The increased availability of advanced medical care, extensive health education and increased awareness of a healthy lifestyle are just some of the factors that have resulted in an improvement in retirement longevity.
This increased duration has left retirement income funders with a conundrum. Either force individuals to delay retirement, thereby reducing the duration and increase savings, or alternatively find methods to more efficiently utilise retirement funding to generate retirement income.
Practical impossibilities
While the first option provides the ideal scenario, it is not practically possible for the majority of retiring South Africans in the short to medium term.
However, the second option is viable for a retiree using their Longevity Dividend – the identification of personalised life expectancy to identify associated longevity risks and extract maximum personalised value.
A retiree will therefore need to understand how long she is expected to live and her risk tolerance to the life expectancy being incorrect. The investment return on retirement funds loses importance if the duration of retirement is unknown or materially incorrect.
Three primary products are available in the market to generate retirement income from compulsory retirement funds:
? Guaranteed annuities;
? With-profit annuities; and
? Living annuities
Each product assumes a different life expectancy, and provides different financial protection against that assumption being incorrect.
Guaranteed annuities
This product will allow you to use the technology of an insurer to attain an objective view of a retiree’s life expectancy.
Innovation in the objective determination of longevity using underwriting ensures that individuals are assessed according to their own characteristics, and not general population characteristics.
It is therefore more prudent to use a fully underwritten annuity for this analysis.
A guaranteed annuity allows retirees to pass all longevity risk to the insurer. The starting income and future increases are guaranteed as long as the retiree is alive.
There is therefore no risk to the retiree of the life expectancy calculation being incorrect.
With-profit annuities
A with-profit annuity passes all longevity risk associated with the starting retirement income to the insurer.
The starting income is therefore guaranteed for life.
However, future increases are, amongst other factors, dependent on the mortality experience of the associated group of with-profit policyholders.
All policyholders are therefore sharing the risk that the insurer’s life expectancy assumptions are incorrect. The retiree is therefore hedging her longevity risk.
Living annuities
After the purchase of a living annuity, the retiree retains all longevity risk and other financial risks. There is therefore a risk that the client can outlive their funds if they live longer than expected.
The retiree should therefore ensure that their income drawdown rate is at a level that would be sustainable for the rest of their life.
The calculation of a sustainable drawdown rate would need to take account of multiple factors including investment returns, income inflation and longevity.
Reasonable assumptions can be made for all factors, except longevity. A probability of the retiree being alive to receive income at each point in the future will need to be made.
A proxy for this calculation is the use of the guaranteed annuity rate for that same retiree. This will use an insurer’s proprietary algorithms to determine the retiree’s longevity.
Where a fully underwritten annuity is used, the algorithm will be more sophisticated thereby ensuring that the retiree’s longevity analysis will be directly linked to that retiree’s lifestyle (income, occupation and smoker status) and medical condition (past and present).
This calculation would need to take place every year.
Sustainable retirement income is the ultimate goal for any retiree. The risk of longevity therefore needs to be mitigated by choosing a retirement income product best suitable based on the individual life expectancy of the retiree and her risk appetite.
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