Value for Money and Prudential Regulation of Annuities
A lifetime annuity is an insurance product that an individual purchases, typically around retirement, from an insurance company. The individual exchanges a lump sum of wealth (the premium) for a regular income stream for the remainder of his or her life. This exchange insures the individual against longevity risk; that risk is pooled by the insurance company by selling the same product to individuals who will die at different ages. We can assess the VfM of this exchange using the MW metric (Mitchell et al. 1999), which is defined as the ratio of the expected value of future annuity payments to the premium that was paid. Finkelstein and Poterba (2002) and Cannon and Tonks (2004) have estimated the MW of lifetime annuities in the United Kingdom.
Cannon and Tonks (2016) provide time-series estimates of the MW of lifetime annuities in the United Kingdom’s compulsory purchase market, which was the largest annuity market in the world from 1994 to 2012. They report MW by age (see figure 1), by gender, and by product type (for level, real, and escalating annuities, discussed next). Cannon and Tonks (2016) start by considering level annuities, which pay a constant nominal income for life. Summarizing one of their main results, they find that, over the whole sample, level annuities for men aged 65 had an average MW of 0.935, which is extremely high for an insurance product.