What do the Chilean People Know About Retirement that Most Americans Don’t?

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.

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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.

7 Responses to What do the Chilean People Know About Retirement that Most Americans Don’t?

  1. You kind of demonize Americans there at the end after you just illustrated some very important and clear differences between the Chilean and American systems overall that would likely make Americans less likely to participate (i.e. no inflation indexing, no government guarantee).

    • Demonize? I don’t see greed and aggressiveness as a negative (obviously to certain limits). Notwithstanding, you don’t believe we as a society have a short term memory? You have people in the middle east and parts of eastern europe fighting over the same piece of land for centuries (notwithstanding the fact that that the land had been monetarily worthless until recently). America is just a blimp on the historical radar right now. Our country is the average age of the homes in some towns in Italy and Greece. Again, I didn’t look at the second reason as a negative.

      With that being said, you can buy a SPIA with an inflation rider pretty easily. Alternatively, you could layer the SPIAs. So you buy one this year, buy one in 5 years, etc OR you buy a SPIA coupled with a Deferred Income Annuity/Longevity Annuinty, which has a set income which starts sometime in the future regardless of how the market does.

      As far as the gov’t guarantee. Here the very few mutual companies that go defunct are swallowed by stronger bigger insurance companies. It is done for self preservation of the industry. Some may argue that the balance sheet of those companies (think: MassMutual, The Guardian, Northwestern, etc.) are stronger than a promise from Chile whose newest gov’t is only 30 or so years old.

  2. How about:

    3) Buy an SPIA and die the next day. What do my heirs get? (You buried the lede in #2!)

    Maybe it’s American optimism here too, but even people with small retirement accounts want to leave something to their children (and grandchildren, nieces, nephews, and other close relatives). That applies even when the amount they have amassed isn’t truly enough to live on for themselves in retirement.

    I don’t think that’s greed and aggressiveness. The “family” (in a general sense) is how you pass down social capital. In America, we have a long tradition of also passing down actual capital. Perhaps if we had a more guaranteed retirement system (a la Chile), you would see more of the middle class saying “they’ll be fine when they reach retirement”. As it is, now? Do you trust SS to provide for your kids?

  3. I have to agree with PK. People like the idea of passing on an inheritance legacy. That is taken away if all retirement funds are used for a SPIA. Not to mention what happens to the surviving spouse? I assume people buy SPIAs for each individual, but that could still mean 1/2 of the income gets cut off with the passing of one spouse. My wife and I are planning to purchase SPIAs after we are well into retirement, but will only use part of our assets. The SPIAs and Social Security will provide basic financial support, and we will hopefully retain enough assets to have fun and also leave a large inheritance.

  4. I think one of the problem with SPIAs is that it’s hard for people to understand.

    So it’s not life insurance, but it’s sold by life insurance companies… confusion.

    What are the fees involved? Is there a simple expense ratio allowing me to compare many plans? Confusion.

    Are there different terms and conditions to each policy from different companies? (I don’t know this, I’m asking.) If so, confusion.

    Throw in the stuff that PK mentioned about buying a policy and dying the next day to see your financial legacy go to waste and I don’t think I’m interested.

  5. I have to agree with LM&M above. The annuities offered can be so complicated, and laden with fee’s and penalties that their not worth it. How does the average Joe figure out which is a good one?

    Buy 20 or 30 dividend paying blue chip stocks, I’m sure you can get close to a 4% return regardless if the share price goes up or down. Ladder some GIC’s at the same time and you have kind of made your own mini annuity. I too would rather take. Even some funds out there that offer a monthly payment would be better as long as the ROC was minor.

    The reason many of these are pushed now is the product simply makes the most comission for the person selling them.

  6. Interesting.

    I think one concern Americans have with annuities in general is the fear that they can’t get their principal out of the need it or want it. Big medical bills, for example…or say you learn you’ve got six months left to live and you want to take a world cruise while you’re still breathing. If all your money’s in an annuity, you can’t use it for any other purpose.

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