# **1. Introduction**

## **1.1 Regulatory Challenge**<sup>**1**</sup>

<mark>This paper discusses the mechanics and regulation of participating and unit-linked variable payout annuities (VPAs). These annuities offer benefits that are not fixed in either nominal or real terms but depend on the performance of the fund or funds in which the underlying reserve assets are invested, their profit sharing features, and the treatment of longevity risk.</mark> <mark>The basic motivation for writing the paper stems from the realization that all retirement products have their strong points but also suffer from serious shortcomings. Hence, policymakers may well favor a combination of payout options, covering different products at a particular point in time as well as different payout options over time.</mark><sup>2</sup> <mark>Variable payout annuities may play an important part in the retirement markets of some countries.</mark> All types of retirement products have strong and weak points. Fixed real annuities protect against longevity, investment and inflation risks but require access to an ample supply of inflationindexed securities, issued by both the public and private sectors, to enable providers to hedge their risks in an economically effective way.<sup>3</sup> Absent such hedging instruments, the cost of providing fixed real annuities would be prohibitively high. For their part, fixed nominal annuities provide protection against longevity and investment risks but are exposed to inflation risk and thus fail to provide adequate protection, especially to long-lived individuals. In addition, fixed annuities, real or nominal, are exposed to annuitization risk, i.e., the risk of annuitizing at an inopportune time when financial markets are depressed and the cost of fixed annuities is high.

Variable participating and unit-linked annuities have their own advantages and shortcomings. They protect against longevity risk and allow for some participation in the higher (and more volatile) returns of corporate equities and other real assets. As a result, they offer greater flexibility and potential for higher benefits. They also avoid the annuitization risk because their benefit payments vary with investment performance and are not fully determined by the prevailing conditions at the time of retirement. But VPAs are exposed to investment and inflation risks, are more complex to design and regulate than fixed annuities, and may suffer from much higher charges. They require a high level of integrity and meaningful transparency on the part of providers to ensure the fair treatment of annuitants and raise difficult regulatory and supervisory

> 1 In preparing this paper I benefited from extensive comments offered by Mark Fowler, actuary consultant, and from the assistance of Lars Billberg, Chief Actuary of the Swedish Pensions Agency, who provided detailed data and commentary on the operational aspects of PPM annuities. I am also indebted to John Ashcroft, Gregorio Impavido, Estelle James, Don McIsaac, Moshe Milevsky, John Pollner, Roberto Rocha, Heinz Rudolph, and Anita Schwarz for their insightful comments. Officials of several European regulatory agencies clarified some points of detail, while a group of actuaries linked to the International Actuarial Association provided some very helpful comments. The usual disclaimer applies.

> 2 This point is underscored in Rocha and Vittas (2010), a paper that addresses the policy issues, constraints and options in designing the payout phase of pension systems.

> 3 Over the past few decades many OECD countries have expanded the supply of inflation-protected government bonds but Chile is a rare exception of a country where private sector long-term corporate and mortgage bonds are also linked to inflation.

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