August 2008

Minimising risk

Prospect theory demonstrates that we are by nature risk averse. If offered the chance to win £1000 or lose £1000 very few people appear willing to take the bet. The upside needs to move to around £2500 to attract a reasonable number of takers.

This predilection to minimise risk becomes more pronounced in retirement. Studies attribute this to retirement as a life stage. Intuitively this feels right: We no longer have the cushion of a regular salary each month, our savings may have taken many years to build (there is a correlation between the effort taken to create wealth and the risks we are prepared to take) and there is the uncertainty of not knowing how long our savings need to last. As the economist Professor Samuelson noted, 'the last thing we learn is the time of our death'.

Financial risks

So if people become more risk averse in retirement, exactly what are the financial risks they face and how can they best mitigate these?

- Longevity risk. Most people underestimate how long they may live. A healthy 65 year old woman has a one in two chance of reaching 93 years of age. For a couple both aged 65 there is a one in four chance that one of them will still be alive at 99.

- Inflation risk. With retirement increasingly likely to last for 20 to 30 years or more the corrosive impact of inflation can have a crippling impact financially even at modest rates of inflation. For example, at 3% inflation each year the value of money effectively halves every 24 years.

- Asset allocation risk. In order to combat inflation and build a sustainable lifetime income in retirement, it is necessary to retain exposure to equities during retirement. At the same time it should be recognised that retirement is a more unforgiving environment. Drawing income from capital when that capital is decreasing as a result of investment markets can deplete resources rapidly.

- Withdrawal risk. A further risk retirees incur is the risk of withdrawing too much money too early in retirement. For example, at a 6% withdrawal rate, adjusted each year for inflation, there is a one in 10 chance that the money could run out in just 12 years. A point at which the majority of people who retired in good health at 65 would still be alive.

- Liquidity risk. Long term care is probably the most significant liquidity risk, but there are other major unexpected costs that can impact retirement finances. For example, major housing repairs. Any major unforeseen expense falls into this bracket and can destabilise the best laid plans.

When you consider these risks, it's not difficult to understand why variable annuities have been so successful. They more effectively mitigate or eliminate these risks than any other product I can think of. The longevity risk is covered; there is the prospect of a rising income to combat inflation; money can still be held in mix of assets including equities; withdrawal risk is eliminated and the liquidity risk is covered as assets can still be accessed (at least in the US version of these products). In short, they are something of a holy grail in terms of retirement income planning.

Replicating success

Despite this, it is unlikely the success these products have enjoyed in the US and Japan will be replicated here in the UK for a number of reasons:

- They do not fall within the definition of a 'compulsory purchase annuity'. The annuity market was £11 billion last year and is forecast to double over the next five years. The providers of these products have lobbied for the government to review the role of variable annuities but there appears to be no appetite to do so. The opposition seem more open to some liberalisation of the annuity market and so there may be movement if, as seems increasingly likely, there is a change of government at the next election.

- These products are currently confined primarily to playing in the income drawdown market. This is currently around £3 billion but is also likely to double over the next five years. However, providers have been forced to 'shoehorn' their products to comply with the drawdown regulations and the requirement in practice to annuitise at 75. This undermines the simple elegance of the product and also restricts the flexibility that these products enjoy elsewhere.

A secondary market is the market for non pension retirement savings but this is a much more nebulous, ill defined segment of the market.

- The third issue is the universally applied criticism of these products: The price of the guarantee. Of course, the price in isolation is largely irrelevant; it needs to be considered in the context of the probability of capital exhaustion and the likely impact if the money does run out. Our own analysis suggests that in purely economic terms, the price appears expensive. For example, assuming 40% equities and 60% bonds our stochastic model would suggest that if the money were invested in a non guaranteed fund with a 1% fund management charge the chance of the capital being exhausted after 30 years (and the individual being alive to benefit from any guarantee) is only one in 70.

This isn't to suggest that the companies offering these products are making exceptionally high profits, they need to cover the catastrophe risk of a step change in longevity that could have a profound impact on the value of these products: An all too real possibility given the relentless advances in science and medicine.

Ultimately, value is in the eye of the beholder and there are many people who will willingly pay the price charged for a guarantee of a lifetime income, but for those people who may have a chunk of their income guaranteed from say a DB plan or who have substantial wealth such that capital exhaustion isn't an issue, they may want to consider other solutions.

David Dunn
Director
Fidelity Retirement Institute