Pre-retirement investing

Transcription

1 Pre-retirement investing

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3 Pre-retirement investing Contents Setting the scene 5 Annuity pricing 6 Annuity protection 8 Investing over time 10 Conclusion 11 Pre-retirement investing 3

4 4 towerswatson.com

5 Setting the scene Whilst we have seen an increase in the flexibility that individuals may have, an annuity is likely to remain an important element of most people s income in retirement. An annuity provides the certainty of an income for life, assuming the provider remains solvent, removing the investment risk for individuals, but more importantly, the risk that they outlive their savings. During the years prior to retirement individuals are likely to want to gain certainty over the pension they will be able to purchase with their pension savings. It is in the years immediately prior to retirement that an individual has the most money saved, with their fund values potentially doubling during the last ten years. Not only is the magnitude of financial loss at its greatest, but more importantly, the individual is also increasingly exposed to the risk of converting their savings capital into pension income. As defined contribution (DC) schemes mature, the greater the proportion of an individual s overall wealth that is exposed to these risks and the greater this aspect will become to ensuring individuals achieve a good outcome. This is a complex area with many factors to consider. The diffi culty that individuals face is that annuity prices do not remain constant. Over the fi ve years to end of 2012 we witnessed price increases of 10% per annum with annual volatility of prices of 4.5%, so how do individuals plan for their retirement and secure an income that is in line with their expectations? Historically the solutions adopted by many schemes have been relatively simple, relying on bond and gilt indices to match fl uctuations in annuity prices. However, better solutions are now beginning to appear as the market grapples with this issue and the demand in this area increases. In this paper we consider how members should be invested in the run up to their retirement. To help to inform this decision we initially consider the factors that drive annuity prices before turning our attention to thoughts of investing over time. If you would like to discuss these aspects further please contact your DC Investment consultant or Paul Herbert paul.herbert@towerswatson.com Pre-retirement investing 5

6 Annuity pricing If a member intends to purchase an annuity with their pension fund, it is not the absolute performance of their fund that is important but the performance relative to annuity prices. In theory, the member s risk-free position is a portfolio that matches the movements in annuities perfectly. This portfolio would offer the highest certainty over the level of income generated through their eventual annuity purchase. When considering what investment risk to take in pursuit of additional returns, it should be relative to this risk-free position rather than the risk of the fund value falling in value. This section considers the factors that infl uence annuity pricing. This will allow us to understand the risk-free benchmark against which a member may wish to invest as closely as possible, or take investment risk. Annuity pricing An insurance company estimates the discounted value of future payments as a part of its calculation of the price of an annuity. This is in part dependent on the length of time the annuitant will survive. The likelihood of an individual surviving an additional year diminishes as they age, reducing the expected payment in that year. The insurer will sell annuities to a large number of individuals, allowing it to spread the risk that a single individual lives longer than expected. For the cohort of individuals purchasing a level annuity the provider expects to pay an ever decreasing amount over a number of years as the group dwindles in size. This results in a payment profi le similar to that illustrated in Figure 01. Figure 01. Example of insurer s payment profile Payments Annuity Years There are essentially three elements involved in the pricing of an annuity. 1. The value of payments in each future year The value of payments in a future year depends on the proportion of annuitants expected to survive to that age. How long an individual is expected to live for is therefore a major factor in pricing annuities. Increases in life expectancy have been one of the main factors that have driven up the cost of an annuity over the long term. While mortality rates are an important factor, we also need to consider the age individuals will purchase an annuity. 6 towerswatson.com

7 The average age men retire is now close to 65 with the average age for women being 62. The proposed changes in State Pension ages are likely to increase typical retirement ages and may bring retirement ages closer together for both sexes. 2. The expected investment return Insurers follow different investment strategies which will reflect the liabilities they have written and the amount of investment risk they can afford to or wish to take. However, there are two main aspects that are likely to have the biggest impact on expected returns. Figure 02. Annuity prices Pension p.a. ( ) Interest rates and the yield curve Changes in the interest rates priced into bonds of different terms to maturity (that is, the yield curve ) are typically the biggest driver of annuity price changes. The sensitivity of annuity prices to changes in the yield curve reflects the average length of time the money is expected to be invested (sometimes referred to as duration). Insurers currently estimate a duration of about 11 years for individuals retiring at age 65. This means that for every 1% change in interest rates the price of the annuity is likely to change by 11% Provider A Provider B Provider C Provider D Provider E Provider F Annuity assumptions: Purchase price 50,000; male annuitant aged 65; single life; level in payment; 5 year guarantee period; payable monthly in advance Date Credit premium Many providers invest significantly in corporate bonds, taking some investment risk in pursuit of additional returns whilst retaining their exposure to interest rates. Changes in market conditions can impact the relative yields of bonds from companies with different credit ratings. This change is typically reflected in the price of an annuity but not always. It depends to some extent on the reasons for the change as well as the overall strategy being adopted by the insurer. In addition, the extent of the change is not always the same. 3. Business considerations like running costs, competitiveness and profit margin Insurers may offer better terms to improve their competitiveness and improve the diversification of the policies they have written, or less competitive terms once quotas for specific policies have been reached. This can lead to changes in the insurer who offers the best terms as illustrated in Figure 02. With variations of 20% or more between the best and worst prices, individuals could end up receiving a significantly lower income if they do not identify the insurer offering the best terms, something an annuity broker can assist with. Benchmarking Historically most people have looked to assess the performance of their annuity protection fund against a benchmark. In most cases the benchmark has been a bond index. Whilst this may be helpful for assessing the ability of the fund manager to manage relative to this index, it provides little insight into the fund s ability to mirror the movements in annuity prices. We have developed an index based on current annuity prices. This allows individuals to understand the changes which are occurring in terms of annuity prices, but more importantly, it allows an effective assessment of performance relative to the cost of an annuity individuals are likely to purchase. Of course what this approach cannot incorporate is an assessment of the cost of the annuity the individual will purchase, which for most members further from retirement is effectively a deferred annuity. While these products exist as buy-in products for defined benefit (DB) schemes, they are rarely sold individually as a retail policy and do not have a readily accessible or reliable price. Of course, in terms of matching annuity prices, the individual wants to ensure they track the best rates available, not one insurer. This removes an annuity pricing factor from the challenge of matching annuity prices. However, an individual will still be affected by how competitively the annuity they purchase is priced, but not the competitiveness of individual providers. Pre-retirement investing 7

8 Annuity protection Historically, protection solutions have been relatively simple in their design, predominantly offering exposure to long-dated bond indices which reflect bond market capitalisation rather than bearing any relation to the expected payment profile from an annuity. 8 towerswatson.com

9 Some more advanced solutions gave some thought to an appropriate duration and the split between corporate bonds and gilts. Larger trust-based schemes have taken the step of combining index-based funds to match the assumed duration of their retiring members, rather than relying on pre-packaged solutions. Convexity the problem with bond indices Investing in a portfolio of bonds with the same duration as an annuity offers a reasonable first attempt at building a portfolio which changes value in line with annuity prices. However, two portfolios can have the same duration (the average length of time before payments are paid) but the payments can happen at very different times. If the yield curve increases uniformly across all years then this would not matter, but this is not often the case. Changes in different parts of the yield curve will mean that portfolios with the same duration but different timings of payments, referred to as convexity, will change in value differently. Bond indices typically have a very spiky shape with small coupons for long periods, and large redemption payments in particular years as issues expire. This is illustrated in Figure 03 below. Conversely an annuity has a regular, smooth series of expected payments. As a result a bond index does not track annuity prices as well when interest rates at the short-end and longer-end move differentially from each other, as is most often the case. In addition, the convexity and duration of an index changes over time as new bonds are issued or as the time to maturity gets close enough for the issue to drop out of the index (for instance the 2028 gilt in the over 15 years index). Figure 03. Payment profiles Payments More recently we have seen managers looking to create more sophisticated, pre-packaged solutions. These solutions more closely manage the duration of their portfolios with the aim of ensuring they are appropriate for individuals at retirement. Most focus on the needs of members aged 65 but this does vary from product to product. In some cases, the construction of the portfolio reflects the shape of the expected annuity payment stream to more closely match the convexity as well. The degree to which credit is used in these solutions remains one of the most significant areas of differentiation. The investment theses contain contrasting views as to whether this improves or worsens the funds ability to track annuity price movements based on the extent to which insurers include these returns in their pricing; the protection these assets provide in poor market environments; and the proportion of the member s assets which are actually invested in these funds during the glidepath period of the lifestyle design. We welcome these developments as we believe they significantly improve the protection characteristics available to DC members. However, as each manager tackles the problem in a different way we expect to see varying degrees of success in different market scenarios. We are encouraged by the proliferation of designs as they offer real choice to our clients. Nevertheless, the increasing sophistication of the market suggests an increasingly sophisticated approach is required to select and monitor these solutions. One of the other problems with the current annuity protection solutions is that they look to apply a single solution to meet the differing needs of all individuals in the approach to retirement. In practice, individuals have a wide range of annuity choices at retirement from the age at which they retire to the type of annuity that they purchase. Catering for this choice can be difficult, even if you are able to engage the individuals in these decisions many years from retirement. We believe further improvements can be made in the design of annuity protection solutions to allow them to cater for the needs of a cross section of individuals. Annuity Bond index Years To help understand the array of options, and how effective they could be, we have developed a framework that identifies the type of annuity the fund is aiming to track and the manager s ability to minimise the tracking error with changes in annuity prices. Our risk-based framework focuses primarily on interest rate risks, considering both duration and cashflow profiles, and the level of credit risk and how this is managed. Our analysis will allow fiduciaries to understand the risks in the investment and when the deviations are likely to occur. Pre-retirement investing 9

10 Investing over time Now that we understand annuity pricing and how we could potentially invest to minimise the movements in annuity prices relative to fund values we can now turn our attention to some of the other factors to consider when investing over time. Many of the annuity protection funds aim to address the risks faced by individuals very close to retirement. In practice, individuals may be seeking a degree of protection a number of years prior to retirement. When thinking about investment over these longer time horizons there are other factors to consider. Portfolio duration Individuals further from retirement will have their contributions invested for a longer period of time before payments will be made than those at the point of retirement. As a result, they will be impacted to a greater extent by a reduction in the expected future return (or interest rates). To help protect the individual against this loss, the ideal duration for maintaining the same pension in retirement will be longer. Individuals do not always retire when they expect. Annuity prices for younger people are more sensitive to interest rate changes as a result of the expected payments being longer. A portfolio with a longer duration will help to protect individuals that retire at an earlier age, whether this is by choice or a change in circumstances. Inflation When investing over time, inflation is an important consideration as this can reduce the purchasing power of the individual s pension. While for individual s intending to purchase a level annuity this may focus on the actual inflation experienced in the years prior to retirement, the inflation post-retirement may also be an important consideration for managing wealth in retirement. Returns in excess of inflation There are other factors that could increase the cost of an annuity. For example, current annuity protection solutions are unable to manage the risk that health improvements result in people living longer. This will result in an increase in the cost of an annuity. A return above the theoretical risk free portfolio may be needed to compensate for this risk. Individuals that are further from retirement are likely to be able to tolerate some investment risk as they may be able to redirect money towards their pension if they experience an investment loss or amend their retirement plans. This may allow individuals to take investment risk with the aim of increasing their overall wealth. Understanding the level of risk an individual is exposed to at the different terms to retirement is critical in determining how risk should be adjusted in the years prior to retirement. We have developed a range of short-term risk metric that allows a clearer understanding of the level of risk different investment strategies expose individuals to. Our short-term risks focus on the actions individuals can take in response to an investment loss which include paying higher contributions, deferring retirement or adjusting the level of income received in retirement. These risks are discussed further in our paper titled Understanding risk in a DC journey. 10 towerswatson.com

11 Conclusion Designing an investment that addresses the different needs of individuals in the run up to retirement is a complex problem to solve. Building an understanding of how annuities are priced and the risks individual face when investing over time provides a useful framework to tackle this problem. The developments in the marketplace now offer access to potential superior solutions which are likely to be of interest individuals and fiduciaries alike. Our short-term risk metrics, knowledge of this market, and our unique monitoring solutions can help identify the solution that is right for you. Pre-retirement investing 11

12 About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of benefits, talent management, rewards, and risk and capital management. Towers Watson 21 Tothill Street Westminster London SW1H 9LL Disclaimer This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watson s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. Copyright 2013 Towers Watson. All rights reserved. TW-EU November towerswatson.com