system of non-employer-based individual accounts, a central register of performance data is indispensable.

# **Switching rules and exit fees**

Switching of annuity contracts is an option that is not traditionally offered to annuitants (see Box 2). Granting a switching right to annuitants creates two complex pricing issues. The first concerns the right of annuity providers to levy an explicit exit fee. The second concerns the valuation of portable balances, which may itself entail an implicit exit fee. The regulatory authorities would need to set clear rules on the imposition of explicit exit fees. They would also need to develop a methodology for the valuation of portable balances. The latter would not present major difficulties in the case of variable annuities without any minimum guaranteed benefits. But for fixed annuities and for the minimum guaranteed benefits of variable annuities, the rules would have to allow for the potentially adverse impact of switching on the longevity risk of the remaining pool of annuitants.

## **Box 2. Switching of Annuity Providers: Feasibility and Fairness**

In traditional life annuities, switching annuity provider is not permitted. Life annuities are irrevocable and nonportable contracts. The irreversibility of annuity contracts is justified by the pricing of annuities, which is based on the projected life expectancy of the pool of annuitants at the time the contracts are issued. A loss of a contract because of switching or outright cancellation will upset the actuarial calculations of insurance companies. If the annuitants who wish to cancel a contract or switch provider are those who are diagnosed with serious illness after purchasing their contract, the average life expectancy of the remaining pool of annuitants will be longer, potentially causing large losses for insurers.

If contract switching or cancellation is allowed, annuity providers have three options for avoiding these losses. First, in calculating the value of the refund or of the portable balances they can deduct a fair estimate of the potential marginal losses from the switching or cancellation of the particular contract. This will presumably be based on the life expectancy of the pool of annuitants before and after the loss of this contract. Second, annuity providers can use statistical models to estimate the probability of serious illness among their clients and adjust their prices accordingly before issuing their annuity contracts. And, third, they can retain the right to renegotiate all existing annuity contracts.

The complexity of these calculations probably explains the traditional irreversibility of annuity contracts. However, this system is unfair on people who are diagnosed with a serious illness a few years after purchasing an annuity. Allowing switching or cancellation of annuity contracts will remove this unfairness but will also run the risk of opening the annuity market to expensive marketing campaigns that target annuitants suffering from serious illnesses.

One potentially effective way to address this issue is to centralize account administration and longevity insurance but retain decentralized asset management. The centralization of longevity insurance will allow the creation of two distinct pools of annuitants: one pool will cover those who have been diagnosed with serious illness; and the other for all the rest. Joining the first pool can be permitted both at the time of retirement and at a later time, say within the first ten years after retirement, if a person is subsequently diagnosed with serious illness. This system will work better in the case of variable annuities, where annuitants share in the longevity risk of annual bonuses, but it can also work in the case of fixed annuities, provided the latter can be adjusted for the impact of subsequent switching of annuitants with seriously impaired health.

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