The longevity issue: Mapping the new retirement landscape

Ian Porter shares the findings of a paper commissioned to give advisers greater insight into the consequences of pensions freedom. The first of three articles explores longevity risk

The freedoms offered to pension investors by Mr Osborne have been broadly welcomed by commentators and individual savers alike.

But with these new found freedoms comes a significant transfer of responsibility for income and security from the life assurance industry to the individual (and, of course, their advisers).

Accompanying this transfer of responsibility comes a transfer of liability and new standards of client understanding and acceptance of risk will need to form part of the advisory process.

To help our colleagues in the advice industry we commissioned some research from Dr Paul Cox of Birmingham University to write a paper based on his interest in this topic (he is a chief examiner for the CISI and an adviser to NEST) and his experience of being a fund manager in his pre-academic life.

The report delivered is comprehensive and comprised of four interrelated parts. The white paper will be available on Incisive Media’s Financial Library website.

The longevity issue

This article, the first of three in-depth pieces, examines how life expectancy is increasing and people continue to underestimate how long they will live.

Life expectancy and survival probability measures are key factors in determining post-retirement investment strategy as wealth may need to last a lot longer than one expects.

Life expectancy is increasing yet few have a concrete plan for the financial eventuality of a truly long life.

Part of the problem is that statistics relating to lifespan may in themselves be misinterpreted but, additionally, the ability of the individual to willingly consider issues that may be 20 or more years in the future as well their own, eventual demise gets lost in the here and now.

As with any complex financial decision, the role of the financial planner becomes not only one of adviser but also ‘educator’.

Do you understand just how long your clients may live? Stories that refer to “average life expectancy” paint a broad brush picture of how long one could live but is more than one measure of longevity.

The two key measures are:

  • Period life expectancy – this shows life expectancy in a given period eg as at 2015, for differing years of birth
  • Cohort life expectancy– this tracks the experience of a given cohort who share the same year of birth year after year and takes into account known and predicted improvements in mortality. Projections of cohorts are based on extrapolation of past trends in mortality improvement and expert opinion about future trends. Because the latter measure takes into account expected improvements in mortality it suggests greater life expectancy than the former.

UK life expectancy projection table

 

As can be seen from the table above the difference in expectations is quite marked and if commentators quote the period expectancy number while actuaries rely on the latter for pricing annuities we start to understand why “annuities are poor value”.

 

RP annuity purchaser life expec chart

Reappraising the timeline

Research by Ignition House finds that most consumers have a reasonable awareness of average life expectancy.

But when asked about survival probability, savers tended to over-estimate how many people die between 65 and 70, and under-estimate how many live beyond 80. The diagram below represents this.

UK longevity table

When told the actual statistics, which appear to the right, respondents, were surprised how many people live beyond 80.

Respondents found it surprising that they might be drawing on their pot for so long, and there was low awareness that they might be taking money out of the pot for longer than they put in.

The ‘couples’ effect

Between two-thirds and three-quarters of people age 65 live in couples. Later in life the number of widowers increases but we need to remember that they are the remaining part of a couple. When designing a strategy it is probably most appropriate to think in terms couples as opposed to individuals.

Later in life the number of widowers increases but we need to remember that they are the remaining part of a couple. When designing a strategy it is probably most appropriate to think in terms couples as opposed to individuals.

There’s a one in two chance that one or other of a couple will be alive at age 95. This means that 1 in 2 couples will need to stretch household financial resources to 30 years of retirement or more. In fact, there’s a 1 in 4 chance that one or other of a couple will be alive at age 100. The challenge for DC retirees is huge!

This means that one in two couples will need to stretch household financial resources to 30 years of retirement or more. In fact, there’s a one in four chance that one or other of a couple will be alive at age 100. The challenge for DC retirees is huge!

The challenge for DC retirees is huge!

 

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Transferring longevity risk

Insurance is one way of offloading the risk of living to an advanced age. However, so long as consumers aren’t expecting to live as long as experts believe they will, consumer demand for longevity insurance is likely to be limited.

What doesn’t seem right to many consumers is handing across what feels like a large amount of wealth close to or at retirement to purchase an annuity or other longevity based product. Experience from Australia suggests that in a free market demand for traditional pension annuities largely disappears.

Long life or good life?

Of course living longer doesn’t mean that the balance between healthy and unhealthy retirement years is changing as fast as the overall length of retirement. Common wisdom is that “I’ll do my living early while I’m healthy” and then I won’t need to spend as much later.

Those now attaining older ages include large proportions who have had children or who are not yet widowed, and smaller proportions who have never married. Consequently, and as many will know, a large part of the care needed by our elderly is provided by family members on an unpaid basis, but this looks set to change.

The proportion of elderly people who are divorced is increasing. Cohorts born since the mid-1950s have shown different patterns of family formation and dissolution, and the longer-term prospects for family support of old people are, therefore, likely to be less favourable.

This may increase demand on welfare services and care and regardless of any good intentions for the state or local authorities not to raid pension funds for care costs, reality may have to bite.

According to Just Retirement research only 10% of respondents stated that they were prepared for the cost of care.

Few do any real planning, and where planning does take place, it is often very late in the day and after other considerations.

When does capability run out?

While we give advice to literate, confident clients we do need to remember that financial literacy is reported to decline 1% to 2% each year after age 60.

 

RP overconfidence chart

 

Of course, the base level of financial literacy is pretty low anyway but this begs a question of when should the retirement income decisions of older people not be their own?

An older, wealthy client may have far higher levels of literacy and capability than a less well of more unhealthy younger person.

There is a tendency to be hearing only one side of the debate and this is being put to us by those who favour defaulting people into forms of constant lifetime income.

Summary

• Be aware of the concept of cohort life expectancy
• Educate your clients about the possibility of a very long retirement
• Design strategies for couples, not just the individual where appropriate
• Longevity implies a need for real assets in the portfolio but flexibility is key
• Clients mental capacity may decline with age there may come a time when alternatives to drawdown need to be considered
• Changes to family formation my result in a different experience of care costs for new retirees versus their parents

Ian Porter, head of business development and marketing, Sanlam Private Wealth