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Milevsky: Solving Chile’s Annuity Puzzle

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To an academic economist—which is something I occasionally fancy myself to be—exquisite Chile is somewhat of a utopia. I’m not referring to the Andes Mountains or Atacama Desert, although they are remarkable. Rather, I’m referring to its government’s approach to economic policy.

As in a number of other South American countries, many of Chile’s cabinet minsters and even elected politicians earned graduate degrees and doctorates in economics, having been trained in the best universities. In fact, none other than the great Milton Friedman himself helped design the plumbing of their economic system in the early 1980s. Even today, public and political discourse is replete with phrases usually reserved for graduate courses on microeconomics.

Yet, what might be of special interest to the readership of this column is Chile’s retirement system, also redesigned from scratch a mere 25 years ago, in the post-Allende epoch. Remarkably, Chileans have no universal government-run pension program, like Social Security in the U.S.

Rather, Chilean citizens save and invest for their own retirement. What is even more striking is that when they reach retirement age—and transition to the de-accumulation phase, withdrawing money from their individual accounts—they do something few retirees do anywhere else in the world. Most of them voluntarily annuitize. To put it bluntly, they walk into their neighborhood insurance company with their accumulated nest egg and say: “Please give me an income for life.”

So, this is the desafío de la renta vitalicia (annuity puzzle, very loosely translated) that placed me in Santiago at the behest of the Chilean government. Why do so many Chileans buy life annuities? Is it something they put in all those pisco sours?

Some Background

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.

The value of the account grows with time and age, but obviously varies depending on the particular funds selected, asset allocation, etc. As with everyone else, the 2008-09 global financial crises adversely affected Chileans’ account values—especially those participants who allocated to equities—but the Chilean economy has grown at a very impressive pace, of late. And, like so many home-biased investors all over the world, the majority of these individual accounts are allocated to stocks and bonds in—you guessed it—Chile and many copper companies.

Also, unlike for the Greeks, Spaniards and Portuguese, for example, this bias didn’t bite them.

The Chilean Pension Model, as it is called, has been exported to a number of other Latin American countries in the region—much to the Chileans’ pride and delight. Similar models have been implemented in much larger countries such as Mexico, Peru, Colombia and even Argentina (until the government in Buenos Aires absconded with the money a few years ago, but that is a story for another column).

Retirement Time

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. It is no surprise that many international insurance companies have been setting up shop in Santiago, as more and more Chileans reach retirement.

This 65% rate of annuitization is quite puzzling, when contrasted with a 5% rate (at best) in the U.S. So, in an odd twist of fate that might only happen south of the equator, I—your humble correspondent and annuity uber advocate—was approached by economists within the Chilean Superintendent of Pensions: “We worry that the annuitization rate might be too high. How do we make systematic withdrawals plans (SWiPs) more appealing to Chileans?”

You see, some regulators are getting concerned that over 85% of insurance industry reserves are linked to life annuity liabilities, while the other 15% is in life insurance liabilities. Most companies don’t use reinsurance, which means that this lopsidedness exposes the industry to a unique type of longevity risk. What if Chileans live longer than projected by the actuaries? And, to be honest, after having spent a week in charming Santiago, I wouldn’t be surprised if their tranquil lifestyle produces a disproportionate number of centenarians.

Some Want More

Without getting too caught-up in the political minutia, my sense was that not all regulators were unhappy or concerned with the high levels of annuitization, and commensurate low level of SWiPs, especially given the sound actuarial economics of mortality credits. In their defense, insurance industry representatives claimed to be properly updating their mortality assumptions and carefully monitoring their balance sheet and risk exposure. When I asked them about capacity constraints, one executive said half-jokingly, infinity. (I’ve heard that one before.)

In fact, one cabinet-level minister contended that the SWiP option should be entirely abolished for lower- income retirees. Her words to me (loosely translated) were: “This group within society should not have their limited retirement income exposed to the vagaries of the stock and bond market, especially considering they have no more human capital remaining to extract.” She went on to proclaim: “Remember, the Modigliani lifecycle hypothesis indicates that annuities really dominate all other assets.”

Is this bordering on paternalistic? Perhaps. Although, I must confess that there is nothing sexier to an academic financial economist, than a lovely Latin cabinet minister who can quote Modigliani. I was smitten!

Puzzle Pieces

Getting back to the high rate of annuitization (puzzle) here are some reasons I might offer for why life annuities are so popular in Chile. In fact, I was fortunate enough to be able to observe some of the conversations and interactions between the soon-to-be retirees and the front-line tellers at the pension ministry where many people come for help. And, while these are more anecdotal than scientific, here it goes.

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. My view is that a proper retirement product allocation should include a mix of the two, and I think even Modigiani would agree! Why not annuitize 40%, 60% or 80% and then SWiP the rest? Or, annuitize slowly. Why are so many annuitizing all of their retirement account?

So now the insurance industry and regulators are working on designing and promoting novel combination products that allow for a more robust mix of annuities. They are working to make it easier to offer true advanced life delayed annuities (ALDAs), which is a decade-long and very quixotic undertaking of mine. In fact, some executives are proposing to “import those successful American-style GLWBs…” (Oh dear!)

Anyway, I’ll be back in 18 months to take another look.


It is difficult to sum-up the Chilean lesson in a pithy sound bite, so I offer a different egress. I encourage financial advisors to take any opportunity they have to experience how other countries and cultures go about generating a sustainable retirement income. The summer travel months are here. Perhaps spend one-less day on the tourist trail, and instead visit the local pension, retirement or superannuation office. (This is my brand of ecotourism.)

Now sure, the economics of retirement might not be up there in the pantheon of global concerns like climate change, poverty, or terrorism. But I can assure you that there comes an age at which you can translate and then ask this question into almost any language, and it will resonate. “Will your nest egg last as long as you will?”


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