In the first part of this article around annuitisation (“Let’s talk about annuitisation – Part I” featured in Pensions World Q4 2024), we discussed the need for trustees to review the annuity strategies and products available to members in light of the introduction of the Two-Pot System to ensure that these remain appropriate. While that article focused on the appropriate products for annuitisation, this article focuses on the appropriate pricing of these products.
Introduction
To recap, the Two-Pot System requires that two-thirds of future retirement savings must be preserved until retirement and at retirement be used to purchase a pension. There is no opt-out that allows the withdrawal of this portion of retirement savings before or at retirement in normal circumstances.
In the previous article we made the point that while the provision of appropriate, fit for purpose and appropriately priced products is always important, it becomes critical in a system where there is no exit available. The stakes are higher. The repercussions of forcing people to preserve and annuitise what is arguably the biggest asset they will ever have, and not paying attention to the products used for that annuitisation, can be significant.
We reached the conclusion in the previous article that the structure of the life annuity makes this product most fit for purpose to meet our objective of providing income security in retirement. What we need to do now is make sure that it is appropriately priced. If it is not, then it does not matter how well it meets its objectives, it will be inappropriate for members.
Combrink and Taylor presented a paper entitled “Fairness of annuity pricing for low-income earners in South Africa” at the Actuarial Society of South Africa’s annual conference in October 2023, where they discussed whether the life annuities were fairly priced in the South African market, with particular emphasis on fairness towards lower-income earners.
What do we mean by appropriate pricing?
By appropriate pricing, we mean that the price of the annuity is fair, in other words:
The price of the annuity must be reasonable relative to the expected benefit received (unless there is an argument to be made that cross-subsidisation would result in the less vulnerable subsidising the more vulnerable). More on cross-subsidisation in the information box.
The system should treat and price essentially similar situations similarly and with consistency.
Pricing of annuities 101
When we price an annuity, we need to determine how much money a member would need to pay now (the purchase price) so that the insurer is able to pay them a specific amount of pension per month, with increases, until their death. In this calculation, many assumptions are made about investment returns, costs, increases, and importantly how long the payments will be made for, known as mortality / life expectancy.
Impact of income on life expectancy on annuity pricing
It is intuitive that if two individuals both want a pension that pays them R1,000 per month until their death, and one of these individuals is expected to live longer than the other one, then the one who is expected to live longer will have to pay more than the other one (because he is expected to receive more payments).
Mortality investigations show that lower-income individuals have a higher probability of death at each age and therefore in general live shorter than higher income individuals. The 2017 CSI report shows that the mortality rate (chance of dying) for a 60-65 year old male who has a pension of less than R10,000 per month is three times higher than those who earn a pension of more than R100,000 per month.
This means that lower income individuals should pay around 20-30% less than their higher income counterpart for the same pension when they retire.
But they do not.
Annuity pricing in South Africa
In the retail market (where an individual wants to purchase a pension for themselves at retirement), insurers do not take income or any income proxies into account when pricing life annuities. This means that the lower-income and higher-income individual will pay the same amount for the same pension even though the high-income individual will outlive the lower-income individual and receive more pension payments.
This is not fair as the premium does not reflect the expected benefit and the cross-subsidy is from lower income to higher income, i.e. the higher income are paying less than they should and lower income more than they should.
Inconsistencies
1. Retail vs institutional pricing
Where a pension fund (rather than an individual) approaches an insurer to take over its pension payments, this is called the institutional market. In the institutional market insurers do take income into account in annuity pricing. Thus the pricing is not consistent between the retail and institutional markets.
Insurers argue that this is due to anti-selection risk i.e. that where an individual retires, if they know they will live shorter they will rather take cash, so anyone choosing to buy an annuity will have a longer life expectancy than average which poses a risk to the insurer. This risk is not present in the institutional market where the individual has no say in whether an annuity is purchased.
Though this argument has some merit, it only accounts for part of the pricing difference.
If the purchase of a life annuity, even up to some limit, was legislated for everyone, this would eliminate anti-selection risk and result in lower annuity rates for lower income individuals. Though the Two-Pot system requires the purchase of an annuity at retirement, living annuities are permitted. Individuals who expect to live shorter could rather purchase a living annuity and take a high drawdown, thus anti-selection risk remains.
2. Life insurance pricing
Life insurance is where in return for a monthly premium, the insurer will pay a lump sum on the death of an individual. Income is taken into account in the pricing of life insurance. Because insurers know that low income individuals have a higher chance of dying, and therefore the chance of paying a claim is higher, the cost of each rand of life cover is higher for a low income individual than a high income individual.
If this is taken into account in life insurance pricing to benefit the insurer, should it not also be taken into account in life annuity pricing, this time to benefit the member?
We note that the insurers have provided some reasons for why it is impractical to rate individual policies by income.
Conclusion
The authors concluded that not allowing for income rating in the retail annuity market results in unfair pricing as the price does not reflect the expected benefit. In their view, the insurers’ reasons for not doing this could be addressed.
The authors also noted that there is more incentive and willingness for insurers to offer more competitive rates in the institutional market than in the retail market. As retail annuity rates are publicly available, it is in their view unlikely that insurers would voluntarily begin to apply income ratings in retail annuities as this would indeed expose them to anti-selection risk. In their view, the requirement to take income into account needs to be legislated.
They also noted that the level of discrepancy between retail and institutional pricing is unlikely to be explained by anti-selection alone, and the costs and other margins in retail annuities should be addressed as the impact on pricing is material. In addition, “as long as living annuities continue to be permitted for compulsory annuitisation purposes, anti-selection will result in higher life annuity prices than would otherwise be the case.”
At the time of writing this article there is one insurer that we are aware of who does take income into account in the retail market.
Let’s ask the others to do the same.
Let’s ask the government to support.
Let’s apply our minds. Let’s find a way to make things better.
INFORMATION
Cross-subsidy vs Homogenous pricing
Homogenous pricing and cross-subsidisation are opposing approaches which could both be considered fair, but which yield different results.
Cross-subsidisation refers to the concept whereby one group of individuals pays more than they should (given their risk factors) and another group pays less than they should (given their risk factors) so that though the premium for each group is not correct for either group, it is correct on average. This is an important concept and is the fundamental risk-spreading tool used in insurance markets. By pooling risk in this way, insurance products can be offered to high risk individuals who would otherwise not be able to afford the premiums. Without any cross-subsidy from the lower-risk group the premiums payable by the high-risk group (who are most in need of insurance protection) would be unaffordable.
In plain English this is where some people pay more than they should and others pay less than they should so that those who need the benefit most can afford it. One example of this is found in medical scheme pricing in South Africa. A person with cancer will have higher medical expenses than a person without cancer, but they are both charged the same amount as a premium. The unused premiums of the healthy person are used to pay the claims of the sick person. Without the cross-subsidy from the healthy person to the sick person, the sick person could not afford the healthcare (which they would effectively have to fund themselves).
This method is considered fair because everyone gets the same benefit for the same price.
Homogenous pricing refers to a pricing mechanism whereby the premium paid by an individual is directly related to the expected benefit to be paid to that individual based on their own risk factors. In our medical scheme example above, all the cancer patients would be grouped together and their average cost would be charged to each as a premium. This method is considered fair because the premium directly reflects the specific individual’s expected benefit.
In recent times there has been a shift from cross-subsidisation to homogenous pricing; from “everyone pays the same rate and gets the same benefits if they need them” to “each pay for themselves and their particular risk”. We have seen this in the retirement industry in the move from defined benefits to defined contribution funds, and within defined contribution funds in the move from a smoothed bonus approach to individual member investment choice and daily unitisation.
However, cross-subsidisation in other contexts remains acceptable and unavoidable. For example:
The medical schemes industry in South Africa operates on the basis of community rating, where the medical scheme is prohibited from charging an unhealthy person a higher premium than they charge a healthy person for the same set of benefits. This creates an intentional cross subsidy from the healthy / young to the sick / old.
Costs in the pension system are often deliberately charged as a fixed percentage of salary or assets rather than a Rand per member per month amount even though the Rand value of the actual cost is the same for all members. This creates a deliberate cross subsidy from the rich to the poor.
The South African tax system, being progressive, applies a higher marginal tax rate to higher income individuals than it does to lower income individuals. This creates a deliberate cross subsidy from the rich to the poor.