Including variable annuities in a pension decumulation strategy: An international risk-return analysis

  • Jairo Andrés Rivera-Rozo Jairo Andrés Rivera-Rozo

From the international analysis of pension systems we conducted, it seems that in countries where the pensions structure and regulations offer a big share of secure pensions income, individuals take risks on their earnings-related pension income when they have the opportunity to do so. Variable annuities are a decumulation instrument that could satisfy the risk appetite for the group of retirees willing to take some risks on their pension income. They are a financial instrument that links the pension payouts to the returns of a group of assets chosen by the retirees. This type of annuities can give higher expected pension payouts to retirees than current decumulation strategies. However, these higher payouts in expectation will have a higher volatility. Given the risk-return tradeoffs inherent to the nature of this product, in this project we study how the relative added value of variable annuities develops during retirement and how it changes when they are introduced to different existing pension decumulation strategies. This relative added value is assessed using as the performance measure the ratio between the expected excess pension payouts obtained with a decumulation strategy that includes variable annuities and the volatility of these pension payouts. From our results, there are three important remarks that deserve the attention of those pension designers considering the use of variable annuities in their pension systems as well as the consideration of those individuals who see this financial instrument as an option to decumulate their pension assets. First, we find that the added value of variable annuities, both when they are the only decumulation instrument and when they are part of a group of instruments, tends to decline during the retirement period. Second, we find that if variable annuities are included replacing existing decumulation instruments in a proportional way in different pension systems, their added value is the same in all the countries, regardless of the differences in the initial compositions of the decumulation strategies. Finally, we find that choosing the underlying portfolio of variable annuities has an important effect on the initial levels and trends that the added value of variable annuities will have during retirement. In general, less risky underlying portfolios give a higher added value in the first years of retirement and a lower added value at advanced ages than riskier underlying portfolios.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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