Deciphering the longevity conundrum

Investment risk has been well documented. However, with ever reducing yields, the focus needs to move toward how a fund can effectively manage the longevity and other risks associated with the provision of income to the retired pensioners.

There is little debate that people are now living longer than ever before in history. In the UK and Germany, the population of retirees above the age of 80 is expected to increase by in excess of 121%. This is against the backdrop of retiree life expectancy doubling over the past 50 years.

 

Currently estimates of mortality improvements range from 1% to 2% per annum. However, these improvements can differ by age group and gender. Retirement funds and their valuators will need to carefully consider the impact of these improvements on the solvency of funds and the income increases that will in turn be affordable into the future.

The risk associated with longevity can be carved out and hedged without the need of a full pension-fund outsource. This can be performed via a longevity swap. In such a transaction, the fund is insured against the risk that members will live longer than expected. The net effect is that the fund purchases a policy whereby a defined premium payment stream is paid to the insurer in exchange for the insurer paying the fund the actual income payment stream to pensioners.

In turn, the fund is able to focus on the investment plan required to meet the premium payment stream without the burden of the effects of longevity on future fund cash-flows.

While a longevity swap removes longevity risk, a fund may not wish to retain its investment risk or may not have sufficient assets to cover the premium cash-flows of a longevity swap. In this case, the removal of all risks can be implemented via a full outsource.

 

In this scenario, an insurer accepts the transfer of all fund liabilities in exchange for a purchase consideration. The pension fund is subsequently closed. The outsourcing is specifically reliant on the pension fund’s having sufficient funds to pay the required purchase consideration. Fund trustees should bear in mind that the consideration may be unaffordable because the insurer’s existing pool of annuitants has higher longevity (i.e. the longevity assumption used to calculate the consideration) than the members of the fund. In such a scenario, a fully underwritten outsourcing could provide a fund with a cheaper option to enable outsourcing.

The latest budget proposals call for the launch of a default option for retirees exiting a retirement fund. This will place the burden on retirement fund trustees – they will need to ensure that their members receive either financial advice at retirement or automatically purchase an annuity as selected by the trustees.

South Africa is unique in that fully underwritten annuities that individually analyse the longevity of annuitants are available. Trustees’ default option selection will therefore need to be flexible to ensure that exiting members who are smokers, low earners and/or are in ill health are able to select an underwritten annuity that enhances their income based on their particular personal circumstances.

The introduction of retail and wholesale longevity solutions mentioned, as mentioned above, has extended the ability of trustees to provide members with sustainable, cost-effective retirement income solutions. Trustees are therefore able to tailor-make and make available income solutions that take into account the unique characteristics of their members, while at the same time choosing which risks they will retain within the fund and which risks should be insured.