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Tax Incentives for Annuitization – Direct and Indirect Effects

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Tax Incentives for Annuitization – Direct and Indirect Effects Alexander Kling*) Institut für Finanz- und Aktuarwissenschaften, Ulm, Germany phone: +49 731 5031242, fax: +49 731 5031239 [email protected] Andreas Richter Professor, Chair in Risk & Insurance Ludwig-Maximilians University Munich, Germany phone: +49 89 2180 3755, fax: +49 89 2180 993755 [email protected] Jochen Ruß Managing Partner Institut für Finanz- und Aktuarwissenschaften, Ulm, Germany phone: +49 731 5031233, fax: +49 731 5031239 [email protected] Abstract We analyze the financial consequences of tax incentives for annuitization from the perspective of the insured and the insurer. We model heterogeneity among the insured through a simple frailty model for the individual mortality. We find the critical frailty factor below which annuitization is optimal decreases signifi-cantly if tax incentives for annuitization are introduced. Analyzing a pool of insured, we find that tax incentives for annuitization all other things being equal result in a significant increase of the insurer’s profit since less healthy individuals also annuitize, i.e. adverse selection ef-fects become smaller. However, the problem that different insured get a different value for money is even increased by tax incentives. If so-called enhanced annuities, i.e. products where the annuity is the higher, the shorter the insured’s estimated life expectancy, are introduced, the percentage of insured who should annuitize further increases, adverse selection is further reduced and everybody gets a similar value for money from annuitizing. However, the first of the three effects is only present if the quality of the underwriting is rather high. *) Contact Author11 Introduction In many countries tax incentives exist for annuitizing benefits from an old age provi-sion contract. In Germany, for instance, since 2005 a strong tax incentive for annuitizing money that has been accumulated inside an insurance contract has been introduced: if the benefit from an insurance contract is received as one or several lump sums, then depending on certain criteria, either 50% or 100% of the difference between benefits received and pre-miums paid have to be taxed. If, however, the benefit is converted into a lifelong annuity, then only the so-called taxable portion of each annuity is taxed. The taxable portion is given in the German income tax law and depends only on the insured’s age when the annuity payments start. For instance if the annuity payments start at age 65, then 18% of each annu-ity received have to be taxed at the beneficiary’s individual income tax rate. This taxable por-tion is a rather rough and simplified approximation for the earnings after the annuity pay-ments start, assuming, e.g., that a certain fixed rate of interest is credited to the policy re-serves each year and that everybody lives exactly to their life expectancy (cf. e.g. Richter and Ruß (2002)). For immediate annuities, this means that taxes are paid on an approxima-tion for the earnings received from the policy. For deferred contracts, however, this means that essentially all earnings from the accumulation phase are tax-free if the contract is an-nuitized. Similar tax privileges for annuitization hold in many other countries, as well (cf. e.g. Charupat and Milevsky 2001 for the situation in Canada). There are, of course, several reasons why the government may choose to provide tax incentives for annuitization. Primarily, such incentives are implemented in order to encourage individuals to hedge against the risk of outliving their money. Particularly at times where in many countries benefits from state funded pension systems are being reduced, these incen-tives seem to be necessary in order to stipulate demand. Whereas empirical studies seem to confirm that the money’s worth of an annuity in many situations is typically high enough to make purchasing this product attractive for an individual (see, e.g. Mitchell et al. (1999) or James and Song (2001)), real world markets so far show surprisingly little demand for annui-ties. Reasons for this, as discussed in the literature, include adverse selection (see for in-stance Finkelstein and Poterba (2004)), bequest motives (see e.g. Bernheim (1991)), pre-cautionary savings for compensating income risk by factors such as health problems (see Strawczynski (1999)), and inner-family risk-sharing (Kotlikoff and Spivak (1981)). Whilst tax incentives are a suitable means to stipulate demand for annuities, in mar-kets where only standard annuities (as opposed to enhanced or impaired annuities) exist, there may also be undesired effects. In standard annuities, the annuity providers calculate the annuity than can be paid out for a given premium with average mortality rates. Thus, the ratio of invested premium and lifelong annuity depends only on age and gender but not on the individual health condition of the insured. Therefore, an annuity contract that may be2priced at an actuarially fair rate for a certain average individual may be rather unattractive for a person with medical impairments and rather attractive for a very healthy person. As a con-sequence, such standard annuities provide a good value for money only for people with at or above average life expectancy. With enhanced or impaired annuities, insurers attempt to offer the same value for money to all clients: At the start of the contract for immediate annui-ties or at the end of the accumulation period for deferred annuities, the condition of the in-sured is assessed by some form of individual underwriting. The underwriting results are con-verted into individual mortality probabilities that are then used in the pricing of the annuity contract. Thus, the resulting annuity is the higher, the shorter the life insurer’s estimate for the insured’s life expectancy. In the absence of both, tax incentives for annuitization and enhanced annuities, the majority of people with below average life expectancy would choose not to annuitize their contract at the end of the deferment period. This is also consistent with observations made in many insurance markets: People who own an annuity contract in the annuity payout phase have significantly lower mortality rates than the average population. In the presence of enhanced annuities, at least in theory (i.e. if the underwriting is as-sumed to be perfect), everybody should receive the same value for money when taking out an


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