Heffron's Blog is a collection of comments related to the latest superannuation comings and goings.
Living longer – dealing with the risks
by Meg Heffron
I attended a fascinating presentation at the SPAA conference earlier this month that looked at longevity risk (the risk of living too long and running out of money). It was delivered by Jeremy Cooper (not surprising given Challenger’s presence in the annuity market) and Catherine Nance (an actuary with PwC who has been an active participant in the debate on retirement incomes policy for many years).
Catherine took me back to my actuarial roots and reminded both me and the rest of the audience that there are really two types of longevity risk.
Firstly, what she called “idiosyncratic” longevity risk. This is the risk that a particular individual will happen to have mortality experience that is not precisely average. It’s the risk that you will die young (or in this case, live longer) than most of your peers.
Then there is a completely different risk which we could call “systemic” longevity risk. This is the risk that improvements in medicine, living standards etc will cause everyone to live longer than the previous generation. (This effectively moves the average life expectancy up.)
She made the very good point that one of the conventional wisdoms supporting the provision of annuities by life insurance companies is that it allows pooling of risk. If a superannuation fund (or any other entity for that matter) tries to provide an annuity for 1 person, it’s impossible to know how much will be needed because that person may die tomorrow or could just be the 1 in 100 who lives for another 40 years. If, however, a life insurance company is providing annuities for 10,000 or even 1,000 people, chances are that the experience of the pool will, overall, be “average”. In other words, we can’t predict the experience of a single individual but we can probably make some sensible guesses about the group as a whole.
However, pooling only ever evens out “idiosyncratic” risk – it is designed to ensure that we have enough people to give us a spreadh of people who die young and also those who will live for a very long time. (It’s also why if you ever buy an annuity, you would ideally like everyone else in your pool to have had an exhausting physical job that causes them to die young – perhaps hang around outside building sites and promote your provider’s products?)
So how do we deal with systemic longevity risk (the fact that everyone is living older and the average is moving up)?
The argument used here was that an insurance company holds reserves for this. In other words, they make sure they take a bit extra from everyone to set aside some money for a rainy day. They can be pretty confident that rainy day will come because history would suggest that we are indeed living longer.
Naturally this raises a new risk – institution risk. If you buy an annuity at 60, you want to be sure of two things:
- that the institution you bought it from holds enough reserves to allow for continued improvements in life expectancy; and
- that the institution itself will be around then (or – more likely in financial services – that the institution that bought the company that bought the company that bought the company that sold you the annuity. You get the picture)
So what sorts of institutions can you be confident will still be around in 40 years?
Given some of the recent spectacular failures of banks and even (in the US) a major insurer, I suspect now is not the time to be presenting institution risk as a minor or triffling thing. The buying public just won’t believe you.
Jeremy’s rebuttal of this point was reasonable. He made the point that APRA’s regulation of the providers of these products is strong – hence Australia’s success in avoiding major failures in recent times.
To my mind, however, there is a flaw in this argument. Certainly Australia’s current regulatory environment is strict. The extensive reserves APRA requires life insurers to have is one of the many reasons annuities are expensive to provide (therefore pushing up prices to annuitants) and are offered by very few institutions. In fact to some degree this explains their lack of traction in Australia – because they are expensive, the consumer (perhaps based on an inadequate understanding of the risks they are taking) largely refuses to buy them.
The big question, however, is whether Australia’s regulatory environment will stay that way over the very long timeframe for which an annuity is in place.
We live in a democracy. In that environment, good government relies on the assumption that because all decisions are ultimately made with the approval of the majority of people, self interest will ensure that they are good decisions. However, what about when a good decision involves some self sacrifice or doing without?
What if a good decision was to keep anuity reserving rules strong because that maximises the chances that annuity providers will be around for the long haul to meet their promises of an income for life? At the same time, however, what if a popular decision was to relax those reserving rules (just a little you understand….) so that annuities became more affordable and everyone could have one?
The question then becomes : when the majority of Australians are more interested in an affordable annuity right now and the providers insist that antiquated and unnecessarily harsh reserving rules are keeping prices high, how long will it take before the rules are relaxed? How long will it be before the baby boomer generation (with plenty of lovely individuals but as a group, not especially well known for putting the greater good ahead of their own interests) decides by majority vote that it is best to meet their immediate need for cheap annuities and worry about systemic longevity risk later?
And how strong will our institutions be then?
(You can see why Japan has toyed with the idea of giving parents the right to extra votes which they cast on behalf of their under age children. It’s the next generation that pay for many of the decisions we make today.)
So what’s the solution? A government guarantee? Since government pensions are being cut all over the developed world at the moment (and no doubt would be here too were it not for the mining boom), I wouldn’t find that sort of guarantee particularly comforting either.
Personally, I think a whole new way of thinking is needed – there’s room (and need) for some external annuity products but we also definitely need some legislative intervention. I’ll talk about that another time.