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Understanding the mortality credit

01 October 2014 Mayur Lodhia, Momentum Wealth

At retirement, South Africans typically consider two options for a retirement income: a living annuity and a traditional life annuity. Life annuities pay a minimum income for life and are the traditional choice at retirement. On the other hand, living annuities are not guaranteed for life but they have the ability to grow with strong investment returns.

These two products are at opposite ends of a spectrum, with full guarantees at the one end and no guarantees at the other end. With an increased focus on longevity protection, products that sit in the middle of the spectrum could go a long way towards improving an individual’s wellbeing during their retirement years.

Longevity concerns

In its discussions on retirement reform, National Treasury highlighted the lack of longevity protection for individuals in retirement. Advancements in medical research have made it possible for people to live longer which complicates retirement saving as retirees may outlive their savings. In this context, longevity protection can be translated as comfort that one’s retirement savings will generate an adequate income for their remaining years.

Some experts predict that we are moving into a period of lower expected investment returns, so longevity risk is likely to return to the fore. In simple terms, if investment returns are expected to be lower, how can one secure an income for life, especially if one has no idea how long that could be?

Mortality credits

The traditional way to solve the conundrum of outlasting savings is to use what is known as the mortality credit.

This is best explained as follows: suppose ten friends contribute R100 to a kitty at the start of the year, with the agreement that the money will be split between those that survive the year. During the year, two of the ten die, so the kitty is split between the remaining eight who receive R125 (R100X10/8) each. This R25 difference between their R100 contribution and the R125 payout is the mortality credit. It is a return that one gets for surviving a given period. In the context of retirement, the mortality credit is particularly appropriate, since it only accrues to those who need it, those who are alive and those who require an income to live from.

Another way to think of the mortality credit is as an insurance against ‘living too long’. The principle is that some individuals will live shorter lives than others. Those who die sooner will need fewer income payments, and those who live longer will require more. If the average assumption is correct, those who die sooner will subsidise those who live longer.

What if new norms are set?

If everyone lives longer than the average, there are no early deaths to fund the incomes of those who survive longer than expected. Therefore, it is important to have an insurer standing behind these products for when the average assumption is incorrect. The insurer will determine this average assumption using actuarial skills, and will stand to lose if its assumption is too short. Similarly, the insurer can gain if the assumption is too long.

The obvious concern is the resulting temptation for insurers to be overly conservative in their pricing. However, the competitive nature of the life annuity market limits this.

The mortality credit can therefore be thought of as a tool, much like investment performance, to help stretch retirement savings. Traditionally, the only way to access the mortality credit has been through a life annuity. The other extreme is a living annuity where there is no longevity protection, but full market exposure.

It is time for the industry to start looking at newer generation products that combine the mortality credit from life annuities, and investment exposure from living annuities, in solutions that blend the best of both worlds.

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