Annuities and the decumulationphase of retirement

Chris Daykin

Chairman, PBSS Section of IAA

Actuarial Society of Hong Kong

17 September 2008

ACCUMULATION AND DECUMULATION

The two phases of pension savings (especially DC)> the accumulation phase

> contributions accumulated up to retirement age> usually the main focus of attention

> the decumulation phase> pension income is drawn down from the accumulated funds> how can this phase best be managed?

CASH LUMP SUM AT RETIREMENT

Cash instead of pension> popular with participants> can be used to pay off mortgage on house…> …or to buy a retirement home, car, etc.> gives flexibility for investing as individual wishes> may facilitate handing money on to children> favourable tax treatment in some countries…> but it is not directly “income in retirement”> and may be spent or “squandered”> and may increase cost of means-tested welfare benefits

INCOME WITHDRAWAL

Main features> keep accumulated individual fund invested> maintain investment control> withdraw money regularly from fund as pension> purchase annuity at some later date (perhaps)> also known as “draw-down” …> …or “programmed withdrawal”> may be available as flexible withdrawal from fund> or as a specific regulated product (as in UK)

INCOME WITHDRAWAL

Advantages> allows investment in equities, etc. for longer period> permits greater investment flexibility> permits flexibility in amounts taken each year> not obliged to withdraw the whole fund

> when market value of fund is depressed, or > when annuity rates are low

> avoids handing whole fund to insurer> can pass to survivors what is left in fund at death

INCOME WITHDRAWAL

Disadvantages> risk of outliving assets> implications for means-tested welfare benefits> risk of drawing money down too quickly…> …or too slowly> mortality drag> rising cost of annuities and selection problems> risk of investment returns being below expectation> expenses of contract or of managing assets

INCOME WITHDRAWAL

Mortality dragThe cost of an annuity due can be expressed as follows:äx = 1 + ( v · ℓx+1 + v2 · ℓx+2 + … vω-x · ℓω ) / ℓx

at rate of interest i, where ω is the limit of life= 1 + v · ℓx+1 · äx+1 / ℓx

The extra cost of taking a withdrawal of 1 at age x and then buying an annuity at age x+1, instead of buying an annuity at age x is:

v · äx+1 – (äx – 1) = v · äx+1 [ 1 - ℓx+1 / ℓx ] = v · qx · äx+1

The extra cost is effectively the loss of the risk-sharing which would arise under the annuity in respect of those who do not survive from age x to age x+1.

INCOME WITHDRAWAL

Figure 7 The additional returns required in drawdown to compensate for mortality drag for person attaining age 60 in 2006

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Mortality underlying 2004-based population projections, UK - source: Government Actuary's Department

Mortality drag

INCOME WITHDRAWAL

Other adverse factors> apart from overcoming mortality drag…> there is also the possibility that the terms of annuity

pricing might move against the individual> because of falling interest rates, or> because of reassessment of mortality

> to gain from deferral the yield on the fund needs to besufficiently more than the yield implicit in the originalannuity pricing basis to overcome these two factors

> the probability of not achieving this can be high

ANNUITISATION

Arguments for> spreads risk of longevity> efficient use of assets to provide lifetime income

> individual cannot draw down to provide stable lifetime income as lifetime is uncertain

> ensures pension fund money is used to provide pension> avoids reliance on means-tested benefits> ensures that money is received as income …> …and hence can be taxed

ANNUITISATION

Arguments against> prevents the pensioner leaving the money to family> if he or she dies early, they “lose all their money”

> but cash on retirement, guarantees, survivors’ annuities offset this> could also have decreasing term assurance to cover early death

> annuities are seen as poor value> annuitants tend to live longer than average> those in poor health may get a bad deal

> pension income depends heavily on investment yields (and annuity prices) on day of retirement

ANNUITISATION

Pricing annuities> allow for age and gender (if permitted!) > pensioner annuitant mortality

> allow for selection> allow for lower mortality for higher pensions> allow for improvements in mortality> health status; occupation; smoker/non-smoker

> current market redemption yields on bonds> can “match” portfolio by investing in bonds> adjust yields for risk

> expenses> contingency margin and profit

ANNUITISATION

Pensioners and annuitants> greater longevity increases costs> population mortality is too heavy> strong difference between voluntary/mandatory> mortality highly dependent on nature of covered group> options, e.g. programmed withdrawal> projecting mortality is problematic> prudent margins needed for reserving

ANNUITISATION

Annuity rates at 5% on various mortality bases - Males

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ELT15PML92(C=2010)PMA92(C=2010)PML92(U=2004)Projected populationPMA92(U=2004)PMA92(U=2004)mc

ANNUITISATION

Pension increases> fixed annuities appear attractive (30-40% higher)> if same fund at retirement, increasing or index-linked

annuity provides smaller initial pension> effect of inflation

> after 20 years, with 5% p.a. inflation, cost of living has increased by 165%, $1000 pension would only be worth $380 in purchasing power

> selection, if option> people with increasing annuities tend to be healthier> annuities may offer poor value to less healthy individuals

ANNUITISATION

Underwriting annuities> differentiate by class of annuitant…> …but traditionally not underwritten> only the healthy would buy annuities voluntarily> however, compulsory annuitisation changes things> medical questionnaire or examination for impaired lives> enhanced rates for smokers> occupation and postcode/zipcode rating> non-impaired lives become ever more ‘select’

ANNUITISATION

Other types of annuity> with-profit> unit-linked> annuitised fund> successive temporary annuities> new forms of risk-sharing

ANNUITISATION

With-profit annuities> basic annuity is guaranteed> bonuses awarded at annual actuarial valuation to

increase amount of annuity> priced to give a margin for the insurer…> …a buffer against adverse experience> permits a more flexible investment policy> initial pension is lower than for a level annuity

ANNUITISATION

Unit-linked annuities> premium invested in unit fund (or funds)> value of account changes with unit price> unit cancellation rate calculated at start as

> number of units held by the policyholder…> …divided by life expectancy at starting age

> that number of units is then cancelled at each payment point in respect of all those surviving

> income received depends on current unit price> known in USA as TIAA-CREF annuities

ANNUITISATION

Unit-linked annuities

Consider a batch of annuities sold to ℓx individuals aged x, each purchasing N units. ⇒ total number of units in force at age x = N · ℓx.

Unit cancellation rate is defined as N / ex , ex being the expectation of life at age x.

After one year, ℓx+1 individuals remain (if mortality follows the assumed table) and the number of units cancelled at age x + 1 = ℓx+1 · N / ex

Total number of units in force at age x+1 after annuity payments have been made= N · ( ℓx – ( ℓx+1 / ex)) = N · ( ℓx / ex ) · ( ex – ( ℓx+1 / ℓx)) = N · ℓx+1 · ex+1

ex

The number of units runs down with a factor of proportionality ℓy · ey (→ 0 as y → ω), running down in accordance with the number of survivors from the original group according to the assumed mortality table.

ANNUITISATION

Annuitised fund> unitised fund with choice of investment options> income withdrawal by cancellation of units…> …between maximum and minimum number> maximum might be as for unit-linked annuity> units from deaths redistributed to survivors> cohort effectively bears own risk of unanticipated

improvement in mortality> balance in fund used to purchase conventional annuity at

advanced age, e.g. 85

ANNUITISATION

Successive temporary annuities> buy n year temporary annuity with fraction p of fund> (1-p) remains invested in choice of funds> after n years use q of remaining fund to buy another

temporary annuity> (1-p)·(1-q)·Fx+n / Fx remains invested, where Fx is index

of fund size corresponding to age x> continue until advanced age at which balance of fund

has to be used to purchase life annuity

RISK MANAGEMENT

Risks for retirees> longevity risk> market risk on sale of assets> interest rate risk> annuity purchase risk> expense risk> inflation risk> health care risk> long term care risk> risk of declining faculties

RISK MANAGEMENT

Risks for providers> mis-pricing risk> selection risk> systemic longevity risk> risk of limited investment market> mismatch risk> risk of guarantees> expense risk> tax and regulatory risk

RISK MANAGEMENT

Other forms of risk-sharing> scope for development of different products> differing levels of mortality risk sharing> differing approaches to investment choice> …and to controlling investment risk

Annuities and the decumulationphase of retirement

Chris Daykin

Chairman, PBSS Section of IAA

Actuarial Society of Hong Kong

17 September 2008

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA – an association of associations> founded 1895 as Comité Permanent des Congrès> renamed IAA in 1968> new IAA constitution in 1998> now an association of professional actuarial associationsThe vision of IAA is:To seek worldwide recognition for the actuarial profession as a major player in the decision-making process within the financial services industry, in the area of social protection and in the management of risk, for the well-being of society as a whole.

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA – an association of associations> representing the profession with international bodies> encouraging the development of professionalism> setting minimum standards for associations> planning an International Actuarial Education Programme> assisting new associations to get started> advancing the body of knowledge of actuarial science> furthering the professional development of actuaries

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA – sections for individual members> ASTIN (general insurance)

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA – sections for individual members> ASTIN (general insurance)> AFIR (investment and financial risk)

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA – sections for individual members> ASTIN (general insurance)> AFIR (investment and financial risk)> IAAHS (health and care)

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA – sections for individual members> ASTIN (general insurance)> AFIR (investment and financial risk)> IAAHS (health and care)> LIFE (life insurance)

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA – sections for individual members> ASTIN (general insurance)> AFIR (investment and financial risk)> IAAHS (health and care)> LIFE (life insurance)> IACA (consulting practice)

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA – sections for individual members> ASTIN (general insurance)> AFIR (investment and financial risk)> IAAHS (health and care)> LIFE (life insurance)> IACA (consulting practice)> AWF (actuaries without frontiers)

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA – sections for individual members> ASTIN (general insurance)> AFIR (investment and financial risk)> IAAHS (health and care)> LIFE (life insurance)> IACA (consulting practice)> AWF (actuaries without frontiers)> PBSS (pensions, benefits and social security)

INTERNATIONAL ACTUARIAL ASSOCIATION

IAA Sections> sections are for individual members> actuaries from any member association of IAA can join > role of sections is

> to encourage actuarial research> to organise meetings for the exchange of ideas> to provide CPD for actuaries in their practice area> to promote the role of the profession in the practice area

INTERNATIONAL ACTUARIAL ASSOCIATION

PBSS Section – Pensions, benefits and social securitySpecial interest section for actuaries with interests in

> commercial issues> social issues> public policy issues

concerning the provision of pensions & other benefits> social security> private (occupational and personal) pensions> social security reform> annuities and related financial contracts> employee benefits, share options, etc.

PBSS SECTION OF THE IAA

Future meeting plans

4th PBSS ColloquiumTo be held 4-6 October 2009 in Tokyo, Japan, in association with the celebration of the 20th Anniversary ofthe Japanese Society of Certified Pension Actuaries

29th International Congress of Actuaries7-12 March 2010 in Cape Town, South Africa

Questions and discussion