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Retirement income innovation and longevity

01 April 2016 Jason Sharp, Paramount Life & Adam Jacobson, Paramount Life

Each month we are bombarded by multiple statistics of how South Africans have not saved sufficiently to generate sustainable retirement income.

However, the saving aspect forms only one part of the challenge. The manner in which savings are used and the efficiency thereof needs to be considered in any reform.

The expected income generated by retirement capital can in fact be represented by a closed formula.

The formula

Retirement capital must equal the expected present value of future income minus expected expenses. Income advisers should be able to generate this calculation and explain it to retiree clients.

Three main factors influence the calculation being future investment returns, the expected income inflation rate and the probability of the client being alive to receive the income. These three factors directly correspond to three of the primary retirement income risks being:

• Investment risk: the risk of investment returns not meeting expectations;
• Inflation risk: the risk of expenses growing faster than income; and;
• Longevity risk: the risk of outliving capital.

Longevity

Longevity remains the primary factor because if the client is not alive to require income, then the investment returns and income inflation are irrelevant.

Consider the retiree with serious cancer who is expected to live one year versus the healthy high net worth retiree - a vastly different future income expectation and requirement.

The expected investment return and income inflation only become applicable if the retiree is alive to be influenced by those factors. In fact, for a given level of retirement capital, the first retiree could be expected to be able to draw a significantly higher income while alive.It is therefore important that any longevity assumptions are correct. The study of retiree longevity is receiving massive attention worldwide. These studies not only look at the current state of longevity, but how longevity is changing in the future.

A retiree’s probability of being alive is influenced by multiple factors including age, gender, income, occupation, smoker status as well as current and past medical diagnoses.

An interesting line of study has inferred that any longevity projection is influenced by the period in history in which a retiree was born. As an example, the longevity pattern of a 70 year old ten years ago is different to a 70 year old today because the first retiree was born before World War II.

Income generation

The product or method used to generate the income is irrelevant as all will at their base need to incorporate the formula highlighted above.

The key focus should be the on the approach in each product to the elimination or amplification of the risks associated with each of the factors to achieve the desired outcome. Elimination of the risks results in greater certainty. Amplification of the risks allows the potential to increase affordable income with the potential for negative outcomes.

Guaranteed annuities

Guaranteed annuities ultimately provide advisers a baseline result of the calculation and the easiest way for an adviser to perform a discounted cash flow calculation that incorporates longevity.

The resultant income incorporates longevity to generate a resultant affordable sustainable income. This means that an adviser is able to perform the calculation by simply requesting a quotation where the underwriting takes account of the factors listed above that affect longevity.

The South African insurance market has seen significant work over the past several years to build country specific longevity models.

These have resulted in products that allow retirees to protect themselves against the income risks associated with their longevity as well as use longevity to enhance retirement income. This allows the elimination of the longevity component from the sustainable income calculation and allows retirees to acquire risk free sustainable income that is not subject to the risk of outliving their retirement capital.

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