The pricing of these guarantees is highly complex and reflects the cost of hedging, which in turn depends on the volatility of investment returns on the selected funds. Sudden, abrupt increases in volatility which occur at times of declining market prices and low liquidity cause a substantial increase in the cost of hedging and often force providers to suspend the offer of VPAs with guaranteed payout benefits.

**CREF and PPM unit-linked VPAs** raise even fewer regulatory issues on pricing policies, other than the paramount importance of transparency. The charges that are made for expenses and longevity changes need to be disclosed and to be supported by sound justification. In addition, any changes in the basic parameters, such as the AIR and the mortality tables, should be communicated to annuitants in a clear and comprehensible manner. The PPM unit-linked annuities as currently offered do not include guaranteed minimum benefits. This simplifies pricing and reserving decisions but transfers the investment risk to annuitants. The public or semi-public nature of the providers of these annuities implies a strong need for effective control of governance structures and a strong commitment to a high level of integrity.

# **5.2 The Regulation of Reserving Policies of Unit-Linked Annuities**

Reserving policies are very easy for the **PPM unit-linked annuities,** where the liabilities are always equal to the value of the remaining assets on each account. Since the providers bear neither investment nor longevity risk, there is no need for any supplementary reserves. Future benefits will be determined by the future value of assets. This is equivalent to projecting benefits by assuming that the RIR will be equal to the AIR and discounting future benefits by the AIR. Expected mortality is reflected in the annuity divisor that is used each year to calculate annual benefit payments. The counter side to all this is that annuitants bear the investment risk as well as the nondiversifiable component of the longevity risk.

Asset valuation is based on market prices and since the assets are invested in authorized mutual funds, they reflect the daily market prices (net asset values) of those funds. There could be some problems with the valuation of particular assets held by the various mutual funds, say holdings of mortgage-backed securities that have become illiquid. These could have an adverse effect on net asset values and could depress the benefits of annuitants but they would not require the setting aside of any reserves by either the managers of the affected mutual funds nor the Swedish Pensions Agency.

Broadly similar considerations apply to the case of the **CREF annuities** as well as the **standard unit-linked VPAs** without any guarantees. A main difference is that in the standard unit-linked VPAs the mortality risk is assumed by the providers. In addition to projecting future benefits at the AIR and the assumed mortality table and then discounting back to the present by the AIR, the providers are required to create a mortality fluctuation reserve to cover future deviations between observed and assumed mortality. This is usually a relatively small reserve because providers use conservative mortality tables and future deviations are unlikely to be very large.

In contrast, reserving policies for VPAs with guaranteed payout annuity floors (GPAFs) are highly complex. The offer of GPAFs transforms unit-linked VPAs from being one of the least risky annuities from the perspective of providers to one of the most risky. This is because a very large part of investment risk is borne by the providers rather than the annuitants as in the version 24