Last time, I wrote about the latest mortality projections from the Continuous Mortality Investigation (“CMI”) and the effect this could have on pension scheme liabilities and that it may provide some relief for trustees and sponsoring employers. I then began to cover how mortality affects members of Defined Contribution (“DC”) schemes. This blog covers these issues in more detail.
In DC schemes, members pay contributions towards their own personal fund at retirement, referred to as the “accumulation” phase. When the member retires, they use that fund to finance their retirement, in pretty much whatever way they choose (i.e. the “decumulation” phase). The growing trend towards this process has prompted a joint paper by three actuarial bodies (the Australian Actuaries Institute, the Institute and Faculty of Actuaries and the American Academy of Actuaries), on the issue of longevity risk (“the Joint Paper”).
Longevity risk is related to mortality and life expectancy. Quite simply, it is the risk that a person’s actual life span exceeds their life expectancy. What the Joint Paper highlights is the difficulty for people estimating how long they will live, so as to adequately plan for and fund their retirement.
Whilst the structure of retirement benefits are different in each of the countries identified in the paper, similar problems affect each of them. There are two main risks illustrated for the individual; either that they will use up all of their life savings before they die, or that they will die before they have the opportunity to maximise their utility from those savings. The root cause of these problems is that many people simply underestimate their life expectancy – we have a tendency to think that we’ll not live for as long as we actually do! What the Joint Paper seeks to do is explore if a default option could be created that protects everyone from longevity risk, to an appropriate level.
Perhaps the first thing to note is that longevity risk is not really understood by most people. Arguably this lack of awareness has been a motivation behind the introduction of auto-enrolment , “pensions freedoms”, and the DWP’s heavy promotion of the “Workie” mascot, as an attempt to get the general public thinking more about retirement. After all, for most under 25’s like me, retirement plans may not exactly be at the top of the to do list!
So retirement planning is in the public eye more than ever before – which is certainly a positive thing. But as always, more can be done. The Joint Paper goes on to suggest 5 key principles on how longevity risk should be managed: Adequacy, Information, Flexibility, Equity and Sustainability.
These headline principles represent some crucial realities for individuals:
- the benefits in retirement must be adequate to maintain their standard of life;
- information and advice must be available to individuals in order to make informed decisions;
- each person’s ideal income in retirement will depend on their individual circumstances, which their chosen benefits should reflect and be flexible towards;
- the framework designed for retirement provision must be equitable (especially with regards to tax relief) and;
- any system adopted must be sustainable (So no continuous tinkering with the system!).
Ensuring that your savings last through retirement can be challenging. Also, it may even be the most important decision you make in your working life. There are so many different retirement products out there, in this new age of pension freedoms. The traditional method of purchasing an annuity in retirement is disappearing towards the horizon, especially in light of the changes to pensions taxation.
This is despite the view of the Joint Paper that generally annuities give the most stable income in retirement and protect against longevity risk fairly well. The flight away from annuities may be due to a view that annuities offer low value for money compared to other options, such as drawdown or taking the whole pension pot as a lump sum.
It should of course be remembered that each individual’s circumstances are different, meaning a pension product suitable for Mrs A may not be suitable for Mr Z. For example, a person in ill health would perhaps benefit from an impaired life annuity, which would generally give a higher pay-out than a traditional annuity due to the individual not being expected to live as long.
The Joint Paper also stresses the importance of would-be pensioners receiving expert advice as soon as possible, and suggests that it should reasonably fall on employers and governments to provide such advice. This is a sentiment that I agree with.
In this new era of additional choice in retirement, people need all the help they can get. Especially since HMRC has recently confirmed that over 55’s have cashed-in over £2.7bn of their pension pots since the pension freedoms were introduced. That is a lot of money, and possibly represents a significant decrease in future pension payments. It is clear that a significant degree of financial management needs to be promoted to ensure those over 55’s are making the most informed decisions possible.
Tellingly, the Joint Paper does not take a view on what a default fund at retirement should be. Rather, it calls on governments and financial providers to develop a framework in which individuals can make their pension provision last for the duration of their retirement. Will this happen in the UK? As with the mortality finding released by the CMI, it’s probably best to wait and see.
Longevity has often been seen as a secret science, understood only by actuaries and health professionals. However, as can be seen, if you are involved in a pension scheme as a trustee, sponsoring employer or a member, it is important to get to grips with mortality. Only then will our longer lives be complemented by more appropriate pension provision.