Financial and Monetary Economics

Longevity risk and life annuity
challenges around the world
Professor David Blake
[email protected]
www.pensions-institute.org
Santiago, Chile
March 2013
1
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
Longevity and other retirement
risks
3
Income needs in retirement
are not smooth or certain
POST TAX INCOME
ACTIVE
RETIREMENT
PASSIVE
RETIREMENT
I
N
? HE
N
R
U
I
R H T
S O A
I M N
N E C
G
E
INHERITANCE
AGE
4
Risks in retirement

Interest rate risk:
 when
annuity is purchased

Inflation risk

Investment and reinvestment risk

Longevity risk:
 outliving
 leaving
 failure
resources
unintended bequests
to leave intended bequests

Morbidity or care risk

Pensioners have limited understanding of these risks
5
Variability in life expectancy
5
Life
expectancy
= 86.6
4
Most likely
age
at death =
90
3
2
1
25%
25%
Random
Variation
Risk
Random
Variation
Idiosyncratic risk
10
Most likely age
at death = 86
Life
expectancy
= 91.6
9
8
7
6
1 in 3 will
reach 93 and
5% will reach
100
Idiosyncratic risk
5
4
3
2
1
Risk
0
Expected distribution of deaths: male 85
% deaths at each age
% deaths at each age
Expected distribution of deaths: male 65
65 70 75 80 85 90 95 100 105 110
Age
1 in 1000 chance of living twice
life expectancy at age 65
0
85
90
95
Age
100
105
1 in 10 chance of living twice
life expectancy at age 85
Source: 100% PNMA00 medium cohort 2007
6
The challenge is huge: Individuals consistently
underestimate how long they will live...
Age
INDIVIDUAL UNDERESTIMATES OF LIFE EXPECTANCY BY AGE
20-29
30-39
40-49
50-59
60-69
Men
Women
0
10
2
4
6
8
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
Current retirement income
products:
Annuities and phased withdrawal
8
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 - £7,773
£
8000
7000
6000
5000
4000
3000
2000
1000
AGE
0
65
70
75
80
Growth less charges
85
Capital
90
95
100
105
110
Cross-Subsidy
Source: Own analysis using 100% PNMA00 medium cohort 2007
9
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 65
£
8000
7000
6000
5000
4000
3000
2000
1000
AGE
0
65
70
75
80
Growth less charges
Investment growth
significant
85
Capital
90
95
100
105
110
Cross-Subsidy
Source: Own analysis using 100% PNMA00 medium cohort 2007
10
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.
ANNUITY £7,773
Significant cross-subsidy
NO DEATH
BENEFIT MALE 65
Limited cross-subsidy
£
8000
7000
6000
5000
4000
3000
2000
1000
AGE
0
65
70
75
80
Growth less charges
85
Capital
90
95
100
105
110
Cross-Subsidy
Source: Own analysis using 100% PNMA00 medium cohort 2007
11
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 85
25000
20000
15000
10000
5000
0
85
90
95
100
105
110
AGE
Growth
Capital
Cross-Subsidy
Source: Own analysis using 100% PNMA00 medium cohort 2007
12
If retirees continue to use phased withdrawal from age
85, many will run out of money
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
Fund £
100000
80000
% age still
alive
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
50% will outlive their
assets
60000
40000
20000
0
85
90
%age still alive
95
100
105
£20,000pa with 5% return
Source: Own analysis using 100% PNMA00 medium cohort 2007 and £100,000 fund
13
Reducing income taken and increased investment returns
have little impact on the erosion of the fund at older ages
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%
Fund £
100000
%age still
alive
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
80000
33% will outlive
their assets
60000
40000
20000
0
85
90
%age still alive
95
100
£20,000 5%
105
£16,000 6.5% return
Source: Own analysis using 100% PNMA00 medium cohort 2007 and £100,000 fund
14
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
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
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
Phased
withdrawal
Pension
annuities
Equity release
There is a narrowing funnel of doubt
Rainy day
based on life expectancy
fund
Immediate needs annuity
Non-pension annuities
Insurance
17
How retirement income products can be
improved
18
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
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
Money-back or capital-protected annuity
CAPITAL PROTECTED ANNUITY
MALE 65 INCOME £7,222
ANNUITY NO DEATH BENEFIT
Death
Ben £
MALE 65 INCOME £7,773
Income
£ p.a.
Income
£ p.a.
100000
8000
8000
£551 p.a. = Cost of death benefit
90000
7000
7000
80000
6000
6000
70000
5000
60000
4000
50000
5000
4000
40000
3000
3000
30000
2000
2000
20000
1000
10000
0
0
65
70
75
80
85
90
95
100
105
1000
0
65
70
75
80
85
90
95
AGE
100
AGE
Growth less charges
Capital
Cross-Subsidy
Death Benefit
Source: Own analysis using 100% PNMA00 medium cohort 2007
21
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
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
Insurance firm solvency and
risk-based capital
24
Solvency II (2014)


Three pillar approach in EU (same as Basel II):
Pillar 1:

Minimum capital charges will apply to:


Standard Model or Internal Risk Based (IRB) Model to
determine regulatory capital:


aim to bring regulatory capital closer to economic capital
Pillar 2

Supervisory pillar


underwriting, credit, market and operational risks
operates ‘ladder of intervention’ between SCR and MCR
Pillar 3

Market discipline through greater information disclosure
25
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
Challenges for annuities and
longevity risk
27
Population aged 60 or over:
World and development regions, 1950-2050
Source: World Population Ageing: 1950-2050 (United Nations)
28
Potential support ratio:
World and development regions, 1950-2050
Source: World Population Ageing: 1950-2050 (United Nations)
29
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
Support ratios in Japan
Source: Fig. A2 in Mayhew (2009)
31
Relationship between growth rate in
GDP and changes in TSR in Japan
Source: Fig. A3 in Mayhew (2009)
32
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




Higher growth rates in countries with slower
ageing populations
More volatile stock markets


due to more flexible labour 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
FTSE100 Index 1985-2012
8000
7000
6000
5000
4000
3000
Increasingly
volatile stock
markets
2000
1000
1/85
1/1990
1/1995
1/2000
1/2005
1/2010
1/2015
34
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
A role for government in
longevity risk sharing?
36
Longevity fan chart for 65-year old male
(Cairns-Blake-Dowd model)
37
Mortality fan charts
(CBD model)
38
Survivor fan chart for 65-year-old male
(CBD model)
100
SURVIVOR RATE %
AGE 75
80
60
AGE 90
40
20
0
AGE
Expected value
90% confidence
39
Decomposition of longevity risk
Total longevity risk
=
Aggregate longevity risk
[Trend risk]
+
Specific longevity risk
Government
hedges
[Idiosyncratic
and modelling risks]
Private sector
hedges
40
Longevity volatility
driven
by threeby
underlying
…
Longevity
riskis is
driven
threerisks
underlying
risks
Outcome probability, %
Expected
Outcome
A
B
C
Alternative
Outcome
Modelling Risk
Trend Risk
Idiosyncratic Risk
A
Modelling Risk: Risk that
probability distribution is incorrectly
modelled due to a limited data set.
B
Trend Risk: Risk that large
unanticipated changes in socio economic environment or health care
significantly improve longevity.
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
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
100
80
Capital markets deal
with this segment in
long run
60
Govt. earns
longevity risk
premium
TERMINAL
PAYMENT
40
20
0
AGE
Expected value
90% confidence
42
Longevity bond cash flows across ages and time
YEAR
2045
2040
Issue year of
bond
2035
Deferment
period on bond
2030
Payments on
bond
2025
2020
2015
2010
65
70
75
80
85
90
95
100
1945
1940
1935
1930
1925
1920
1915
1910
AGE
BIRTH YEAR
43
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
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
But it’s if not when to annuitise
Annual mortality cross subsidy
20%
15%
Limited value from
annuitization – Death
benefit seen as more
valuable.
Annuitization essential
to provide income for life
10%
5%
0%
AGE
46
Thank you!
Longevity 10:
Tenth International Longevity
Risk and Capital Markets
Solutions Conference
September 2014
Santiago, Chile
www.longevity-risk.org
47