will still be alive 20 years after retirement and will suffer heavily from the decline in the real value of payments.

Fixed real annuities avoid this problem but may be more expensive than fixed nominal annuities. This may be due to two causes. First, real returns on inflation-linked bonds may be lower than those on nominal bonds because of the inflation protection that is provided to investors. The real return differential between nominal and real bonds can be seen as a premium for insuring against uncertain future inflation. However, empirical evidence on this point is inconclusive, probably because the inflation risk premium on nominal bonds is offset by a liquidity premium that burdens the less liquid inflationlinked bonds. Second, another reason why fixed real annuities may be more expensive relates to the absence in most countries of inflation-linked corporate and mortgage bonds.<sup>7</sup> In contrast, nominal annuities benefit from the ability of annuity providers to invest in corporate and mortgage bonds that offer higher returns than government bonds.

Fixed nominal annuities start with higher initial payments than other types of annuities. For this reason and despite their exposure to inflation risk, they appeal to workers with short life expectancy or to those who underestimate their longevity. In contrast, fixed real annuities start with lower initial payments that increase over time in line with inflation. Fixed real annuities appeal to people with long life expectancy and low levels of risk tolerance. This self-selection bias is reflected in annuity quotations of fixed nominal and real annuities.

The gap in monthly payments between nominal and real annuities depends on the differential between the _real yields_ on inflation-linked bonds and the _nominal yields_ on nominal bonds. Even with moderate inflation, the gap in monthly payments can be large. Data on quotations obtained from the website of the UK FSA show that initial monthly payments of fixed real annuities can be lower by 36 percent for single annuitants and by 42 percent for joint annuitants (see Annex A for further details). The gap also reflects differences in the life expectancy of the groups of people who select the different types of annuities.

# **Escalating and reserve currency annuities**

Escalating nominal annuities provide partial protection against inflation, depending on the rate of escalation (which is usually set at 3 or 5 percent) and the rate of inflation. If they increase at a rate that is higher than the rate of inflation they entail an increase in the real value of annuity payments and thus contribute to preserving the value of pensions relative to wages. However, escalating nominal annuity payments decline in real terms when the inflation rate exceeds the escalation rate.<sup>8</sup>

> 7 Chile is a notable exception in this respect (see below).

> 8 Escalating real annuities provide full protection against inflation and also allow for a gradual increase in the real value of pensions.  Their main disadvantage is that early payments are further reduced compared to fixed nominal annuities and are therefore even less attractive to people with short life expectancies.

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