Longevity Returns

Meeting these objectives is heavily dependent on a saver’s ability to earn sufficient returns and having an accurate understanding of the duration during which that retirement income will have to be generated.

With the introduction of underwritten annuities in South Africa, annuitants now have the ability to more easily use the guaranteed annuity as a vehicle to generate excess returns, particularly in relation to their own personal lifestyles and medical circumstances.

 

The pricing of a guaranteed annuity depends on the yield curve that an insurer expects to achieve. The yield curve is not typically flat which means that the period of time over which an insurer invests money is important. The time period therefore needs to directly correspond to the life expectancy assumption of an annuitant.

 

The life expectancy is therefore important because it not only determines the expected duration during which annuitants will be paid an income, but also determines the yield expected to be achieved on the investment.

Assume that the weighted average yield curve, used for a 65-year-old who is purchasing a guaranteed annuity, is 8.5% and that his life expectancy is calculated as 20 years. The annuitant can expect to receive an internal rate of return of 8.5% per year on his investment if he survives until age 85. However, if the annuitant lives longer than the 20-year mark, his return on capital gears up dramatically.

These enhanced returns are difficult to achieve when a guaranteed annuity is not underwritten and the annuity payable does not reflect the annuitant’s own personal circumstances. However, when the annuity is underwritten, the annuitant is making a calculated decision as to whether the insurer’s life expectation is lower than what the annuitant expects.

The following graph shows how this "longevity return” gears upward as annuitants grow in age and as their health deteriorates. As an example, an unhealthy 75-year-old can expect to achieve a return well in excess of 30% on living longer than 10 years.

These enhanced returns using a guaranteed annuity are not solely in the domain of a retail investor. The same rationale used for a sole individual can be extended to a group included in a post-retirement medical aid fund or receiving a defined benefit pension.

The primary difference when considering an institutional offering is that it is the fund that needs to pay these excess returns to the members who live longer than expected. Funds seldom have a safety net to cover this scenario, unless a willing employer still exists, or new members are used to fund the excess returns.

A solution does exist to assist with the payment of these excess returns via a Longevity Swap™, now available in the South African market. This means that the members of the fund are able to participate in longevity returns, while the fund removes the risk of incurring the liability to pay such enhanced returns to its members.

There is no doubt that the primary aim of a guaranteed annuity is to protect the income of a retiree when he or she lives longer than expected.

 

There is, however, a clear market for a diversified portfolio of investments to include an investment in the longevity of the investor, whether retail or institutional.

 

There cannot be a more personal investment than investing with a view to live longer than an insurer expects you to, and harnessing the enhanced returns that come along with that investment.