How To Pay Out Of Pocket

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1 Longevity risk and life annuity challenges around the world Professor David Blake Santiago, Chile March

2 Agenda Longevity and other retirement risks Current retirement income products How retirement income products can be improved Insurance firm solvency and risk-based capital Challenges for annuities and longevity risk A role for government in longevity risk sharing? Conclusions 2

3 Longevity and other retirement risks 3

4 Income needs in retirement are not smooth or certain POST TAX INCOME ACTIVE RETIREMENT PASSIVE RETIREMENT N U R S I N G? H O M E I N H E R I T A N C E I N H E R I T A N C E AGE 4

5 Risks in retirement Interest rate risk: when annuity is purchased Inflation risk Investment and reinvestment risk Longevity risk: outliving resources leaving unintended bequests failure to leave intended bequests Morbidity or care risk Pensioners have limited understanding of these risks 5

6 % deaths at each age % deaths at each age Variability in life expectancy Expected distribution of deaths: male 65 Expected distribution of deaths: male Life expectancy = % Most likely age at death = 90 25% 1 Random Variation Risk Idiosyncratic risk Risk Age 1 in 1000 chance of living twice life expectancy at age Most likely age at death = 86 Source: 100% PNMA00 medium cohort 2007 Life expectancy = in 3 will reach 93 and 5% will reach 100 Idiosyncratic risk Age 1 in 10 chance of living twice life expectancy at age 85 6

7 The challenge is huge: Individuals consistently underestimate how long they will live... Age INDIVIDUAL UNDERESTIMATES OF LIFE EXPECTANCY BY AGE Men Women Number of years by which consumers underestimate life expectancy Sources: O Brian, Fenn, and Diacon, 2005, self-estimated life expectancy compared with GAD forecast life expectancy; own analysis. 7

8 Current retirement income products: Annuities and phased withdrawal 8

9 The lifetime income guarantee provided by an annuity is funded by investment growth, the annuitant s own capital and the capital released by those dying early Expected composition of each annuity payment for a male aged 65 purchasing an annuity for 100,000 providing an income of 7,773 payable at the end of each year to all annuitants still alive ANNUITY WITH NO DEATH BENEFIT MALE 65-7, Growth less charges Capital Cross-Subsidy Source: Own analysis using 100% PNMA00 medium cohort 2007 AGE 9

10 In the early years, investment growth is the most significant constituent of the income payment and cross-subsidy is small Limited cross-subsidy ANNUITY 7,773 NO DEATH BENEFIT MALE Growth less charges Investment growth significant Capital Cross-Subsidy AGE Source: Own analysis using 100% PNMA00 medium cohort

11 The lifetime income guarantee provided by an annuity is funded by the capital released by those dying early The funds of those dying in a year are spread over the lives surviving. Limited cross-subsidy Significant cross-subsidy ANNUITY 7,773 NO DEATH BENEFIT MALE Growth less charges Capital Cross-Subsidy Source: Own analysis using 100% PNMA00 medium cohort 2007 AGE 11

12 At age 85 the cross-subsidy provides half of the guaranteed income and continues to grow in significance ANNUITY 20,401 NO DEATH BENEFIT MALE AGE Growth Capital Cross-Subsidy Source: Own analysis using 100% PNMA00 medium cohort

13 If retirees continue to use phased withdrawal from age 85, many will run out of money Fund Male aged 85 with 100,000 fund taking 20,000 per annum exhausts fund by life expectancy of 91.6 years but 50% will live longer than this %age still alive 50% will outlive their assets 20,000pa with 5% return % age still alive 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: Own analysis using 100% PNMA00 medium cohort 2007 and 100,000 fund 13

14 Reducing income taken and increased investment returns have little impact on the erosion of the fund at older ages Fund Male aged 85 with 100,000 fund taking 16,000 per annum exhausts fund by age 94 33% will outlive their assets even with growth of 6.5% 33% will outlive their assets %age still alive 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% %age still alive 20,000 5% 16, % return Source: Own analysis using 100% PNMA00 medium cohort 2007 and 100,000 fund 14

15 An annuity is the best option for most of the mass market Most pensioners have limited means Mass market households are likely to have to accept a relatively simple strategy with default options Primary focus on maximising retirement income Reliance on State and any housing equity for providing for health care and other retirement contingencies Bequests typically left more by chance mainly in form of residual housing equity 15

16 Optimisation for the mass affluent is very complex Optimisation is an extremely difficult task for pensioners in their 60s looking forward to retirements of 20 years or more Very difficult task to optimise controlled run down of pensioner s assets throughout retirement Pensioners have varying needs and face many risks Many pensioners have not focused on many of these risks: makes optimisation difficult Optimal solutions are likely to differ: because each set of needs and risks differ 16

17 As life expectancy reduces optimisation becomes easier Fortunately as people get older, optimisation task becomes easier: fewer risks around investment considerations become easier when people go into nursing home income expenditure become less volatile There is a narrowing funnel of doubt based on life expectancy Rainy day fund Phased withdrawal Insurance Pension annuities Non-pension annuities Equity release Immediate needs annuity 17

18 How retirement income products can be improved 18

19 Issues to take into account People need reassurance that it pays to save Pension death benefits are generous for phased withdrawal not for annuities Phasing into annuitization may be more acceptable Annuity products with equity linking might be valuable for those who are sufficiently risk tolerant 19

20 Money-back or capital-protected annuity Any pooling of mortality needs to be perceived to be fair by the public: Currently, this is not true! At younger ages, annuity mortality cross-subsidy gives poor value to those dying early Money-back or capital-protected annuity: Removes single biggest consumer objection to annuities: If I die soon after I retire, the annuity provider will keep my fund 20

21 Money-back or capital-protected annuity Income p.a. ANNUITY NO DEATH BENEFIT MALE 65 INCOME 7,773 Death Ben CAPITAL PROTECTED ANNUITY MALE 65 INCOME 7,222 Income p.a p.a. = Cost of death benefit AGE AGE Growth less charges Capital Cross-Subsidy Death Benefit Source: Own analysis using 100% PNMA00 medium cohort

22 US-style variable annuity GMAB guaranteed minimum accumulation benefit Guaranteed minimum fund at end of accumulation phase GMDB guaranteed minimum death benefit Guaranteed minimum fund on death of insured GMIB guaranteed minimum income benefit e.g. five for life but < annuity and higher charges, e.g. 60bp for 5% guarantee when VA was offering 5 for life, fixed annuity was offering 7.5 for life GMWB guaranteed minimum withdrawal benefit guaranteed minimum amount from fund on periodic basis, regardless of fund performance if for life, then equivalent to GMIB 22

23 Other new product ideas Advanced life deferred annuity (ALDA) An annuity that begins paying after a significant deferral period, e.g. 20 or 30 years Life care annuity An income annuity that pays an increased benefit if the purchaser needs care 23

24 Insurance firm solvency and risk-based capital 24

25 Solvency II (2014) Three pillar approach in EU (same as Basel II): Pillar 1: Minimum capital charges will apply to: underwriting, credit, market and operational risks Standard Model or Internal Risk Based (IRB) Model to determine regulatory capital: Pillar 2 aim to bring regulatory capital closer to economic capital Supervisory pillar Pillar 3 operates ladder of intervention between SCR and MCR Market discipline through greater information disclosure 25

26 Solvency II (2014) Solvency Capital Requirement (SCR) Set as minimum capital to attract S&P BBB rating: has good financial security characteristics, but is more likely to be affected by adverse business conditions than are higher rated insurers Equiv to 99.5% probability that insurer survives one year i.e., can experience a single 1-in-200 year negative event and still meet all its liabilities to policyholders Minimum Capital Requirement (MCR) Minimum level of regulatory capital needed Below this supervisor will order suspension of new business or winding up of whole firm unless firm offers credible recovery plan 26

27 Challenges for annuities and longevity risk 27

28 Population aged 60 or over: World and development regions, Source: World Population Ageing: (United Nations) 28

29 Potential support ratio: World and development regions, Source: World Population Ageing: (United Nations) 29

30 Total support ratio (TSR) and economic growth Ratio of the number of workers to the number of both young and old people High TSR is typically associated with rapid economic growth Cf China, India and Korea In Japan, TSR peaked in 1992 and its economy has been fairly static since 30

31 Support ratios in Japan Source: Fig. A2 in Mayhew (2009) 31

32 Relationship between growth rate in GDP and changes in TSR in Japan Source: Fig. A3 in Mayhew (2009) 32

33 Implications of an ageing population Living standards likely to fall in some countries with fast-ageing populations: GDP growth in EU and Japan could fall from 2% to 1% pa US likely to escape this fall due to more flexible labour markets Higher growth rates in countries with slower ageing populations More volatile stock markets As capital flows to economies with higher returns Lower real interest rates Investment demand falls with a smaller population by more than savings falls? 33

34 FTSE100 Index Increasingly volatile stock markets /85 1/1990 1/1995 1/2000 1/2005 1/2010 1/

35 Implications for pension products Fixed annuities Increasing longevity, low interest rates, and SII seriously reduce payments: SII reduces payments by up to 20% Phased withdrawal and investment-linked annuities: Increasingly volatile stock markets lead to increasingly volatile payments Mitigated by a smoothing fund 35

36 A role for government in longevity risk sharing? 36

37 Longevity fan chart for 65-year old male (Cairns-Blake-Dowd model) 37

38 Mortality fan charts (CBD model) 38

39 SURVIVOR RATE % Survivor fan chart for 65-year-old male (CBD model) AGE AGE AGE Expected value 90% confidence 39

40 Decomposition of longevity risk Government hedges Total longevity risk = Aggregate longevity risk [Trend risk] + Specific longevity risk [Idiosyncratic and modelling risks] Private sector hedges 40

41 Longevity volatility risk is driven driven by three by underlying three risks underlying risks Outcome probability, % Expected Outcome Alternative Outcome A Modelling Risk: Risk that probability distribution is incorrectly modelled due to a limited data set. A Modelling Risk B Trend Risk: Risk that large unanticipated changes in socio - economic environment or health care B Trend Risk significantly improve longevity. C Idiosyncratic Risk C Idiosyncratic Risk: Risk that mortality rates still vary from the expected outcome as a result of random chance. Life expectancy Modelling Risk and Idiosyncratic (Random Variation) Risk are greater the smaller the number of scheme members and the greater the distribution of scheme benefits. 41

42 Potential role for government in helping to hedge longevity risk PAYMENT Tail risk longevity bond from age 90 with terminal payment at 100 to cover post-100 longevity risk Capital markets deal with this segment in long run Govt. earns longevity risk premium TERMINAL PAYMENT 0 AGE Expected value 90% confidence 42

43 Longevity bond cash flows across ages and time YEAR Issue year of bond Deferment period on bond Payments on bond AGE BIRTH YEAR 43

44 Conclusions Limited ability to hedge interest rate, inflation and investment risks long term: We will have to cope with living in an increasingly volatile financial world Hedging longevity risk becomes THE single most important consideration: Essential at the level of the individual Feasible at the macro level with longevity bonds 44

45 Conclusions Annuities can be improved: Capital protection Smoothing fund Deferred annuities Linking to care costs But too much regulatory capital and we kill the goose that lays the golden egg! Also high charges can lead to significant consumer detriment 45

46 But it s if not when to annuitise Annual mortality cross subsidy 20% 15% 10% 5% Limited value from annuitization Death benefit seen as more valuable. Annuitization essential to provide income for life 0% AGE 46

47 Thank you! Longevity 10: Tenth International Longevity Risk and Capital Markets Solutions Conference September 2014 Santiago, Chile 47