The Political Economy of Government-Issued Longevity Bonds

ABSTRACT This article explores the trade-offs associated with government issuance of longevity bonds as a way of stimulating private annuity supply in the presence of aggregate mortality risk. We provide new calculations suggesting a 5 percent chance that aggregate mortality risk could ex post raise annuity costs for private insurers by as much as 5-10 percentage points, with the most likely effect based on historical patterns toward the lower end of that range. While we suspect that aggregate mortality risk does exert some upward pressure on annuity prices, evidence from private market pricing suggests that, to the extent that private insurers are accurately pricing this risk, the effect is less than 5 percentage points. We discuss ways that the private market can spread this risk, while emphasizing that the government has the unique ability to spread aggregate risk across generations. We note factors that might hamper such an efficient allocation of risk, including potential political incentives for the government to shift more than the optimal amount of risk onto future generations, and the possibility that government fiscal policy might allocate risk less efficiently within each generation than would private markets. We also discuss how large-scale longevity bond issuance might affect government borrowing costs, as well as political economy aspects of how the proceeds from such a bond issuance might be used. INTRODUCTION The provision of longevity insurance is a central function of governments around the world, as evidenced by the large share of public expenditures dedicated to public defined benefit pension systems. In most developed nations, the national government provides pension benefits in the form of annuities, which provide individuals with insurance against outliving their resources. At least since Yaari's (1965) seminal article, it has been known that the theoretical welfare gains to providing individuals with access to annuities are substantial. These gains arise because annuities provide risk averse individuals with a guaranteed lifelong income stream that lasts for as long as the annuitant survives, thus enhancing consumption smoothing by eliminating the individual's mortality risk as a significant source of financial uncertainty. Despite the potential welfare gains from annuitization, the private annuity markets in many countries, including the United States, are not well developed, and a large literature has developed to explore the reasons why this is so. (1) Indeed, the potential "failure" of private annuity markets is often listed as one of several leading rationales for why government intervention in the retirement income market is potentially welfare enhancing. While there are many possible reasons that the annuity market is small, including both rational and behavioral explanations, the private annuity market failure that is most commonly discussed in the literature is adverse selection. There is ample evidence that individuals who purchase private annuity contracts live longer, on average, than individuals who do not, and that this longevity differential leads private insurers to charge higher prices for annuities than they would in the absence of this selection effect (Mitchell et al., 1999). Adverse selection is a form of market failure that can, in principle, be addressed through government intervention. That is, if the government required that individuals annuitize part of their savings, individuals with lower-than-average life expectancies would be forced into the market, thus eliminating the information-based selection effects. Importantly, the government need not be the annuity provider in this scenario; instead, the government must simply use its power of compulsion to force individuals into annuity arrangements. Even if adverse selection were adequately addressed through government intervention, however, another potential market failure is not solved simply by mandating that individuals annuitize. …