oversight

Social Security Reform: Implications of Private Annuities for Individual Accounts

Published by the Government Accountability Office on 1999-07-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                  United States General Accounting Office

GAO               Report to the Ranking Minority Member,
                  Committee on Ways and Means, House
                  of Representatives


July 1999
                  SOCIAL SECURITY
                  REFORM
                  Implications of Private
                  Annuities for Individual
                  Accounts




GAO/HEHS-99-160
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Health, Education, and
      Human Services Division

      B-282223

      July 30, 1999

      The Honorable Charles B. Rangel
      Ranking Minority Member
      Committee on Ways and Means
      House of Representatives

      Dear Mr. Rangel:

      Social Security serves as the foundation of our retirement income system,
      providing benefits to workers and their eligible spouses, children, and
      survivors.1 In 1998, the Social Security program provided $265 billion in
      retirement benefits to about 31 million individuals and their dependents.
      Currently, 148 million workers contribute to the program in anticipation of
      future benefits. While Social Security has successfully provided retirement
      income to millions of Americans, the program faces significant future
      financial problems because of demographic changes, including the aging
      of the baby boom generation and increased life expectancy.

      Many options exist for restoring the long-term solvency of the Social
      Security program. Some proposed options include creating individual
      retirement accounts, wherein participants would own and, to varying
      degrees, manage their accounts. Benefits they received from their
      accounts would generally be linked to the amount of their contributions
      and their account investment returns. Individual accounts offer the
      potential of higher rates of return by investing in stocks and bonds than
      the implicit rate of return workers receive on their Social Security
      contributions. However, individuals would also face certain investment
      risks that could affect the security of their retirement income.2 Another
      concern about such proposals is how the accounts would be paid out at
      retirement. We recently issued two reports that provide information on the
      issues to consider when designing and implementing a system of
      individual accounts.3

      Some Social Security reform proposals would require individuals to
      purchase annuities at retirement with their individual account balances to

      1
      The Disability Insurance portion of the Social Security program provides benefits for disabled
      workers and their dependents.
      2
       In a forthcoming report, we will discuss the difficulties in comparing the rates of return for the
      current Social Security program and private market investments.
      3
       Social Security Reform: Implementation Issues for Individual Accounts (GAO/HEHS-99-122, June 18,
      1999) and Social Security Reform: Administrative Costs for Individual Accounts Depend on System
      Design (GAO/HEHS-99-131, June 18, 1999).



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                   ensure that retirees do not outlive the income from their accounts.4 To
                   better understand the potential effects such proposals could have on
                   retirement income, you asked us to (1) determine the effect individual
                   Social Security accounts might have on the existing annuities market,
                   (2) discuss factors that affect the amount of annuity payments, and
                   (3) discuss the potential role of the federal government in regulating the
                   annuities market if individual accounts were established.

                   We conducted our work between December 1998 and July 1999 in
                   accordance with generally accepted government auditing standards. (See
                   app. I for information on our scope and methodology.)


                   The private annuities market could likely provide annuities from individual
Results in Brief   accounts without significantly disrupting the market. Our work shows that
                   the current annuities market has grown over the last 2 decades, with
                   premium payments for annuity purchases increasing from $22.4 billion in
                   1980 to over $197 billion in 1997. Furthermore, the amount of
                   annuity-related reserves—funds set aside by insurers, as required by
                   states, to pay future claims—increased from about $172 billion to over $1.4
                   trillion during the same period. Initially, payouts (when workers retire and
                   begin drawing on their individual accounts) would be small because most
                   retiring workers would not have built up substantial account balances
                   before retirement. If contributions to accounts were based on as much as
                   5 percent of earnings, it could take 20 years before the account balances
                   being converted into annuities in a year would equal the current annuity
                   purchases. If account balances were based on contributions of 2 percent
                   of earnings, it could take over 50 years before the annual amounts being
                   converted into annuities would equal the amount of current annuity
                   purchases. While the size of the annuities market would significantly
                   increase as a result of new annuity purchases, these purchases would be
                   phased in over a number of decades, because in the initial years, few
                   workers would have substantial savings in their individual accounts when
                   they retired. This phase-in period would give insurance companies and the
                   annuities market considerable time to adjust to the increasing amount of
                   annuity purchases. However, according to the Society of Actuaries, some
                   insurers may not offer annuities for individual Social Security accounts
                   because meeting current reserve requirements could strain their financial
                   resources.


                   4
                    An annuity is an insurance product that provides a stream of payments for a pre-established amount
                   of time in return for a premium payment—the amount being converted into an annuity. For example, a
                   life annuity provides payments for as long as the annuitant lives.



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Income from annuities based on individual accounts would depend on
account balances, interest rates, current and projected annual mortality
rates, and administrative and other costs charged by annuity providers at
the time individuals retire. Individuals with small account balances would
likely have difficulty obtaining individual annuities because of the
relatively high cost of annuitizing a small account balance; if they were to
receive annuitized monthly payments, these payments would be small.
Because interest rates fluctuate over time, the date individuals purchase
annuities can also significantly affect their annuity income. For example,
an individual with a $100,000 account balance would receive, assuming no
administrative or other expenses, about $810 a month if the interest rate
were 6 percent and about $910 per month if the interest rate were
7.5 percent—about a 12 percent higher payment. A reduction in expected
mortality rates for retirees would also result in smaller annuity payments
because the purchase price of the annuity must provide for a larger
number of monthly payments. Finally, administrative and other costs for
individual annuities currently can amount to as much as 15 percent of the
amount being converted into an annuity. The effects of these factors on
annuity income could be mitigated if all retirees were required to purchase
annuities, the types of annuities individuals could purchase were limited,
or group annuities were purchased. However, private annuities would not
be able to provide certain Social Security features, such as fully indexed
cost of living increases, without reducing initial monthly annuity payments
to retirees.

Privately annuitizing individual accounts could also have important
consequences for the existing federal-state structure of insurance
regulation. The federal government’s role in regulating annuities is
currently limited; under a system of individual accounts, this role could
significantly expand. States have primary responsibility for regulating the
annuities market under their longstanding authority to regulate the
insurance industry. Each state develops its own laws and regulations
regarding the insurance industry’s operations, including the development
and sale of annuities as well as the protections afforded to annuitants.
Individual state guaranty associations are responsible for the guarantee of
annuities in the event of insurer insolvency. If payouts from individual
accounts were to increase the size of the annuities market, policymakers
would need to reevaluate the current regulatory framework for the
insurance industry to ensure uniform protection for retirees’ annuity
income.




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                 Only insurance companies can underwrite annuities in the United States.
Background       Other financial intermediaries, such as banks and stock brokerage firms,
                 may sell annuities issued by insurance companies. Annuities purchased by
                 individuals directly from insurance companies or through brokers or
                 agents are termed individual annuities while those purchased through
                 group master contracts are termed group annuities. Group master
                 contracts are usually issued to employers for the benefit of employees, and
                 individual members of the group hold certificates as evidence of their
                 annuity. For example, federal employees who participate in the Federal
                 Thrift Savings Plan may, upon retirement, purchase an annuity with their
                 thrift savings account balances through a contract between the Federal
                 Retirement Thrift Investment Board and Metropolitan Life Insurance
                 Company.

                 Insurance companies determine the size of an annuity that can be
                 purchased for a given premium payment using assumptions about a
                 number of variables, including the following:5

             •   Interest Rates. The assumed interest rate is used to discount projected
                 payments and costs back to the annuity purchase date. The rate should
                 reflect current rates available in the capital markets, adjusted to produce
                 the insurer’s target level of profits desired from the annuity.
             •   Mortality Rates. The assumed mortality rate reflects death rates associated
                 with known or assumed characteristics of the annuitant population, with
                 some adjustments to account for future potential improvements in
                 mortality. There are a number of published tables available for pricing
                 annuity products.6 For example, the Society of Actuaries published the
                 Annuity 2000 mortality tables for valuing individual annuities for
                 establishing reserves—funds set aside by insurers to pay future claims.
                 These tables, or adjustments to the tables, are sometimes used for pricing
                 individual annuities. In the private market, separate mortality rate tables
                 are generally used for men and women, reflecting the lower mortality rates
                 of females. However, federal law requires employers to use combined
                 male and female mortality rates, termed “unisex rates,” for annuities
                 purchased by employer-sponsored pension plans.
             •   Administrative Expenses, Sales Costs, Taxes, and Other Costs.
                 Administrative charges for annuities, known as expense loads, are


                 5
                  John L. Santoloci, Pricing and Product Development for Income Annuities (Society of Actuaries,
                 1993).
                 6
                  Mortality tables show, for hypothetical groups of individuals, the number of individuals surviving at
                 each age and the number of individuals dying and the probability of dying within 1 year of reaching a
                 designated age.



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included in the pricing formula. Commissions paid to agents and brokers
for explaining and selling annuities are payable at issuance of the annuity,
and some states charge premium taxes.

Insurance companies offer several premium payment options. Immediate
annuities are purchased with a single premium payment and usually begin
making payments 1 month after the annuity is purchased. Premiums for
deferred annuities are usually paid over several years. At the time the
contract holder wishes to access the deferred annuity cash value, usually
at retirement, one of three options might be selected: (1) lump-sum
distribution, (2) annuitization, or (3) systematic withdrawals.

Insurance companies also offer several annuitization options. For
example, monthly income can be a fixed amount per month (fixed
annuity); a steadily increasing amount based on an index, such as the
Consumer Price Index (indexed annuity); or a variable amount based on
returns from investing the premium (variable annuity). Under a single-life
annuity, the annuitant receives a guaranteed stream of payments that end
with the annuitant’s death. Under a joint-life annuity, the payments
continue to be made, sometimes at a reduced rate, to a secondary
annuitant on the death of the primary annuitant. For a term-certain
annuity, payments are not contingent on the annuitant’s life; instead, they
are guaranteed for a specified period of time, such as 5 or 10 years.

Although regulation of the insurance industry is generally a state
responsibility, several federal agencies play a role in regulating annuities.
The McCarran-Ferguson Act, enacted in 1945 to preserve the traditional
state regulation of the insurance industry, precludes the application of
federal statutes to the business of insurance, unless they specifically relate
to that business. The Employee Retirement Income Security Act of 1974
(ERISA), which regulates employee benefit plans, is a federal law that
specifically relates to insurance. Under ERISA, the Department of Labor
(DOL) and Pension Benefit Guaranty Corporation (PBGC) have issued
regulations and other guidance covering private employer-sponsored
pension plans.7 Additionally, variable annuities are regulated both as
insurance products by the states and as securities by the Securities and
Exchange Commission.




7
 PBGC is the federal agency that provides benefits for participants of insured-defined benefit plans
that terminate with insufficient assets to pay benefits.



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                                       Providing the annuities necessary to convert retirees’ individual account
Private Annuities                      accumulations into a stream of monthly income is unlikely to significantly
Market Can Likely                      disrupt the annuities market.8 As shown in table 1, total premiums (for
Provide Annuities for                  group and individual annuity purchases) paid to insurers increased from
                                       $22.4 billion in 1980 to $197.5 billion in 1997. Furthermore, the amount of
Individual Accounts                    annuity-related reserves increased more than eightfold—from about
                                       $172 billion to over $1.4 trillion—during the same period. The demand for
                                       annuities in a given year would depend on the number of retirees during
                                       the year, the amount of their individual account balances at retirement,
                                       and whether or not retirees are required to purchase an annuity on
                                       retirement. If a large portion of the population purchased annuities, these
                                       purchases could be phased in over a long period of time, thereby allowing
                                       insurance companies to make the necessary financial adjustments, such as
                                       finding sufficient investments to fund their annuity payment obligations.

Table 1: Growth in Annuity Premiums,
Annuitant Income, and Insurance                                                          Total payments to
Company Reserves Between 1940 and      Year                    Premiums paid                    annuitants                Policy reservesa
1997 (Dollars in Millions)             1940                                $386                          $176                              NA
                                       1960                                1,341                           830                       $19,279
                                       1980                              22,429                        10,195                        171,960
                                       1990                             129,064                        32,575                        797,923
                                       1997                             197,529                        55,080                      1,454,962
                                       a
                                           Funds set aside by insurance companies to pay policy obligations.

                                       Source: Life Insurance Fact Book, 1998, American Council of Life Insurance.



                                       The figures in table 1 for 1997 annuity activity include certain investment
                                       vehicles, such as deferred annuities, that are rarely annuitized but, instead,
                                       can be used as tax-deferred investments. In 1997, premium payments for
                                       immediate annuities (individual and group) were almost $48 billion or
                                       about 24 percent of all annuity premiums. According to the Society of
                                       Actuaries, immediate annuities usually have a different impact on
                                       insurance company reserves and surpluses than deferred annuities. Selling
                                       immediate annuities usually causes some strain on insurers’ reserves and
                                       surpluses. To the extent that increased annuity purchases strain the
                                       financial resources of some insurers, the likelihood of insurance company
                                       insolvency would increase and the ability of insurers to provide other
                                       types of products might be lessened.


                                       8
                                        For more information on the potential effects of individual accounts on the capital markets, see our
                                       report Social Security: Capital Markets and Educational Issues Associated With Individual Accounts
                                       (GAO/GGD-99-115, June 28, 1999).



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                                       Funds used to purchase annuities would likely result in a shift of funds
                                       among investment asset classes but would not represent a flow of new
                                       funds into the capital markets. During the working years (accumulation
                                       phase), workers’ contributions to their individual accounts would be
                                       invested in the capital markets. As workers transition into retirement, the
                                       allocation of investments among asset classes might change. For example,
                                       investments might be more heavily weighted in equities than in
                                       fixed-income assets during the accumulation phase. During the payout
                                       phase, investments might be more heavily weighted in fixed-income
                                       assets.

                                       Under some individual account proposals, it could be many years before
                                       the annual amount of account balances being converted to annuities
                                       would equal the amount of current annuity purchases. Two reform
                                       proposals by the 1994-1996 Advisory Council on Social Security illustrate
                                       this point. (See table 2.) One proposal would require mandatory
                                       contributions of 1.6 percent covered payroll to individual accounts, and
                                       the other would require contributions of 5 percent. One proposal would
                                       also require the purchase of annuities, while the other would permit but
                                       not require the purchase of annuities on retirement. Both proposals
                                       assumed implementation would occur in 1998.

Table 2: Two Proposals by the
1994-1996 Advisory Council on Social                                                                            Proposal 1 Proposal 2
Security for Reforming Individual      Mandatory contributions (percentage of payroll)                                   1.6%            5.0%
Accounts
                                       Year distributions could begin                                                  2000            2005
                                       Total distributions in beginning year (billions in 1998 dollars)                 $2.9          $37.5

                                       Under the 1.6-percent proposal, in the year 2000, retirement distributions
                                       from individual accounts would total about $2.9 billion, in 1998 dollars.
                                       Under the 5-percent proposal, distributions would have begun in 2005,
                                       because initial participation was limited to workers under age 55, but
                                       would start at a higher amount, $37.5 billion.9 Under contributions of
                                       5 percent, it could take 20 years from when workers first retire with
                                       individual accounts before the annual amount of account balances being
                                       converted into annuities would approach the amount of current annuity
                                       purchases. Under contributions of 1.6 percent of payroll, it could take
                                       much longer—beyond the year 2050—before individual account


                                       9
                                        SSA estimates were based on intermediate assumptions in the 1995 Annual Report of the Board of
                                       Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. We
                                       converted the payroll amounts to 1998 constant year dollars using intermediate inflation assumptions
                                       in the 1998 trust fund report.



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                             accumulations being converted into annuities would approach the current
                             amount of annuity purchases.


                             The size of individual accounts, interest and mortality rates, and
Income From                  administrative and other costs all affect the amount of income provided by
Annuities Would              an annuity. While these costs could significantly reduce income from an
Depend on Several            annuity by reducing the amount of money available to fund the annuity,
                             options such as purchasing a group annuity for retirees or limiting
Factors                      individual annuity choices would further reduce them. However, private
                             annuities may not be able to provide fully-indexed cost-of-living increases
                             because insurers might not be able to find sufficient investments to
                             protect themselves from increases in inflation.


Account Size at Retirement   The level of income that individuals would receive from converting their
Is a Key Factor              account balances into annuities is primarily a function of the size of those
Determining Annuity          accounts at retirement. An individual’s account balance would depend on
                             various factors such as the amount of wages earned over the individual’s
Income                       working career, the percentage of those wages that are deposited into the
                             individual’s Social Security account, and investment earnings. Estimates of
                             individual account balances vary widely, but our estimates—based on
                             contributions of 2 percent of earnings and various administrative expenses
                             for setting up and maintaining the accounts—provide insight into how
                             much individual account savings retirees might have to purchase
                             annuities. For example, our simulation suggests that a man born in 1984
                             with average annual earnings who worked from age 22 to age 67 would
                             accumulate account balances of $75,995 if administrative expenses for
                             maintaining the account during accumulation were 2 percent annually, or
                             $125,430 if administrative expenses were 0.1 percent annually, in 1998
                             dollars. The same person opting for early retirement at age 62 would
                             accumulate $65,214 with a 2 percent annual administrative cost, or
                             $100,303 if expenses were 0.1 percent annually.10

                             Figure 1 shows the range of monthly annuities that individuals who
                             survive and retire at age 65 in the year 2000 could purchase, with
                             individual accounts ranging from $50,000 to $200,000 and annuity-related
                             expenses of 5 percent, 10 percent, and 15 percent. For example, an
                             individual with a $50,000 account balance, paying a 10-percent expense
                             load would receive a $370 monthly annuity while someone with a $100,000

                             10
                               See app. I for more information on the interest rates and assumptions used to estimate potential
                             individual account balances.



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                                     account balance, and the same expense load, would receive a $740
                                     monthly annuity. The monthly annuities assume an effective annual
                                     interest rate of 6 percent and unisex mortality rates.


Figure 1: Monthly Annuities for
Persons Retiring at Age 65 in 2000   $1,700   Monthly Annuity
With Account Balances Ranging From
$50,000 to $200,000 and Annuity
Expenses of 5, 10, and 15 Percent     1,500



                                      1,300


                                      1,000



                                       700



                                       500



                                       300


                                              $50,000                  $100,000                   $150,000                  $200,000
                                               Account Balance

                                                        5% Expenses

                                                        10% Expenses

                                                        15% Expenses



                                     Note: Annuity expenses are expressed as a percentage of the single premium. According to the
                                     Society of Actuaries, many insurance companies may set their expense loads partially as a
                                     percentage of premium, but also on a per policy basis, which could increase the disparity
                                     between those with low versus high account balances.

                                     Source: GAO calculations. (Our methodology and assumptions are described in app. I.)




                                     Individuals with small account balances at retirement could have difficulty
                                     purchasing individual annuities under current market conditions. They
                                     would receive smaller monthly annuity payments because of the amount
                                     of money in the account available to purchase an annuity, and they could
                                     pay a disproportionate amount of their account balance for annuity-related
                                     administrative costs, further reducing the amount available to fund their




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                          retirement income. Moreover, insurance industry officials told us that it
                          would be inefficient and costly for insurers to provide annuities for
                          individuals with small accounts because of the cost of issuing monthly
                          checks and other administrative costs. Many annuity purchases are
                          currently with premiums of at least $100,000; under some reform
                          proposals, there could be many small accounts with balances initially
                          under $2,000.

                          Insurance industry officials told us that it would be less costly and result
                          in higher annuity payments if individuals received a group annuity. This
                          could be accomplished either by having the government provide the
                          annuity through the Social Security Administration (SSA) or another
                          government agency, or through a contract with private insurers. For
                          example, insurance companies could competitively bid to provide group
                          annuities for people retiring over a certain period. People retiring during
                          this period would be provided an annuity under a master contract, rather
                          than on an individual basis. Such arrangements would enable individuals
                          with small account balances to access the annuities while reducing the
                          administrative and other costs they would pay. The extent to which group
                          annuities could take advantage of economies of scale and thus lower
                          administrative costs would depend, in part, on how the contracts were
                          structured and whether the federal government or annuity providers
                          would be responsible for administrative tasks such as maintaining records
                          and providing services to retirees, including explaining annuity options.


Low Interest Rate         Current and expected interest rate levels also affect the amount of
Assumption Would Result   monthly income individuals would receive from annuities. The most
in Lower Annuities        common way for insurance companies to invest premiums received from
                          the sale of annuities is to purchase corporate bonds, which typically offer
                          a higher rate of return than U.S. Treasury securities. Essentially, the
                          insurer pools the premiums and invests them by buying corporate bonds.11
                          Since interest rates fluctuate, the date that a person retires could
                          significantly affect the amount of monthly income that could be purchased
                          with a given premium payment. For example, as figure 2 shows, the yield
                          for 30-year U.S. Treasury notes varied from about 5 to 15 percent and the
                          yield for investment-grade corporate bonds varied from about 7 to
                          17 percent between February 1977 and 1999.




                          11
                            David Shapiro and Thomas F. Streiff, Annuities (Dearborn Financial Publishing, Inc., 1992).



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Figure 2: Yield for Investment-Grade
Corporate Bonds and 30-Year U.S.       20% Yield
Treasury Bonds Between 1977 and
1999

                                       15




                                       10




                                        5




                                        0



                                            1977            1981                1985           1989           1993          1997

                                                      Corporate Bonds

                                                      30-Year Treasury Bonds



                                       Source: Federal Reserve Board.




                                       Individuals purchasing annuities in the private market also face risk
                                       associated with the volatility in interest rates. As shown in figure 3, a
                                       change in the interest rate assumption used to price an annuity can have a
                                       significant effect on the size of an individual’s monthly annuity. For
                                       example, assuming a 6-percent interest rate and no administrative
                                       expenses, an individual purchasing a unisex annuity at age 65 in the year
                                       2000 with $100,000 would receive about $810 per month. Another
                                       individual with an equivalent account balance but who purchased an
                                       annuity during a period of higher interest rates, such as 7.5 percent, would
                                       receive about $910 per month—a 12-percent higher payment. Insurance
                                       company representatives told us that low current interest rates—and the
                                       resulting low monthly annuities—is one reason why relatively few
                                       deferred annuities and individual retirement accounts are being converted
                                       to annuities.




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Figure 3: Monthly Annuities for
Persons Retiring at Age 65 in 2000     $1,200 Monthly Annuity
With a $100,000 Premium Payment, for
Interest Rates From 3 to 10 Percent


                                        1,000




                                            800




                                            600




                                            400


                                                   3%             4%         5%            6%         7%          8%           9%          10%
                                                  Effective Annual Interest Rate

                                                            Men

                                                            Women

                                                            Unisex



                                       Source: GAO calculations. (Our methodology and assumptions are described in app. I.)




                                       Without some mechanism to offset the effects of interest rate volatility on
                                       annuity payments, requiring individuals to purchase annuities in the
                                       private market will introduce an element of risk in Social Security
                                       retirement income—a risk that does not currently exist. One way to help
                                       protect retirees from interest rate volatility is to allow individuals to
                                       determine when to purchase annuities. For example, rather than requiring
                                       individuals to purchase annuities immediately at retirement, they could be
                                       allowed to maintain their individual accounts up to a certain period of
                                       time after retirement. This could give them the opportunity to purchase
                                       annuities when interest rates seem more favorable.12 Another option


                                       12
                                        Under federal tax law, retirees must begin receiving payouts from retirement plans no later than
                                       April 1 of the year following their retirement date or attainment of age 70-1/2, whichever comes later.



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                         would be to allow individuals to purchase annuities in installments over a
                         specified number of years.


Lower Mortality Rates    Changes in mortality assumptions would also affect the amount of annuity
Would Reduce Annuities   payments future retirees will receive.13 Reductions in the probability that
                         members of the annuitant population die at designated ages would result
                         in smaller monthly annuities for individuals because there is an increased
                         likelihood that each succeeding payment will need to be made. The
                         mortality tables insurance companies use consider changes in medical
                         diagnostics and treatments, public health, and socioeconomic factors that
                         affect life expectancy. When annuitizing individual accounts, insurers
                         would also consider whether annuities would be mandatory or voluntary;
                         the anticipated mortality rate of the annuitant population; and whether
                         annuity calculations would be based on separate mortality tables for men
                         and women or on a unisex table, as the federal government uses.

                         Advances in medical diagnostics and treatment have helped reduce
                         mortality rates in the United States. Figure 4 shows that, according to SSA’s
                         1999 intermediate mortality assumptions, mortality rates for persons who
                         survive to age 65 are expected to continue to decrease. For example, there
                         is a 2.6-percent chance that a person born in 1900 who survives to age 65
                         will die within a year, a 1.6-percent chance for a person born in 1950, and a
                         1.2-percent chance for a person born in 2000. Persons born in 1950 and
                         2000 have a lower probability of dying at each successive age and,
                         therefore, a higher probability of collecting each additional annuity
                         payment than those born in 1900. Consequently, as mortality decreases,
                         more annuity payments will need to be made and the monthly annuity
                         payments will have to decrease to account for the greater number of
                         payments.




                         13
                          All forms of retirement income, including Social Security and private pensions, are subject to the risk
                         of declining mortality.



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Figure 4: Mortality Rates, by Age, for
Persons Who Were Born in 1900, 1950,     100% Probability of Dying Within 1 Year
and 2000 and Survive to Age 65

                                           80



                                           60



                                           40



                                           20



                                             0


                                                   65         70         75           80        85       90        95       100      105
                                                   Age

                                                            Born 1900
                                                            Born 1950
                                                            Born 2000



                                         Source: GAO calculations. (Our methodology and assumptions are described in app. I.)




                                         Reductions in mortality rates mean that future retirees will receive smaller
                                         monthly annuities, all else being equal. As shown in table 3, assuming a
                                         6-percent interest rate and no administrative expenses, persons aged 65
                                         with $100,000 accounts could purchase monthly annuities ranging from
                                         about $750 to about $890, depending on the mortality assumption used to
                                         calculate the annuity’s price.

Table 3: Estimated Monthly Annuities
Purchased at $100,000 for Persons                                                                                                 Monthly
Retiring at Age 65, Assuming SSA         Birth year                                                                               annuity
Mortality Rates for Persons Born in      1900                                                                                        $890
1900, 1950, and 2000
                                         1950                                                                                        $800
                                         2000                                                                                        $750
                                         Note: Calculations assume a 6-percent interest rate and no expenses.

                                         Source: GAO calculations. (Our methodology and assumptions are described in app. I.)




                                         Page 14                                   GAO/HEHS-99-160 Individual Annuities in Social Security
                                         B-282223




                                         Monthly annuity payments could also be influenced by a decision to
                                         permit, rather than require, retirees to purchase annuities. Individuals with
                                         a higher than average mortality risk, such as those with serious illnesses or
                                         a family history of certain diseases, might decide that annuities are too
                                         expensive for them and opt for another form of payment. Adverse
                                         selection—the possibility that the population of annuitants will experience
                                         more favorable mortality rates than the population as a whole—is a
                                         problem that affects the insurance industry, and companies construct
                                         mortality tables to reflect the higher life expectancies of the annuitant
                                         population. For example, the Annuity 2000 mortality table was developed
                                         for the Society of Actuaries for use in the valuation of individual annuities
                                         and, therefore, reflects the mortality characteristics of persons who are
                                         expected to voluntarily purchase individual annuities. Table 4 shows that
                                         the Annuity 2000 mortality table results in significantly smaller monthly
                                         annuities than SSA’s mortality table.

Table 4: Estimated Monthly Annuity for
Persons Retiring at Age 65 in 2000                               Annuity 2000a                            SSA        Percentage increase
With a $100,000 Premium Payment,         Men                                $750                          $870                               16%
and Using Annuity 2000 and SSA
                                         Women                               700                           770                               10
Mortality Tables
                                         Note: Calculations assume a 6-percent interest rate and no expenses.
                                         a
                                          Unlike SSA mortality tables, published Annuity 2000 mortality tables do not provide for
                                         improvements in future mortality rates that might result from medical advances and other factors.
                                         We projected mortality rate improvement beyond the year 2000 using the same scale and
                                         percentages (100 percent of the projected improvement for males and 50 percent for females)
                                         that were used to develop the Annuity 2000 basic tables.

                                         Source: GAO calculations. (Our methodology and assumptions are described in app. I.)



                                         Mandating annuitization of individual account balances will likely reduce
                                         the costs of purchasing annuities for the population at large, but certain
                                         groups could be disadvantaged by such a requirement if aggregate
                                         mortality tables were used to determine monthly payments. For example,
                                         a mortality table based on unisex mortality rates, instead of a
                                         gender-specific table, results in smaller annuities for men, who have
                                         higher mortality rates than women, and higher annuities for women, who
                                         have lower mortality rates. (See fig. 5 for differences in mortality rates.) A
                                         1983 Supreme Court decision found that title VII of the Civil Rights Act,
                                         which applies to employment, requires that employer-provided pension
                                         plans use unisex mortality tables in calculating annuities, so that women
                                         and men with identical salary and work histories receive the same monthly
                                         benefit.14 The individual annuities market, however, is not covered by the

                                         14
                                           Arizona Governing Committee v. Norris, 463 U.S. 1073 (1983).



                                         Page 15                               GAO/HEHS-99-160 Individual Annuities in Social Security
                                       B-282223




                                       Supreme Court ruling, and it is unclear whether or not annuities
                                       purchased from savings in individual Social Security accounts would be
                                       covered by the Court’s ruling.


Figure 5: Average Life Expectancy at
Age 65 for Males and Females Born in   22   Life Expectancy (Years)
1900 Through 1980 Based on SSA’s
1999 Intermediate Mortality Rates      21

                                       20

                                       19

                                       18

                                       17

                                       16

                                       15

                                       14

                                       13

                                       12

                                       11

                                       10

                                              1900       1910         1920    1930     1940       1950      1960      1970       1980
                                               Year of Birth

                                                         Male
                                                         Female



                                       Source: SSA Office of the Chief Actuary.




                                       Aggregate mortality tables might also disadvantage other participants,
                                       such as lower-income individuals, whose mortality rates appear to be
                                       higher than the population as a whole. An analysis of research on mortality
                                       differentials indicates, for example, that in addition to clear differences in
                                       sex, differences in income, race, education, and marital status may
                                       correlate with differences in mortality rates, although they may be more
                                       difficult to interpret.15 To the extent group mortality rate differentials


                                       15
                                        Shripad Tuljapurkar and Carl Boe, “Mortality Change and Forecasting: How Much and How Little Do
                                       We Know?,” North American Actuarial Journal, Vol. 2, No. 4 (Society of Actuaries, Oct. 1998).



                                       Page 16                               GAO/HEHS-99-160 Individual Annuities in Social Security
                            B-282223




                            occur at ages beyond age 65 and persist in the future, mandatory annuities
                            that are priced on the basis of aggregate mortality rates would result in the
                            redistribution of income from groups of individuals who die earlier, on
                            average, to those who die later. Annuities could be designed, however, to
                            reduce the effect of differentials in mortality rates. For example, retirees
                            could be given the option of purchasing a life with term-certain annuity,
                            wherein, if the annuitant died before the end of a specified period,
                            payments would continue to a beneficiary. Payments to the beneficiary,
                            however, would not continue beyond the annuity’s specified period.


Administrative and Other    Expected administrative and other expenses charged by insurance
Expenses Reduce Retirees’   companies would also reduce annuity income. The costs of setting up
Annuity Income              annuity accounts, paying commissions, tracking payments, managing
                            assets, and paying taxes are reflected in annuity prices. Although
                            commission rates typically range from 3 to 6 percent of the amount used
                            to purchase the annuity, they can vary as widely as 0 to more than
                            10 percent.16 Generally, any increase in expected operating expenses
                            would result in smaller annuities, assuming that other factors remain
                            unchanged. Figure 6 shows, for example, that increasing annuity loads
                            from 0 to 15 percent would reduce monthly annuities by about $100 for
                            persons retiring at age 65 in the year 2000 with an account balance of
                            $100,000.




                            16
                              Annuities Around the World, LIMRA (1998).



                            Page 17                              GAO/HEHS-99-160 Individual Annuities in Social Security
                                       B-282223




Figure 6: Monthly Annuities for
Persons Retiring at Age 65 in 2000     $1,000     Monthly Annuity
With a $100,000 Premium Payment, for
Expense Loads From 0 to 15 Percent
                                            950


                                            900


                                            850


                                            800


                                            750


                                            700


                                            650


                                            600

                                                     0%           2%     4%          6%          8%        10%         12%         14%

                                                   Annuity Load
                                                             Men

                                                             Women

                                                             Unisex



                                       Note: Calculations assume a 6-percent interest rate.

                                       Source: GAO calculations. (Our methodology and assumptions are described in app. I.)




                                       Administrative and other expenses for private annuities would vary
                                       depending on how accounts were annuitized. A 1997 analysis found that
                                       prices charged for immediate, fixed, life annuities varied widely,17 with
                                       about a 20-percent difference between the highest and lowest groups of
                                       monthly annuity payments paid by insurance companies. Assuming a
                                       typical investment portfolio of investment-grade bonds, the study
                                       estimated that, in 1995, commercial insurance companies allowed about 14
                                       to 18 percent of annuity premiums to cover marketing costs, corporate
                                       overhead and income taxes, additions to various company contingency
                                       reserves, and profits. The remainder of the annuity premium is used to pay
                                       the annuity. Although the study also found that costs have declined since

                                       17
                                        Olivia S. Mitchell and others, New Evidence on the Money’s Worth of Individual Annuities, National
                                       Bureau of Economic Research Working Paper 6002 (Apr. 1997).



                                       Page 18                                GAO/HEHS-99-160 Individual Annuities in Social Security
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                           the early 1980s, a January 1999 analysis indicates that total expenses for
                           immediate annuities purchased in the individual annuity market could be
                           as high as about 15 percent of the amount being converted into an
                           annuity.18

                           Several options exist that could lower administrative costs. For example,
                           having the federal government provide the annuities or contract with
                           private insurers to provide group annuities could reduce administrative
                           and sales costs because annuities would not be marketed on an individual
                           basis. Limiting the number of annuity purchase options could further
                           reduce costs because insurers would not have the additional costs
                           associated with marketing and selling numerous products to retirees with
                           Social Security individual accounts. However, as long as individuals
                           determine whether to annuitize their account balances, the types of
                           annuity purchased, and the age at which they retire, options for reducing
                           annuity costs are limited.


Private Sector Annuities   While private annuities could be structured in a way that reduces
May Not Be Able to         administrative and other costs, they may not be able to replicate Social
Provide Certain Social     Security benefits. Social Security benefits are currently calculated using
                           workers’ 35 years of highest earnings, and benefits are provided to
Security Benefits          workers’ spouses, children, and survivors. The system also has a
                           redistributive component, which weights benefits in favor of families and
                           lower-income workers. Additionally, Social Security benefits are fully
                           indexed for inflation.

                           Generally, annuities sold in the United States do not provide full inflation
                           protection; instead, retirees can purchase indexed or variable annuities.
                           Indexed annuity payment increases may be limited to a maximum
                           percentage annually, regardless of increases (and decreases) in inflation
                           rates. Variable annuities might also provide inflation protection, but only
                           as long as investment returns meet or exceed the rate of inflation.
                           Investment returns are not guaranteed, and variable annuities generally
                           have higher administrative costs than fixed annuities.

                           Requiring annuities to be fully indexed for inflation would reduce initial
                           monthly annuity payments. Insurance company officials stated that issuers
                           providing inflation-indexed annuities might hedge the inflation risk by
                           investing in shorter-term securities and inflation-adjusted Treasury


                           18
                             James M. Poterba and Mark J. Warshawsky, The Costs of Annuitizing Retirement Payouts From
                           Individual Accounts, National Bureau of Economic Research Working Paper 6918 (Jan. 1999).



                           Page 19                             GAO/HEHS-99-160 Individual Annuities in Social Security
                             B-282223




                             securities, which typically have lower investment returns than longer-term
                             and non-indexed securities. Consequently, retirees would receive lower
                             initial monthly annuity payments in exchange for inflation protection.

                             Private annuities also may not be able to provide auxiliary benefits similar
                             to those under the Social Security program. To calculate Social Security
                             benefits, a progressive benefit formula is used that replaces a relatively
                             larger portion of lifetime earnings for people with low earnings than for
                             people with high earnings. Furthermore, Social Security provides auxiliary
                             benefits to workers’ eligible spouses, children, and survivors without
                             reducing the size of the worker’s own annuity. It is unlikely that a private
                             annuity could be designed that provides the same benefits. For example,
                             an annuity calculated on the basis of expected interest rates, mortality
                             rates, and expenses would not replace the benefit that Social Security
                             currently provides to nonworking spouses.19 Furthermore, under a joint
                             life annuity, the primary annuitant must accept less monthly income than
                             under a single life annuity.


                             Providing annuities to Social Security recipients through the private
Federal Regulation of        market could have important consequences for the existing structure of
the Annuities Market         insurance regulation. If individual accounts were established, federal
Could Expand Under           regulation of annuities could potentially expand to include such matters as
                             establishing and enforcing solvency requirements and providing a
a System of Individual       guaranty program. Currently, the federal government has a limited role in
Accounts                     the regulation and oversight of certain annuities; however, it does not
                             guarantee these annuities in the case of insurer insolvency. States have
                             primary responsibility for regulation of the insurance industry, including
                             solvency and guaranty requirements. However, insurance department
                             oversight and guaranty levels vary among states and could result in
                             unequal treatment of retirees. Furthermore, retiree annuity values could
                             sometimes exceed state guaranty limits.


Federal Government Has a     The federal government has a limited role in regulating the annuities
Limited Role in Regulating   market. DOL and PBGC enforce regulations under ERISA on the selection of
Annuities                    annuity providers by private pension plans. DOL provides guidance
                             concerning the selection of annuity providers to make sure plan sponsors
                             follow their fiduciary responsibilities—that is, they act solely in the best
                             interest of participants and generally select the safest annuity available.

                             19
                               In general, a retired worker’s spouse who is not entitled to benefits under his or her own work record
                             will receive a benefit up to 50 percent of the retired worker’s benefit. The spousal benefit does not
                             reduce the size of the worker’s own benefit.



                             Page 20                                GAO/HEHS-99-160 Individual Annuities in Social Security
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                              PBGC  rules require administrators responsible for terminating private
                              pension plans to provide participants and beneficiaries with information
                              on state guaranty association coverage of annuities. Neither DOL nor PBGC
                              is authorized to establish or enforce solvency and guaranty requirements
                              on private annuities. Variable annuities, because they are considered to be
                              both insurance and securities, are regulated by the Securities and
                              Exchange Commission and are subject to the antifraud and related
                              disclosure provisions of the Securities Act of 1933, the Securities
                              Exchange Act of 1934, and the Investment Company Act of 1940.


State Regulation of           States have primary responsibility for regulating the insurance industry,
Annuities Varies              including individual and group annuities. State insurance departments
                              license companies to sell insurance; examine the financial health of
                              companies; and administer, as necessary, the liquidation of insolvent
                              insurers. They also regulate annuity products, including establishing
                              reserve requirements, investment restrictions, and solvency guarantees.20
                              Some states also generate tax revenue from sales of insurance products.

                              Regulation and oversight of the insurance market varies by state. The size
                              of insurance departments also varies, depending on the size of their
                              markets and the number of insurance companies headquartered in their
                              state. Consequently, some individual state insurance departments have
                              faced difficulties regulating the large, interstate insurance industry and
                              have used the National Association of Insurance Commissioners (NAIC) to
                              establish model laws and coordinate national regulatory activities.21


Insolvency Guaranties May     Differences in state guaranty limits can result in unequal treatment of
Not Fully Protect Retirees’   retirees receiving annuities from the same failed insurer and may not fully
Annuity Incomes               protect retirees’ annuity income. Each state has an insolvency guaranty
                              law that provides some protection to policyholders or annuitants from
                              financial losses due to insolvent insurers. To pay an insolvent company’s
                              obligations, the guaranty association in each state where the company did
                              business assesses the solvent insurers doing business in the state. These
                              associations, however, are limited in the amount of assessments they can
                              make each year. Furthermore, they are not state agencies, and state
                              insurance departments are not responsible for paying the obligations of an

                              20
                                 Gerard M. Brannon, Public Policy and Life Insurance, The Financial Condition and Regulation of
                              Insurance Companies, Conference Series No. 35 (Federal Reserve Bank of Boston, June 1991).
                              21
                               NAIC consists of the heads of the insurance departments of the 50 states, the District of Columbia,
                              and 4 U.S. territories.



                              Page 21                                GAO/HEHS-99-160 Individual Annuities in Social Security
                            B-282223




                            insolvent insurer. To help promote uniformity in guaranty coverage, NAIC
                            has established a Life and Health Insurance Guaranty Association Model
                            Act. Although all states have adopted versions of the model, there are
                            substantial differences among the states in its implementation. Moreover,
                            the current guaranty association structure has a number of weaknesses:22

                        •   Coverage is not uniform across states. As a result, two individuals having
                            identical insurance with the same failed insurer can receive substantially
                            different payments depending on their state of residence.
                        •   Each state’s guaranty association can act independently of the other
                            associations, although the National Organization of Life and Health
                            Insurance Guaranty Associations helps achieve uniformity across the
                            country.
                        •   There is the potential that a large insolvency or series of insolvencies
                            might overwhelm the ability of each state’s guaranty association to provide
                            full, uninterrupted payments to annuitants. For example, in March 1993,
                            we reported that 44,000 retirees with the Executive Life Insurance
                            Company received only 70 percent of their annuities for almost 13 months
                            after California regulators seized control of the company.23

                            Retirees whose annuity values exceed the limit of the guaranty association
                            risk losing a portion of their benefits should an insurer fail. According to
                            the National Organization of Life and Health Insurance Guaranty
                            Associations, in 1998, 44 states limit the obligations of their guaranty
                            associations for annuities to $100,000—the limit recommended by NAIC.
                            Four states have a $300,000 limit, while two others limit their guaranty to
                            $500,000. As an individual account system matures, some workers could
                            have account balances exceeding $100,000 when they retire. Under current
                            state guaranty coverage, the total value of their annuities would not be
                            protected. Furthermore, the number of retirees whose annuities would not
                            be fully protected by state guaranty associations would likely increase
                            over time because most state insurance coverage limits are not indexed to
                            inflation.


Options for a Federal       Currently, the federal government does not guarantee private annuities.
Guaranty of Annuities       Consequently, retirees who purchased annuities with their individual
                            accounts would have to rely on the protections provided by state
                            regulators and guaranty associations. Some policy analysts have proposed

                            22
                              Kenneth Black, Jr., and Harold D. Skipper, Jr., Life Insurance, 12th ed. (Prentice Hall, 1994).
                            23
                             Private Pensions: Protections for Retirees’ Insurance Annuities Can Be Strengthened
                            (GAO/HRD-93-29, Mar. 31, 1993).



                            Page 22                                  GAO/HEHS-99-160 Individual Annuities in Social Security
              B-282223




              extending a federal guaranty to annuities purchases. Options for a federal
              guaranty include having a government entity guarantee annuities
              purchased with funds from individual accounts or establishing a national
              insurance guaranty fund. For example, insurers providing annuities for
              individual Social Security accounts could be required to pay a guaranty
              premium to a federal guaranty agency. The agency would then pay the
              outstanding annuity obligations of an insolvent insurer. However, this
              option faces several difficulties. First, unless the federal government
              began regulating insurers, it would lack any ability to control its liability
              for the annuities. Second, to establish appropriate premium levels, the
              government agency would have to become proficient in rating the risk of
              insurance company failure. Third, a federal guaranty agency would place
              additional regulatory burdens on insurers as well as on the federal
              government. Finally, any additional cost for a federal guaranty program
              would likely be passed on to annuitants in the form of smaller monthly
              payments. A national guaranty fund—whereby a national corporation
              would collect assessments from insurance companies and administer
              guaranty payments to annuitants after an insurer becomes
              insolvent—would face similar challenges.


              The private annuitization of individual accounts is one of many important
Conclusions   issues to consider when deciding whether and how to create a system of
              individual accounts as a part of Social Security reform. While the private
              annuities market is likely to be able to provide annuities for individual
              accounts without disrupting the market, how these annuities are
              structured will significantly affect retirees’ income. Although requiring
              individuals to purchase annuities with their individual account balances
              would help preserve their income throughout retirement, such a
              requirement would also expose retirees to risks and costs that they do not
              face under the current Social Security system. There are options that
              would somewhat mitigate the effects of various costs on annuity
              payments, but some would require limiting the payout choices available to
              individuals when they retire.

              If individual accounts were established, individuals would need to fully
              understand the factors affecting their annuity income as well as the extent
              to which their annuities are protected. Also, if individuals were required to
              purchase annuities, the federal government would potentially need to play
              some role in either ensuring that insurance markets worked efficiently or
              providing annuities when the private market failed to do so. Furthermore,
              to protect retirees and ensure equal treatment of all annuitants, the



              Page 23                      GAO/HEHS-99-160 Individual Annuities in Social Security
                   B-282223




                   government might have to establish standardized solvency requirements
                   for insurance companies and uniform guaranty protections for annuitants.
                   However, policymakers would need to balance the states’ longstanding
                   authority to regulate insurance markets with the desire for uniform
                   protections for retirees purchasing annuities with their individual
                   accounts.


                   We provided a draft of this report to SSA, the American Council of Life
Agency and Other   Insurance, the National Organization of Life and Health Insurance
Comments           Guaranty Associations, the Society of Actuaries, and federal government
                   actuaries. They provided oral or written comments that were primarily
                   technical and clarifying in nature, which we incorporated as appropriate.
                   In commenting on our report, the reviewers generally agreed with our
                   characterization of the factors that influence monthly annuity payments
                   and our discussion on the implications of privately annuitizing individual
                   Social Security accounts. In addition to its technical comments, SSA stated
                   that our report brought necessary attention to the risks facing consumers
                   in the private market. It suggested, however, that we expand our
                   discussion to include how individuals (eligible spouses, children, and
                   survivors) receiving auxiliary Social Security benefits would be affected
                   under a system of individual accounts. Because we addressed this issue in
                   a prior GAO report, we did not expand on it in this report.24 SSA also
                   recommended that we include information on how individual annuities are
                   sold and the potential that annuity purchasers could make unwise
                   decisions. Our report highlights the need for individuals to understand the
                   factors and decisions that can affect their annuity income. We have also
                   pointed out in recent reports that increased education to help improve
                   participants’ understanding of the consequences of such decisions on their
                   retirement income would be an important part of any reform proposal that
                   included individual Social Security accounts.25 SSA’s letter is reprinted as
                   appendix II.


                   We are sending copies of this report to the Honorable Bill Archer,
                   Chairman, House Ways and Means Committee; other relevant
                   congressional committees; the Commissioner of Social Security; the
                   Secretary of Labor; and the Executive Director of PBGC. Copies will also be
                   made available to others on request. If you or your staff have any

                   24
                    Social Security: Different Approaches for Addressing Program Solvency (GAO/HEHS-98-33, July 22,
                   1998).
                   25
                     GAO/HEHS-99-122 and GAO/GGD-99-115.



                   Page 24                              GAO/HEHS-99-160 Individual Annuities in Social Security
B-282223




questions, please contact me on (202) 512-7215. Major contributors to this
report include Charles A. Jeszeck, George A. Scott, and John M. Schaefer.

Sincerely yours,




Barbara D. Bovbjerg
Associate Director
Education, Workforce, and
  Income Security Issues




Page 25                     GAO/HEHS-99-160 Individual Annuities in Social Security
Contents



Letter                                                                                               1


Appendix I                                                                                          28

Scope and
Methodology
Appendix II                                                                                         30

Comments From the
Social Security
Administration
Tables              Table 1: Growth in Annuity Premiums, Annuitant Income, and                       6
                      Insurance Company Reserves Between 1940 and 1997
                    Table 2: Two Proposals by the 1994-1996 Advisory Council on                      7
                      Social Security for Reforming Individual Accounts
                    Table 3: Estimated Monthly Annuities Purchased at $100,000 for                  14
                      Persons Retiring at Age 65, Assuming SSA Mortality Rates for
                      Persons Born in 1900, 1950, and 2000
                    Table 4: Estimated Monthly Annuity for Persons Retiring at Age                  15
                      65 in 2000 With a $100,000 Premium Payment, and Using Annuity
                      2000 and SSA Mortality Tables

Figures             Figure 1: Monthly Annuities for Persons Retiring at Age 65 in 2000               9
                      With Account Balances Ranging From $50,000 to $200,000 and
                      Annuity Expenses of 5, 10, and 15 Percent
                    Figure 2: Yield for Investment-Grade Corporate Bonds and                        11
                      30-Year U.S. Treasury Bonds Between 1977 and 1999
                    Figure 3: Monthly Annuities for Persons Retiring at Age 65 in 2000              12
                      with a $100,000 Premium Payment, for Interest Rates From 3 to
                      10 Percent
                    Figure 4: Mortality Rates, by Age, for Persons Who Were Born in                 14
                      1900, 1950, and 2000 and Survive to Age 65
                    Figure 5: Average Life Expectancy at Age 65 for Males and                       16
                      Females Born in 1900 Through 1980 Based on SSA’s 1999
                      Intermediate Mortality Rates
                    Figure 6: Monthly Annuities for Persons Retiring at Age 65 in 2000              18
                      with a $100,000 Premium Payment, for Expense Loads From 0 to
                      15 Percent




                    Page 26                     GAO/HEHS-99-160 Individual Annuities in Social Security
Contents




Abbreviations

DOL        Department of Labor
ERISA      Employee Retirement Income Security Act of 1974
NAIC       National Association of Insurance Commissioners
PBGC       Pension Benefit Guaranty Corporation
SSA        Social Security Administration


Page 27                    GAO/HEHS-99-160 Individual Annuities in Social Security
Appendix I

Scope and Methodology


             To review the likely effect of individual accounts on the annuities market,
             we analyzed estimates of account accumulations and information on sales
             trends in the annuities market. To estimate potential individual account
             balances, we made a number of assumptions. With respect to population
             and economic projections, including returns on investment and projected
             wages, we used the same assumptions as those used to produce the
             intermediate-range assumptions of the 1999 Annual Report of the Board of
             Trustees of the Federal Old-Age and Survivors Insurance and Disability
             Insurance Trust Funds. This resulted in a 10.3-percent nominal rate of
             return for corporate stocks (or about a 7-percent real rate of return) and a
             6.3-percent nominal return on Treasury bonds (or about a 3-percent real
             return). (See GAO/HEHS-99-131 for additional information on our
             assumptions.) To identify the factors that affect annuity payments, we
             discussed the pricing of annuities with insurance industry and government
             actuaries and reviewed literature on the pricing of annuities.

             To examine the effect on annuities of these factors, we calculated the
             present expected value of life-contingent annuities, payable in equal
             monthly installments at the end of the month, to persons who would
             survive to and retire at age 65 in the year 2000. The present value was
             calculated to adjust future annuity payments for the time value of money.
             The time value of money refers to the fact that a dollar received today is
             worth more than a dollar received some date in the future because the
             dollar received today can be invested and earn interest. The expected
             value was calculated to adjust future payments for the probability that
             individuals would not be alive to collect them.

             Discount factors, based on assumed interest rates, determine the present
             value of future annuity payments. For each interest rate used in the
             analysis, we calculated monthly discount factors assuming the rate
             remained level from the start of annuity payments until the mortality table
             indicated no more persons remained alive to collect an annuity. Before
             discounting, we converted effective annual interest rates to nominal rates,
             compounded monthly.

             Mortality rates determine the expected value of future payments. We
             obtained mortality rates from tables published by SSA and the Society of
             Actuaries. SSA mortality tables were prepared in support of intermediate
             estimates in the 1999 Annual Report of the Board of Trustees of the
             Federal Old-Age and Survivors Insurance and Disability Insurance Trust
             Funds, and we used them to examine the probability that individuals,
             representative of the U.S. population as a whole, would survive to collect



             Page 28                      GAO/HEHS-99-160 Individual Annuities in Social Security
Appendix I
Scope and Methodology




each annuity check. Since the tables provided annual mortality rates, we
estimated monthly rates assuming that deaths were evenly distributed
during the year. Since the tables provided separate mortality rates for
males and females, we constructed unisex rates by computing a weighted
average rate for men and women who would survive to retire at age 65, as
indicated by the SSA estimates. For example, for persons born in 1935 and
retiring at age 65 in the year 2000, we used the distribution at age 65 of
46.5 percent men and 53.5 percent women.

To calculate the present expected value for each month, we (1) multiplied
the amount of the annuity (initially $1) by the number of annuitants who
are expected to survive to collect it and by the appropriate discount factor
and (2) totaled the monthly discounted payments to surviving annuitants,
dividing that total by the number of annuitants alive at age 65. The present
expected value, when adjusted for expenses, is the price of a $1 monthly,
life-contingent, ordinary annuity. We then divided the number of dollars
available to purchase an annuity, by the price of a $1 monthly annuity, to
determine the number of dollars of monthly annuity that could be
purchased by an individual.

We interviewed officials from the National Association of Insurance
Commissioners, National Organization of Life and Health Guaranty
Associations, and the Pension Benefit Guaranty Corporation to discuss the
potential role of federal regulation of the annuities market. We also
interviewed insurance industry officials and researchers from the
American Council of Life Insurance, LIMRA, as well as pension experts
and actuaries.




Page 29                      GAO/HEHS-99-160 Individual Annuities in Social Security
Appendix II

Comments From the Social Security
Administration




              Page 30    GAO/HEHS-99-160 Individual Annuities in Social Security
           Appendix II
           Comments From the Social Security
           Administration




(207047)   Page 31                         GAO/HEHS-99-160 Individual Annuities in Social Security
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