I came across an interesting article about Chile’s retirement system which made me think that the population down there may be on to something that more Americans should take advantage of. In fact, I find it mind boggling that we aren’t, at least in part, following their lead. In the article, Solving Chile’s Annuity Puzzle, the author, Mr. Milevsky, highlights both how the system works and some interesting (to me) statistics:
Chile mandates that all employees in the workforce must contribute at least 10% of their pre-tax salary into an individual account defined-contribution (DC) plan, managed through the payroll system. Within these accounts they are allowed to allocate wealth between a limited set of diversified (low-cost) mutual funds, all of which are managed by the private sector. These individual accounts are held by custodians and are completely independent from the employer.
With such an arms-length approach, portability, ownership and even employer bankruptcy risk shouldn’t be a concern. The closest analogy I could find in North America would be replacing Social Security with one big 401(k) plan, in which every single worker is obligated—not just defaulted or merely nudged—to contribute.
While this relatively young model isn’t immune to the mind-numbing rules and exclusions that afflict all government-administered plans anywhere else on planet earth, Chilean retirees have two basic options: They can either (1) continue to invest their account in a variety of stock and bond funds while withdrawing money from the account, a.k.a. self-annuitization or (2) use the accumulated funds to purchase a life annuity. Technically, a third option could be any combination of (1) and (2).
But, as I mentioned earlier, approximately 65% of Chileans in this system get to retirement, sit down with a financial advisor—which is mandated, by the way—and provide very simple instructions: “Please buy me a life annuity, with all of it.”
Now, lest you suspect I am talking about small sums in a small country, each year over 20,000 life annuity contracts are voluntarily issued in Chile. This is the second highest number in the world after the grand-annuity-daddy of them all, the U.K. (selling 400,000 policies per year.) Remember, though, Chile has a population of 17 million people and its insurance companies issue more life annuity policies than the U.S., Japan or Germany. ***
This 65% rate of annuitization is quite puzzling, when contrasted with a 5% rate (at best) in the U.S.
I am shocked more retirees do not utilize single premium immediate annuities in America.
What is a SPIA?
A Single Premium Immediate Annuity is probably the easiest life insurance product to understand next to term life insurance.
A person (owner) gives a lump sum to an insurance company and receives an income stream for a set period of time based on the life expectancy of another (annuitant). In most cases the annuitant and the owner are the same person. Of course, it can get more complicated but the base is always the same.
The payouts are often much higher than what someone would receive in the form of a dividend, interest or bond payment. This is because of mortality. Insurance companies are smart. Some of the biggest ones in this country have been around for 150+ years. It doesn’t mean they are evil just smart.
So if 1,000 people of the same age buy a SPIA they know that X amount of people will die after year 1, year 5, year 10, etc. and the payments associated will cease to exist. Thus allowing a higher payout in the beginning and still remain profitable.
Why do Chileans Love the SPIA While Americans Hate it?
Mr. Milevsky as an economist tries to explain why Chileans have such a high SPIA rate,
Commissions. When independent retirement advisors—those who stand between the retiree and their decision—offer guidance, it is commission neutral, unlike how things work on this side of the equator. In other words, the compensation to the independent Chilean retirement advisor isn’t affected by whether they suggest a life annuity, a mutual fund or any combination. (Alas, when the Chilean retirement advisor is an employee of a mutual fund company, the annuitization rate is lower. Surprise!)
Illustrations. All retirees are shown (mandated, regulated) illustrations that suggest a volatile and possibly declining income stream if they go with the SWiP, and if long-term investment assumptions are not met. In other words, they have a better understanding of the risk.
Inflation. All life annuities sold in Chile are indexed to inflation, or more precisely to unidades de fomento (UF) as opposed to nominal pesos. So, there is no inflation risk to the annuitant, thus making it a more secure source of real lifetime income. In the U.S. most life annuities are nominal, and the few real ones are real expensive too.
Lack of pensions. Remember that for most Chileans this individual account is all the retirement money they have. There is no other defined-benefit corporate or government pension plan, which would backstop their retirement spending. They have no other form of longevity insurance other than the life annuity.
Perceived safety. The Chilean government explicitly backs or guarantees insurance company payments (up to a limit) in the event of insolvency or bankruptcy. This is different from the U.S. system, which is a mutual arrangement between companies, and overseen by the individual states. Perhaps it even feels like Social Security.
Of course none of this explains the all-or-nothing attitude that prevails with most of these accounts
All the reasons listed above can be applied to America, but why do we have such a low SPIA rate? While I don’t know what makes a Chilean tick I think I can guess on some of the reasons we, as Americans, don’t use the SPIA as much as we should.
Why Don’t Americans Buy SPIAs?
I have two main theories:
A Stupid Amount of Optimism Coupled with a Short Term Memory Problem
We, as a whole, believe in our economy, our markets and our Government. As such, when retirees (or near retirees) look at the market there is always the assumption it will go up. Please who even remembers long ago in an ancient time known as 2007 when the broad indexes lost 40%? Those neanderthals didn’t even have iPhones or an Android operating system. 2001 Dot Com Crash?! Weren’t people using dial ups still?!
Greed and Aggressiveness
90% of the people living in this Country are from descendants 4 generations or less. If I took the time to actually look up that state I believe it may be even more shocking. I believe our DNA is wired for risk taking and then you couple that with the way our broad markets are covered in print, tv and the internet. Of course, we can’t just turn it off when we turn 60, 65 or 75!
In addition to risk taking there is a sense of aggressiveness instilled in us. No one wants to be “that guy” who took the risk off the table and handed it over to an insurance company. What if you die the next year? Your family gets less of an inheritance. Who wants to leave that kind of legacy?
There is a movement now (has been going on for the past couple years) to shift the mindset about SPIAs for retirees in America. Personally, I think we are a decades away before a real surge in SPIAs hit. My guess, would be one or two more corrections for baby boomers and all their trillions will sky rocket SPIA sales.