By Dale Critchley, Workplace Policy Manager, Aviva
When we reach retirement age the risk of dying remains, but for defined contribution pensioners, living longer, also comes into play.
I remember writing letters to retirees in the 1980’s wishing those people taking their pension “a long and happy retirement”. It’s what we all hope for. While I have been told that money doesn’t buy happiness, an adequate pension income is something we all aim to receive. As for the length of retirement, there is a growing recognition that savers need to insure themselves against having a retirement that is too long and running out of money. Research by Aviva and Age UK recently highlighted that many people underestimate just how long retirement can last, and the financial impact that comes with it. Today's retirees can easily spend 20, 25 or even 30 years in retirement. That's a wonderful achievement, but it creates a challenge: how do you make sure your money lasts as long as you do?
In many ways retirement income solutions are another form of insurance, where a mixture of insurance, investment expertise and actuarial skill can mitigate the risk of quite literally living beyond our means.
The most obvious, and currently the only guaranteed solution, is of course an annuity. Longevity risk sharing and a guarantee underpinned by appropriate investments and provider backing ensures that an annuity will pay out a level of income for the whole of the annuitant’s life.
The premium for this guarantee is the price of the annuity. This is increasing set based on detailed information about the customers health and lifestyle. The result is that consumers are more likely to get good value from their annuity, even if they are not in the best of health.
Underwriting is of course a common feature of any insurance, designed to ensure the cost of the insurance reflects the chance that that a risk will crystallise. If we are looking at the risk of outliving our pension pot, not everyone’s risk will be the same, and so a single conversion rate of pension fund to pension income cannot be right either.
While an insurance company guarantee provides certainty, there is the option to simply spread the risk across a population large enough to allow for self-insurance. If we have representatives from across the whole population then we know what the average experience is likely to be, barring any great scientific breakthrough. If investment risk is managed, the insured risk can be absorbed by the group, through an acceptance that income could fluctuate, and there we have collective defined contribution.
The cost of this lower value promise might be less, but there are two premiums that are payable. The first is the potential loss of a payment to loved ones should someone die before they have obtained full value, cross subsidy seems to be inherent within CDC solutions, requiring an acceptance that the risk of outliving your income is greater than the risk of early death. As to whether this is true, we should maybe ask an underwriter, but it will not be true of everyone.
The second cost is that the pension must increase by at least the consumer price index (CPI). This means that savers must accept a lower initial level of income, as a cost of insuring against inflation. While this may make sense to some, for those who don’t live as long, or those who might be more active in the early years of their retirement, a higher real terms income when they first retire might be preferable. This might allow them to enjoy life more when they are healthier and more able.
Insurance can be great, it can ease worries over unforeseen circumstances, but when it comes to retirement we need to guard against a singular focus on the risk of a long retirement and balance it with the need for a happy one.
|
