuity, inflation risk after purchase.
Some solutions to these problems are considered, including a planned programme
of phased annuity purchases to hedge interest rate risk, limited price index
bonds to partially hedge inflation risk, and survivor (or indexed life) bonds,
with coupons declining in direct proportion to the realised mortality of a selected
group of annuitants, to hedge mortality risk. Finally, we examine the advantages
and disadvantages of different institutional forms for the annuity market,
ranging from monopoly provision through limited licensed provision to a fully
competitive provision.

ISSN 1367-580x.