1.6 It should perhaps be pointed out that this paper does not address the so-called 'annuity puzzle'. It accepts the view that the historically weak demand for voluntary annuities should primarily be attributed to the presence of social security and company pensions. Other possible factors include the strength of the bequest motive, the tendency of most individuals to underestimate their longevity, the lack of liquidity and flexibility of annuity products, and the irreversibility of annuity decisions. Life insurance business has been able to flourish in countries with well regulated markets, partly because when they purchase life insurance policies, consumers agree to make small periodic payments and receive the accumulated capital when policies mature or their families are protected in case of premature death. But in the case of annuities, consumers have to part with large capital sums for a stream of future income. This is a more difficult decision to make and requires much greater confidence that the decision is correct.<sup>7</sup> Because most annuity contracts, especially fixed nominal or real life annuities, are long-term contracts that are neither revocable nor transferable by the annuitants, sufficient trust in the integrity and solvency of the chosen company becomes far more important than in the case of life insurance business.

1.7 Another reason that is often underscored in economic studies of annuity markets is the possibility of adverse selection whereby people with impaired health withdraw from the annuity market, resulting in more expensive annuities for healthy annuitants. The increase in the cost of annuities causes more people to withdraw from the market, resulting in a further increase in annuity prices and eventual market failure.

1.8 However, the role of adverse selection in explaining the underdevelopment of voluntary annuity markets is often overstated. After all, risk classification and risk-based insurance premiums are widely used and have been fully accepted in several lines of insurance business, such as home, motor and, especially, life insurance, where people with impaired health are charged higher premiums. There is no reason why risk-based premiums should not or would not also be accepted in annuity business. In fact, insurance companies in several countries have already started to offer special annuities with lower risk premiums that are targeted to people with impaired health.<sup>8</sup>

1.9 The view embraced in this paper is that as the level of social security and company pensions is reduced, the demand for life annuities and phased withdrawals will increase. Policymakers need to recognize the shortcomings of current products, address the challenging regulatory issues of organizing robust and transparent annuity markets, and promote combinations of products and payout options.

> 7 Hu and Scott (2007) address behavioral obstacles to the annuity market, drawing on recent advances in behavioral finance.

> 8 James and Vittas (2000) list 10 reasons for the underdevelopment of voluntary annuity markets.  Adverse selection is one of them and far from the most important. More recently, Babbel and Merrill (2006) also underscore the multiplicity of factors that have held back the growth of annuity markets.

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