Understanding Longevity Risk

Longevity Risk

It is worth taking some time to understand the concept of "longevity risk" and the implications it has for planning any retirement. Understanding longevity risk and the (currently restricted) options available to manage it is neither simple or straightforward but worth taking some time to appreciate.

Longevity risk can have significant consequences for individuals supporting their retirement without access to the the defined benefit (DB) pensions which are expensive mechanisms now largely restricted to our senior politicians and public servants. DB pensions provide members with indexed pensions for life and consequently recipients do not face the same longevity risk of Australians reliant on super savings. Ideally, to place all Australians on the same footing, and to ensure that politicians and public servants alike give the topic appropriate attention and ensure that we do not quietly accrue huge unfunded liabilities at the taxpayers expense, we should promptly move to discontinue all existing public DB schemes.

Longevity risk has two related aspects:

• the risk that people outlive their retirement savings, and
• the risk that people underspend their savings, leading to a lower income over retirement.

Outliving your Retirement Savings

Let's put the first issue into a practical context, using some figures provided by the UK Institute and Faculty of Actuaries, and these will under-estimate the issue in Australia because we enjoy a higher life expectancy than the UK. Looking at the Table below, if I am retiring as a 65 year old male I can expect - on average - to live another 22 years, but there is a 25% chance I will live to 94, and a 10% chance I will live to 99 - twice as long as the average. The situation is even more apparent for women, given their longer life expectancy; with perhaps 1 in 5 women now aged 55 living to age 100.

Of course, before any retiree runs out of money, they will have access to the Age pension - which is effectively a lifetime annuity indexed for inflation. However, we expect that access to the pension will become more difficult over time because of demographics and simply the associated cost. For example, it's difficult to contemplate that over the next 20 or 30 years the family home will remain excluded from means testing.

Also, under our current system, any erosion of a pensioner's capital base may impact their ability to enter a nursing home of their choice - should that ever be necessary. While relatively few people enter actually nursing homes, there is obviously a correlation with age.

Underspending is a Real Problem!

It is a bizarre fact that many retirees, including apparently a large proportion of individuals and couples on the Age pension occupying their own homes, continue to save. They do so, sometimes at the cost of a less enjoyable and comfortable retirement, largely in order to put some money away against the possibility of greater longevity, as discussed above, and to meet sudden "unexpected costs".

At the current time, the latter relates largely to the prospect of major medical and health costs later in life - generated by increasingly significant "gaps" in medical costs, but also a general concern that living costs are rising at a faster rate than retirement incomes. This is particularly with respect to unavoidable "utility" costs such as power, water, council rates, emergency service levies, car registration and health insurance. Uncertainty increases stress and results in a greater emphasis on saving rather than spending.

Continual changes in retirement and super policy also have this impact and it is perhaps no real surprise that the highest spending retirees in Australia apparently live in the ACT/Canberra metropolitan area (Source: Milliman Retirement Expectations and Spending Profiles Q1 2017) and that many have the benefit of Government DB pensions mentioned above.

How to address Longevity Risk

In December 2013, the Australian Treasurer appointed a Committee (the "Murray Inquiry") to undertake a Financial Services Investigation (FSI) and establish the direction of the Australian financial system over the next decade. In the final report, released in December 2014, the inquiry concluded that the, “retirement phase of superannuation is underdeveloped and does not meet the risk management needs of many retirees.”

The Committee's view was that the greater use of "pooled longevity risk products" could increase retirement incomes and recommended that superannuation trustees be required to pre-select what they referred to as a " Comprehensive Income Product for Retirement" (CIPR) for members and that impediments to retirement income product development be removed.

The Government supports the development of more efficient retirement products able to be offered by fund retirees but intends to use the label, "MyRetirement products" for products that provide income in retirement substitutes or supplement the Age pension.

At the moment the Government has essentially outlined the product it would like superannuation trustees to offer, with details still forthcoming, although it will certainly involve some element of "pooled risk". Currently, as we mention above, retirees effectively "self insure" against longevity risk by withdrawing the minimum from account balances and saving "any surplus. It's an expensive, inefficient and unbalanced way of insuring your position because you are often assuming maximum life expectancy, perhaps 35 years, while a pooled product can be accurately based on the life expectancy of a large group, perhaps 20 years.

In essence, the probability is that the product will be a blend of a Group purchased annuity and an account based pension. Annuities purchased on a group basis will provide greater efficiencies, but the downside may be decreased individual payment flexibility and the focus seems to be upon large super funds.

In perhaps the first move by a major super fund QSuper launched it's innovative "Lifetime Pension" in early 2021 - which we will review shortly.

Other Options

We deal with annuities elsewhere on the site, and the most significant problem in terms of uptake is their cost/rate of return - driven by factors including high administration costs, a need to effectively price longevity risk and perhaps a lack of providers in the market.

Pooling risks on a group basis only addresses some of the issues associated with addressing longevity risk, whilst the modern implementation of an old fashioned concept, the "tontine", may present a more cost-effective alternative over the next 5 to 10 years.

The structure involves each investor paying a sum into the tontine. Those investors then receive annual dividends based on the capital annual invested. As each investor dies their share is reallocated among the surviving investors. This process continues until only one, or a designated proportion of, investors survive.

Tontines have been banned in a number of countries for a long time because they were seen as immoral; creating situations where individuals would benefit from the reduced life expectancy of others and because they were associated with a number of significant swindles at the turn of the last century. However, conceptually, they can be more efficient than traditional pensions because they are intrinsically simpler and the plan sponsor does not bear the investment or longevity risks and - if they can be "anonymized" by major super funds or integrated into the modern concept of the "blockchain" - investors could be provided with both security and anonymity, while minimising administration costs by eliminating the middle man.

A "bridge too far" - probably, but it's interesting to think that modern technology may actually deliver a simpler solution.

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