Trading Death: The Implications of Annuity Replication for the Annuity Puzzle, Arbitrage, Speculation and Portfolios, International Review of Financial Analysis.

By Professor Charles Sutcliffe


All defined benefit pensions, as well as the state pension, effectively provide pensioners with an annuity – a regular stream of payments that continues until death. In addition, members of defined contribution schemes have to buy an annuity with their pension pot. (In April 2015 this obligation for defined contribution scheme members will cease.)

While annuities (including defined benefit pensions and state pensions) represent a major proportion of most pensioners’ assets, they are totally illiquid. They cannot be sold or unwound. Nor can the annuitant borrow using an annuity as collateral, as it is non-assignable and all payments cease on the annuitant’s death. This illiquidity has limited their attractiveness to consumers and their inclusion in financial models, as well as preventing pensioners from bringing their consumption forward in time, e.g. to pay for an operation.

This paper shows how short positions in annuities can be replicated using life insurance and debt, permitting long positions in annuities to be offset, or short annuity positions to be created. This permits annuitants to effectively liquidate an annuity, to arbitrage annuity prices and to speculate on their own longevity. Such annuity replication could help reduce the annuity puzzle, improve the price efficiency of annuity markets and promote the inclusion of annuities in household portfolios.

Annuity replication is subject to a range of real world frictions such as the inability of individuals to borrow on the same terms as insurance companies, different longevity estimates for pricing annuities and life insurance, and tax effects; as well as the usual load factors and the need for annuitants to be financially sophisticated enough to execute the replication strategy. However, the evidence is that some annuitants are willing to liquidate annuities at very considerable discounts, opening up the possibility of a limited amount of annuity offsetting; although the frictions may be too great at the moment to make arbitrage and speculation worthwhile.

After decades of hostility, the UK political climate has recently become favourable to the liquidation of annuities. Given the apparent demand for annuities which can be liquidated, insurers may decide to offer such products, and financial service companies may choose to offer a service to help annuitants offset unwanted annuities..

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