Profitability in Longevity

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When Actuaries Missed the Boat

Can we turn the tide on pensions?

Mark O’Reilly, FIADeloitte Touche TohmatsuHong Kong

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“…The first quarter of this year saw a dramatic drop in annuity sales, with only 20,000 policies taken out compared with 70,000 the same time a year ago, according to the Association of British Insurers (ABI), the trade body.This development followed big reforms, which removed the requirement for people to buy an annuity at retirement.“People see annuities as ghastly, poor value products that they were forced into buying,” says Patrick Connolly, certified financial planner with Chase de Vere, independent financial advisers.“When they were given the choice not to buy them, when new reforms came into effect in April, they have stopped purchasing them in large numbers.”

“Annuities Fall Out of Favour, but Still Offer Certainty”By Josephine Cumbo, 20 August 2015

From the FINANCIAL TIMES (UK edition)

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The Great Pension Paradox

Low interest rates

Greater Longevity

Expensive annuities

Individuals managing their own lump sums

But the problem hasn’t changed at all – it has just

been passed from the government/employer to

the individual

Now the individual takes on the full investment risk and the longevity risk

Yet many corporations are in an excellent position to offer

LONGEVITY COVER to individuals – at limited or

no effective cost

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The Story of Pension DemisePension plans originally subsidized limited retirees with many early leavers, then

ignored inflation (i.e. inflation ate away at the real liability)but

Inflation disappeared (almost)

Lifestyle and elderly care improved

Plans that were priced at c.10% of pay were finally show to cost more than double that

>20% of pay? Close the plan!

Productivity growth failed to keep providing high real

returns

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The New Paradigm

“I now accept that I need to save

20%-30% of my pay if I want to

retire comfortably in my early 60s”

“If I (+spouse) live very long and have bad investment

luck, I will run out of funds for the last two decades of my

life”

“If I (+spouse) live long and don’t invest well, I will

run out of funds for the last decade of my life”

“If I (+spouse) don’t live long and I invest well, I will leave behind much of my

savings”

likelihood

25%?

likelihood

25%?

likelihood

15%?

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The Headwinds of Investing

11.6%The annual return on the S&P500 over the

last 30 years

3.8%The annual return

earned by stock mutual-fund investors over

same 30 years*

2.7%The annual rate of price inflation over same 30

years

1.8%The annual return earned

by asset-allocation mutual-fund investors over same

30 years*

“The overwhelming driver is bad timing by investors… It would also help to design products that give an incentive not to bail out at the wrong moment.”

John Authers, The Financial Times

* Quantitative Analysis of Investor Behavior published by the US market research group Dalbar

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The Law of Averages (We Forgot)

The uncertainty of personal longevity is quickly averaged out over a relatively small number of individuals

Though collective longevity has steadily improved in the past, the process is gradual, and

the individual can absorb the uncertain cost of collective improvement much more easily than

market risk or personal longevity.

Though individuals have a long-term

investment horizon, they often buy and

sell at the worst times (i.e. fear and

greed are poor long-term

strategies.) “Locked up” funds typically

do better

Corporations can provide the essential averaging without

significant exposure to them, thereby greatly reducing individual exposure

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Pension Fund (PF) of the Future?

Individual transfers DC funds to the PF, and commits to future contributions at a given rate

PF invested in global, indexed equity/bond mix (60/40, 50/50, 40/60, either fixed or sliding, e.g. 60/40 40/60 over 20 years)

Annuity Promise (below) depends upon staying in the PF throughout.

ANNUITY PROMISERetiring employee can choose between life annuities (with spouse’s

options) calculated at either 8%, 6%, 4% or 2% interest (“INT”)

The amount of the annuity is adjusted:(a) Monthly, for PF return (PFR) above or below INT and

(b) Every N (5?) years, for changes in mortality rates

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Investment Risk

Note that each participant remains entirely subject to their chosen PF performance throughout employment AND retirement

The corporation takes on NO investment risk

The employee takes on investment risk, based on a single fund, for a

mean term of 30+ years

The employee can quit the PF at any time, but thereby forfeits

the annuity promise

The corporation offers longevity averaging without responsibility for

(a) investment (b) collective mortality improvement

The employee is encouraged to stick to a

consistent long-term strategy and discouraged to “play the

market”

The annuity promise offers personal longevity protection independent of

(a) investment and (b) collective mortality improvement

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Mortality Risk - How to Avoid ItDue to mortality improvement alone, the cost of a life annuity has been

increasing by about ½ % per year on average for past 50 years, and has recently accelerated – is this a sustainable trend?

• Less deadly conflict• Richer society• Welfare states• Less smoking, better diet• More health information• Better-informed elderly care

• Obesity• Aging population / budget limits• Pollution, superbugs• Epidemics• Right-to-die• More female breadwinners

PAST FUTURE?

Pooling the Risk Among Annuitants Retaining Risk with Provider

• Set an improvement rate then profit-share the results

• Variances of 20% are tolerable in context of variable investment performance

• Remains a major protection over individual exposure, while achieving “fairness” 

• Conservative rates diminish demand vis a vis cash balances

• Aggressive rates are bad for other stakeholders

• No real underlying science

©2016. For information, contact Deloitte China 11

The 6% Benchmark Performance history of:

60% S&P500 equities combined with 40% mix of high/medium-grade bonds

Measured over the period 1916-2015, the average return has been 9.0%/year;

Periods over which the average return has been less than 6% per year:

.

* Source: NYU Stern School of Business, US Federal Reserve

Period in Years

Number of Periods

Periods When Average <6%

Lowest Period Average Return

1 100 37 -26.2%5 96 28 -4.5%10 91 20 2.3%15 86 11 2.9%20 81 6 4.1%25 76 1 5.5%26 75 0 6.3%

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The Argument for a 4% Benchmark

Inflation has averaged about 3%/year in the last hundred

years

We may be in for a unique period of deflation in which long-term inflation averages

as low as 1%/year

Governments can print money to prevent long-

term inflation below this

A nominal return of 6%/year has therefore been equivalent to a real return of 3%/year, on

average

In an inflation environment averaging 1%/year, a real return of 3%/year is equivalent to a nominal return of 4%/year

The AA corporate 23-year spot rate was

4.6% at 31/7/15and 6.2% at 1/1/10

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Sample Variations: Historical Minimum (1)Minimum case achieved in almost 100% of market history

6%/year median return randomly generated- Lowest point after 9 years

60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 800

20

40

60

80

100

120

140

8% 6% 4% 2%

Age PFR60 -6%61 15%62 19%63 -9%64 12%65 -18%66 4%67 0%68 -8%69 26%70 14%71 24%72 17%73 10%74 4%75 8%76 10%77 22%78 4%79 -15%80

Average

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Sample Variations: Historical Minimum (2)A alternative route to a 6% median return

- Lowest points after 4 and 16 years

60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 800

20

40

60

80

100

120

8% 6% 4% 2%

Median PFR = 6%Age PFR60 27%61 -9%62 -9%63 -15%64 8%65 17%66 2%67 3%68 24%69 5%70 -2%71 6%72 10%73 6%74 10%75 -7%76 18%77 16%78 6%79 10%80

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Sample: Historical Minimum Less 2%/YearMinimum case adjusted for 1% inflation:

4%/year median return, randomly generated

60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 800

10

20

30

40

50

60

70

80

90

100

8% 6% 4% 2%

Median PFR = 4%Age PFR60 -11%61 -19%62 -5%63 13%64 1%65 -6%66 17%67 -2%68 24%69 26%70 5%71 -2%72 26%73 2%74 19%75 8%76 14%77 -4%78 -17%79 16%80

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Sample: Historical Minimum Less 4%/YearAssumes only 2%/year median return over 20 years, randomly generatedNothing close to this poor performance has occurred since stockmarkets began

60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 790

20

40

60

80

100

120

8% 6% 4% 2%

Median PFR = 2%Age PFR60 -16%61 26%62 22%63 14%64 23%65 -17%66 0%67 -9%68 13%69 16%70 -3%71 -12%72 -9%73 1%74 8%75 26%76 26%77 -15%78 -16%79 -7%80

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Sample: Severe and Continuing DeflationAssumes NEGATIVE 2% median return over twenty years, randomly generated

60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 800

10

20

30

40

50

60

70

80

90

100

8% 6% 4% 2%

Median PFR = -2%Age PFR60 9%61 -20%62 -4%63 11%64 -2%65 -11%66 9%67 0%68 -15%69 24%70 9%71 -15%72 -15%73 26%74 -9%75 16%76 0%77 -19%78 5%79 -18%80

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The Advantages (1)

The Employer:

Potentially, no material net P&L cost!*

Any net balance-sheet liability/surplus kept small, based on gap between actual and expected annuitant longevity

The more participants, the relatively smaller the gap

Small employers could commingle their longevity to reduce the gap (adjusted, if desired, through medical evidence at retirement)

The Employee:

A guaranteed life annuity, including spouse if desired,

otherwise unavailable without low-yield bond

investment

A strong incentive to maintain long-term

investment discipline, a strategy advised by all investment experts but

otherwise hard to maintain psychologically in volatile

markets*under IAS19 (revised 2011). Net DB liabilities incur interest cost and net DB assets generate interest income

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The Advantages (2)The Provider

The Product: “The Transparent Annuity”

A select range of indexed portfolios which allow limited switching over time,In order to qualify for longevity protection, e.g., Global equity & bonds Developed equity & bonds Equity, bonds and possibly REITs 60/40, 50/50, 40/60 & 40/30/30

Provider fees based on AUMe.g. 0.45% pre-retirement, 0.75% post-retirement

Per-installment fee for annuity

Risk-pooling for annuitants: Transparent guideposts

for emerging experience Spousal options Actuarially certified Health-insurance options Accommodate long-term

care?