Longevity risk presenting huge challenges for SA retirement industry

The Disruptors (Woman & Money)
12 November 2015

The shift towards living annuities as the preferred retirement vehicle in South Africa is likely to present significant challenges for millions of retirees, unless the industry can develop a solution to mitigate the longevity risk that these products present.

Living annuities, which according to National Treasury, now account for as much as 80% of all annuities sold at retirement, provide investors with the flexibility to choose their income each year (ranging from 2.5% to 17.5% of the capital) and how this money is invested. Any remaining capital after the investor’s death passes to the nominated beneficiaries.

According to Shaun Levitan, Executive Director at Colourfield: “However, in exchange for this flexibility, investors take on the risk that they outlive their savings and the risk that their investment returns are poor. This means that their future income could fail to keep up with inflation, or even that they outlive their savings”.

He says the key reason for this is longevity risk – the risk that people live longer than expected. Many planners at retirement use assumptions and tools that are based on the average life expectancy to determine an individual’s investment strategy.

For example, a male retiring at age 65 is expected to live to 81.5, whilst a female retiring at age 65 is expected to live to just short of 86. These assumptions are based on actuarial tables used by pension funds and insurance companies and are based on historic data and expected trends.

“Suppose our planner bases his assumptions on these tables and structures the living annuity accordingly. The problem comes if each member of this couple live to age 90 – well in excess of the man’s expected life time and 4 years ahead of the woman’s. In this instance, if the couple spend money exactly as budgeted and earn the investment return assumed, they could have little or no assets left for several years. While mathematically, you can’t get to zero, the reality is that the living annuity exposes individuals to a significant longevity risk. It is cold comfort to say that they were never expected to live that long”

“The problem with averages is that there could be a 50% chance of living shorter or longer than the lifetime assumed. In fact, if a couple retire together aged 65, there is almost a 50% chance that one of them could live to age 90. Nobody would determine their investment strategy at retirement using the same odds as a coin toss, but this is what happens in practice.”

Levitan says the results of living annuities has not yet been tested. “In the past, living annuities were predominantly sold to high net worth individuals, but now they have become the post retirement annuity of choice for a much broader section of the population.”

He says that while the obvious option to mitigate this risk is to purchase a life annuity from an insurer that provides you with a specified income for as long as you (or even your spouse) are alive, these products have their own drawbacks, such as not meeting income needs, the reversibility of the purchase decision, perceived or actual higher costs and the risk that if you die early, you and your beneficiaries lose out.

Innovation needed to solve this problem

Levitan believes that the industry will need to innovate to solve the longevity problem.
“One way to solve the problem is to purchase a deferred inflation-linked annuity that begins making a payment at some point in the future (e.g. the expected lifetime of the individual). The premium on such a product should be quite cheap because the likelihood of living that long is very small. However, it would protect individuals against the “tail risk” of living beyond the assumptions made by the financial planner. Such a product, combined with the flexibility of the traditional living annuity would allow for better management of the key risks faced by people at retirement”

He says that while there could be potential regulatory or tax issues that would need to be navigated when combining such strategies, it is critical that the retirement industry applies its mind to this kind of thinking if we are to avoid a retirement crisis in the years to come.

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