Overhaul Needed

India’s annuities market is riddled with issues

On the surface, the Indian pension system has all the ideal elements. It includes a voluntary social security program aimed at the unorganized sector; an earnings-related employee pension scheme; a defined-contribution employee provident fund; and supplementary employer-managed schemes that are largely defined-contribution, comprising superannuation funds and the National Pension Scheme.

But the reality is not quite so ideal. The 2019 Melbourne Mercer Global Pension study of 37 retirement income systems gave the Indian pension system a “D” grade. Where the issue with developed economies is one of sustainability (high debt-to-gross domestic product, under-funded pensions, poor savings rates), the problem in India is also one of coverage and adequacy.

Only 7.4% of India’s working-age population is covered under a pension program compared to 46% in China, 53% in Korea, and 85% in Japan, according to the World Economic Forum’s 2017 Global Human Capital Report.

I will focus on just one of the many issues in the Indian pension system – the annuity market.

Low rate environment

Annuities are an important component of any retirement strategy. It’s the oldest and the only widely available financial instrument that insures against longevity risk. Annuity rates are usually more attractive than the long-term bonds they are often compared to, partly because they represent a return of capital, and partly because of the so-called mortality premium – in other words, people who die sooner subsidize those who live longer.

Critics cite annuities’ unattractiveness in a low-interest environment. But researchers argue that annuities could substitute for the fixed income portion of a balanced portfolio in retirement even in a low-interest environment, supporting a higher equity allocation and resulting in better overall efficiency. And as countries, including India, shift away from defined-benefit to defined-contribution schemes, annuities provide a vital link for ensuring retirement income security.

Providers face challenges

Indian annuity rates are barely higher than long-term sovereign bond yields. On top of this, most retirees choose the option of a joint-life annuity with return of premium at death, reducing the effect of the mortality premium and making it, in effect, a bond. The perceived unattractiveness does not deter robust competition in the marketplace, with at least seven annuity service providers competing for the retirement corpus.

Annuity rates are unattractive because of a lack of robust mortality data, issues in the fixed income market, and other factors such as taxation and the cost of doing business.

• Mortality Data

Mortality data is a key input in the calculation of annuity rates. If mortality data is representative of the annuitant population, the providers are in a better position to price them.

In India, the most recent mortality rates published are based on the insurance population rather than one specifically built on annuitants. But the profiles of the two segments may be different. For example, the insurance pool is likely skewed towards the segment of the population that has more health issues, while the annuitant pool may be healthier than average. This may lead to under-pricing of longevity risk for healthy annuitants to the detriment of annuity providers.

The available data for annuitants is more than a decade old, and reflects the experience of one insurer, the Life Insurance Corporation of India, and isn’t representative of the population in general.

Internationally, annuity providers offer differentiated products such as enhanced annuities, which pay a higher income for people with high mortality risk, including obesity, smoking, or even living in high-pollution areas. Product innovation requires good baseline mortality data covering various segments, and continued investments are needed in this area.

• Fixed income market

The efficient and competitive pricing of annuities depends in large part on the risk management toolkit available to providers. Annuities are long-term contracts that are interest-rate–sensitive, which make asset-liability management crucial.

Indian government bonds with maturities greater than 30 years, which have a similar duration to a life annuity with return of premium option, represent 4% or 2.3 trillion rupees (US$13.09 billion) of the total outstanding issuance. The corporate bond market is not deep, and its maturity only goes up to 10 years. On the asset side, the National Pension Scheme corpus stood at 3.8 trillion rupees at the end of 2019 and growing strongly.

While the weighted average maturity of Indian government debt has been increasing in recent years with the introduction of 40-year bonds in 2016, a higher level of longer-dated issuance is needed to ensure a liquid, long-dated yield curve, which will, in turn, support a robust annuity market. Otherwise, annuity providers are forced to use short-term bonds, which expose them to reinvestment risk.

A poor asset-liability management mismatch leads to higher capital requirements, higher margins (lower rates) to offset adverse deviations in liabilities, and deferment of profits.

As India continues to modernize its economy with massive investments in infrastructure with long gestation periods, greater issuance of long-dated bonds benefits the country on both the asset and the liability front.

Lastly, there are no zero-coupon bonds, which are an efficient instrument for cash flow hedging. Market participants could use interest rate strips, but these are expensive to create. The introduction of zero-coupon bonds would also aid further development of annuities.

• Taxation

The tax treatment of annuities further reduces its attractiveness. In most jurisdictions, only a certain portion of annuity payments, deemed as income, is taxed. But in India, the entire annuity payment, including the portion that is simply a return of capital, is taxed as income.

This puts them at a disadvantage against other financial instruments used by retirees, such as fixed deposits where only the interest is taxed. A fairer tax regime that puts annuities on par with competing for financial instruments would help improve its attractiveness.

Regulator mulls options

In response to opposition by pension fund subscribers to compulsory annuitisation at retirement, the Pension Fund Regulatory Development Authority of India said in February that it’s exploring offering two additional choices: a systematic withdrawal option and variable annuity plans.

A systematic withdrawal plan may prove to be a popular alternative, but, without adequate safeguards, it puts the risk of managing decumulation back into the hands of annuitants.

Variable annuity plans may appeal to some, but they are not an answer to the systemic issues faced by annuity providers. While we understand pensioners should not be forced to annuitise when the prevailing choices are unappealing, given its importance, the focus should be on making them function better rather than on workarounds.

Bill Sharpe, the father of modern finance, once described retirement finance as the most daunting topic he had ever worked on. The issues in India are pressing and demand thoughtful solutions. Tackling challenges in annuities, a critical component in any well-functioning retirement system, would be a good place to start.

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