MANAGING LONGEVITY RISK IN PUBLIC AND PRIVATE PENSION SCHEMES

1. MANAGING LONGEVITY RISK IN PUBLIC AND PRIVATE PENSION SCHEMES Chris Daykin Chairman, PBSS Section of IAA Former Government Actuary of the UK University of Kent, Canterbury, 25 February 2009

2. PENSIONS, BENEFITS AND SOCIAL SECURITY SECTION 4th Colloquium of the PBSS Section of the IAA

3. 4th COLLOQUIUM OF THE PBSS SECTION OF THE IAA • Tokyo, Japan – 4-6 October 2009 • Actuarial Management of Pensions and Social Security • – Past, Present and Future

4. POPULATION AGEING • Expectation of life at age 65 on cohort basis, E&W

5. Expectation of Life for Males, 1950-2020

6. Expectation of Life for Females, 1950-2020

7. Total Period Fertility Rates, 1960-2010

8. Dependency Ratios, 1970-2030(numbers 65 & over for every 1000 aged 15-64)

9. SOME DEFINITIONS - DB • Defined benefit • benefits are defined • in absolute terms or • in relation to salary • benefits are usually a function • of the period of membership or • the period of contributions • the cost of providing the benefits is not known in advance • it depends on mortality and other experience • investment returns, inflation, etc • so there must be some way of adjusting income

10. SOME DEFINITIONS - DC • Defined contribution • contributions are defined • in absolute terms or • as a percentage of salary • benefits are what can be purchased with the contributions • allowing for investment returns and • any guarantees offered by provider • the level of benefits is not known in advance • it depends on investment returns, etc • if benefits are promised there must be a guarantor • e.g. an insurance company or an employer

11. WHO BEARS THE RISK? • Risk structure of defined benefit social security • no (or little) investment risk • longevity risk is met by: • increasing contributions from workers and/or employers • contribution (or increased contribution) from national budget • increase in retirement age for current workers • worsening of indexation provisions for existing pensioners • pension reform leading to benefit reductions, especially for future

12. WHO BEARS THE RISK? • Risk structure of defined benefit occupational plans • investment risk is (usually) carried by sponsor (employer) • longevity risk is met by: • increased contributions from sponsoring employer (and members?) • adjustments to discretionary benefits • reducing benefits for future accrual for existing workers • increasing retirement age for future accrual for existing workers • closing the plan to new entrants • insolvency risk of employer is carried by active members • …and, to a lesser extent, by pensioners • or by a guarantee fund (e.g. PPF)

13. WHO BEARS THE RISK? • Risk structure of defined contribution complementary plans • investment risk is carried by individuals • apart from any guarantees provided by pension institution • longevity risk is met by: • reduced pension benefits for those reaching retirement • or the need to increase retirement age to offset the effect • insolvency of employer does not affect accrued benefits • however, there is a risk of provider insolvency

14. DB OCCUPATIONAL PLANS • Decline of defined benefit occupational plans • increased costs arising from • greater longevity • lower interest rates • lower expected real rates of return on investments • effect of accounting standards on reporting of pension cost • volatility of results from mark-to-market asset valuation • focus of employers has shifted from long-term to short-term • plan closures have highlighted cost of buying out benefits

15. DB OCCUPATIONAL PLANS • Decline of defined benefit – specific UK factors • impact of Finance Act 1986 • incentive for employers to take contribution holidays • removal of Advanced Corporation Tax relief in 1997 • requirements to provide guaranteed indexation • pensions in payment • deferred benefits • contingent debt on the employer if scheme is closed

16. DB OCCUPATIONAL PLANS • Options for sharing longevity risk in a different way • closure of plans to new entrants or to further accrual • reduce accrual rate for future service • change from final average salary to career average salary • reduces exposure to individual member risk • sharing of increased cost between sponsor and employees • higher employee contributions • increase employee contributions in response to deficits • index pension age at which unreduced benefits are paid • flexible indexation to permit offset of longevity costs

17. DB OCCUPATIONAL PLANS • Sharing longevity risk through targeting cash benefit • define the benefit as a capital sum at retirement… • …and convert to pension using current annuity value • employer bears investment risk prior to retirement • member bears investment and longevity risk at retirement • annuity provider bears longevity risk after retirement

18. DB OCCUPATIONAL PLANS • Sharing longevity risk through discretionary benefits • define lower level of guaranteed benefits • apportion emerging surplus to supplement benefits • make revaluation of average salary subject to conditions • have no or low guaranteed post retirement increases… • …and award increases as bonuses from surplus • reduce generosity of ancillary benefits • offer additional benefits as options paid for by members

19. DB OCCUPATIONAL PLANS • DB target (risk-sharing) pensions • employer’s contributions fixed • basic design career average revalued with modest accrual • aim is to deliver RPI indexation pre- and post-retirement • …but indexation is not guaranteed • revaluation provided for each year if funding level permits • increases to pensions in payment if funding level permits • pension age could also be adjusted as safety valve

20. DB OCCUPATIONAL PLANS • Risk-sharing DB plans in Netherlands • mutualised industry-wide schemes • sponsors are insulated from risk of increased contributions • increased costs from longevity (and other reasons)… • …absorbed by flexible retirement age… • …and conditional revaluation/indexation of benefits

21. DC PENSION PLANS • Risk to members in DC plans • investment risk is usually passed fully to members… • …systemic investment risk and individual choice • no insurance of longevity risk - primary benefit is lump sum • each cohort bears longevity risk through cost of annuities • direct exposure to career salary record • employer is generally not at all on risk – fixed contributions • investment risk can be moderated by life-styling • usually at a cost in terms of return • early rebalancing into bonds and deposits may not be optimal • drawdown arrangements carry their own risks

22. DC PENSION PLANS • Risk-sharing in DC plans • mitigation of investment risk by guaranteed returns… • …cash balance with discretionary interest distributions • …guarantees in variable annuity products through insurers • traditional with-profits contracts achieve shared risk • …insurer rather than employer bears investment risk • any guarantees require capital support or strong sponsor • guarantees from employer negate key principle of DC • limited appetite for provision of guarantees by financial institutions

23. DC PENSION PLANS • Risk-sharing DC plans – collective DC (target pensions) • fixed contribution rate for employer • member has a target pension – but not guaranteed • target pension is adjusted • upwards when financial conditions are good • downwards when financial conditions are poor • pensions in payment are guaranteed • by purchasing non-increasing annuities from insurers • actuarial control of pension revaluation process • members can adjust their contributions to respond

24. SPECTRUM OF RISK

25. DC PENSION PLANS • Collective DC (target pensions) • advantages • fixed contribution rate for employers • greater predictability for members close to retirement • greater efficiency • no need for individual investment decision-making • more collective approach than standard DC • disadvantages • higher volatility for younger members • challenge of communicating with members • should targeting principles be completely discretionary • ...or subject to disclosed principles? • age discrimination legislation may restrict design options

26. DC PENSION PLANS • Risk in the decumulation phase • traditional annuities leave the longevity risk with insurers… • …although some of the cost is passed on in annuity price • insurers also carry investment risk unless assets matched • …although cost of interest guarantee is in annuity price • pensioners dislike cost and lack of investment flexibility • insurers fear concentration of systemic longevity risk • …and reinvestment risk when assets are too short

27. DC PENSION PLANS • Risk-sharing in the decumulation phase • programmed withdrawal and deferred annuitisation • unit-linked annuities • with-profits annuities • annuitised fund • successive temporary annuities

28. SOCIAL SECURITY REFORM • Some alternative routes to reform national systems • modification of defined benefit • individual accounts • notional defined contribution

29. INDIVIDUAL ACCOUNTS • Individual account reforms • started in Chile in 1981 • by now includes most countries in Latin America… • …also several countries in central and eastern Europe • competitive private sector investment vehicles • usually mandatory for formal sector workers • compulsory purchase of annuities at retirement • or some form of programmed withdrawal • promoted by World Bank in Averting the Old-Age Crisis

30. INDIVIDUAL ACCOUNTS • Individual account reforms - evaluation • lump sum accumulation helps to manage longevity risk • transaction costs are high… • …competition does not bring down the charges • churning and mis-selling have been an issue • pension levels may not be adequate… • …too many people will qualify for the minimum pension

31. NDC PENSION REFORM • Notional Defined Contribution • structured as defined contribution… • … but on a PAYG basis rather than funded • clear link between contributions and benefits… • …but not subject to investment risk • targets lump sum at pension age… • with ‘notional’ purchase of an annuity • permits flexibility of retirement age • passes on part of longevity risk

32. SWEDEN • Swedish NDC • DB state scheme replaced by NDC • revalorisation of individual accounts by average wage • automatic economic regulator of pensions increase • annuity value responds to improving mortality • automatic balancing mechanism to maintain in balance… • …as otherwise both benefits and contributions are fixed

33. SWEDEN • Automatic balancing mechanism (‘actuarial accounting’) • Annual balance sheet for scheme: • Liabilities = • present value of all future outlay for pensions in payment • + accumulated individual accounts for all persons not yet in receipt of a pension • Assets = • real assets in buffer fund + value of future contributions • Value of future contributions = • contribution rate x wage mass x expected turnover duration

34. SWEDEN • Expected turnover duration

35. SWEDEN • Overall evaluation • hailed by many as a success • PAYG system made sustainable • cohort longevity risk passed on to individual members • dependency ratio risk passed to members through ABM • concern about expected fall in replacement ratios… • …and arbitrary effect of automatic balancing mechanism

36. FINLAND • Dealing with demographic ageing • objectives of recent reform of earnings-related scheme • to postpone average age of retirement by 2 to 3 years • to adapt the pension system to increased expectations of life • to reduce pressures for future increases in contributions • average of last 10 years → career average revalued • variable accrual rate • 1.5% a year from 18 to 52 • 1.9% a year from 53 to 62 • 4.5% a year from 63 to 68

37. FINLAND • Dealing with demographic ageing • introduction of “life expectancy coefficient” • Life expectancy coefficient for year N (>2009) = • cohort life expectancy for those reaching 62 in 2009 • cohort life expectancy for those reaching 62 in N • Multiply pensions of those reaching 62 in N • by life expectancy coefficient for year N • Thus adjusting a DB pension benefit for improving life expectancy

38. UNITED KINGDOM • Problem of adequacy rather than sustainability • continuous pension reform for more than 30 years • basic pension linked to retail price index (1980) • cut back of earnings-related benefits (1988) • equalisation of pension age at 65 (by 2020) (1995) • more generous means-tested minimum pension… • …leading to a trend to more reliance on means-testing • financially stable and sustainable… • …but reliant on low (and falling) level of benefits

39. UNITED KINGDOM • Proposals recently enacted (Pensions Act 2007) • restore earnings link for basic pension (from 2012 or later) • raise pension age to 68 by 2046 • 65 → 66 between 2024 and 2026 • 66 → 67 between 2034 and 2036 • 67 → 68 between 2044 and 2046

40. UNITED KINGDOM • Individual accounts • auto-enrolment into individual accounts • contributions on £5,000 to £30,000 p.a. earnings: • 4% from employees • 3% from employers • 1% from tax relief • employers must collect contributions • wholesale investment of funds • provision for opting out

41. SOME GENERAL LESSONS • Sharing longevity risk • 1. target lump sum at retirement… • …and convert to pension using current annuity value • …funded individual accounts or NDC • 2. index retirement age based on cohort expectation of life... • …or maintain ratio between working and retired life periods • 3. raise retirement age at intervals to offset rising cost • 4. overall adjustment mechanism such as • life expectancy coefficient • sustainability factor • automatic balancing mechanism • 5. risk-sharing between contributors and pensioners

42. May we enjoy a long life!