Methods of pooling longevity risk

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Methods of pooling longevity risk Catherine Donnelly Risk Insight Lab, Heriot-Watt University http://risk-insight-lab.com The Minimising Longevity and Investment Risk while Optimising Future Pension Plans research programme is being funded by the Actuarial Research Centre. 16 May 2018 www.actuaries.org.uk/arc

Overview of entire session I. Motivation II. One way of pooling longevity risk III. Discussion 16 May 2018 2

Overview of entire session I. Motivation II. One way of pooling longevity risk III. Discussion 16 May 2018 3

I. Motivation Background Focus on life annuity Example of a tontine in action 16 May 2018 4

Setting Value of pension savings Life annuity? Drawdown? Something else? Investment strategy Contribution plan Time 16 May 2018 5

The present in the UK DC on the rise Defined benefit plans are closing (87% are closed in 2016 in UK). Most people are now actively in defined contribution plans, or similar arrangement (97% of new hires in FTSE350). Contribution rates are much lower in defined contribution plans 16 May 2018 6

Size of pension fund assets in 2016 (Willis Towers Watson) Country Value of pension fund assets (USD billion) As percentage of GDP Of which DC asset value (USD billion) USA 22 480 121.1% 13 488 UK 2 868 108.2% 516 Japan 2 808 59.4% 112 Australia 1 583 126.0% 1 377 Canada 1 575 102.8% 79 Netherlands 1 296 168.3% 78 16 May 2018 7

Drawdown Value of pension savings Investment strategy Investment strategy II Longevity risk Contribution plan Time 16 May 2018 8

Life insurance mathematics 101 PV(annuity paid from age 65) = a T Expected value of the PV is a 65 = vp 65 + v 2 2p 65 + v 3 3p 65 + v 4 4p 65 + To use as the price, Law of Large Numbers holds, Same investment strategy, Known investment returns and future lifetime distribution. 16 May 2018 9

Life annuity contract Insurance company Insurance company Purchase of the annuity contract Annuity income 16 May 2018 10

Life annuity contract Insurance company Insurance company Annuity income Annuity income 16 May 2018 11

Life annuity Value of pension savings Investment strategy Contribution plan Time 16 May 2018 12

Life annuity Value of pension savings Longevity pooling Investment strategy + investment guarantees + longevity guarantees Longevity risk Contribution plan Time 16 May 2018 13

Life annuity contract Income drawdown vs life annuity: if follow same investment strategy then life annuity gives higher income* *ignoring fees, costs, taxes, etc. Pooling longevity risk gives a higher income. Everyone in the group becomes the beneficiaries of each other, indirectly. 16 May 2018 14

Annuity puzzle Why don t people annuitize? Can we get the benefits of life annuities, without the full contract? Example showing income withdrawal from a tontine. 16 May 2018 15

Drawdown Value of pension savings Investment strategy Longevity risk Contribution plan Time 16 May 2018 16

Drawdown Value of pension savings Investment strategy Longevity risk Contribution plan Time 16 May 2018 17

Aim of modern tontines Aim is to provide an income for life. It is not about gambling on your death or the deaths of others in the pool. It should look like a life annuity. With more flexibility in structure. Example is based on an explicitly-paid longevity credit. 16 May 2018 18

Example 0: Simple setting of 4% Rule Pension savings = 100,000 at age 65. Withdraw 4,000 per annum at start of each year until funds exhausted. Investment returns = Price inflation + 0%. No longevity pooling. 16 May 2018 19

Real income withdrawn at age Example 0: income drawdown (4% Rule) 8,000 Investment returns = inflation+0% p.a. 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 65 75 85 95 105 115 Age (years) 4% Rule (no pooling) 16 May 2018 20

Example 1: Join a tontine Same setup except pool all of asset value in a tontine for rest of life. Withdraw a maximum real income of X per annum for life (we show X on charts to follow). Mortality table S1PMA. Assume a perfect pool: longevity credit=its expected value. Longevity credit paid at start of each year. 16 May 2018 21

UK mortality table S1PMA 1.0 Annual probability of death for table S1MPA 0.9 0.8 0.7 0.6 q x 0.5 0.4 0.3 0.2 0.1 0.0 65 75 85 95 105 115 Age x (years) 16 May 2018 22

Real income withdrawn at age Example 1i: 0% investment returns above inflation 6,000 Investment returns = inflation+0% p.a. 5,000 4,000 3,000 2,000 1,000 0 65 75 85 95 105 115 Age (years) 4% Rule (no pooling) 100% pooling 16 May 2018 23

Real income withdrawn at age Example 1ii: +2% p.a. investment returns above inflation 7,000 Investment returns = inflation+2% p.a. 6,000 5,000 4,000 3,000 2,000 1,000 0 65 75 85 95 105 115 Age (years) 4% Rule (no pooling) 100% pooling 16 May 2018 24

Real income withdrawn at age Example 1iii: Inv. Returns = Inflation 2% p.a. from age 65 to 75, then Inflation +2% p.a. 6,000 Investment returns = inflation-2% p.a. from age 65 to 75, then inflation+2% p.a. 5,000 4,000 3,000 2,000 1,000 0 65 75 85 95 105 115 Age (years) 4% Rule (no pooling) 100% pooling 16 May 2018 25

Real income withdrawn at age Example 1iv: Inv. Returns = Inflation 5% p.a. from age 65 to 75, then Inflation +2% p.a. 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 Investment returns = inflation-5% p.a. from age 65 to 75, then inflation+2% p.a. 0 65 75 85 95 105 115 Age (years) 4% Rule (no pooling) 100% pooling 16 May 2018 26

Example 1 Tontines: Mitigate risk of outliving savings. Provide a higher income. Downside: Loss of bequest. However 16 May 2018 27

Example 2: Join a tontine Same setup except pool 50% of asset value in a tontine for rest of life. Withdraw a maximum real income of 4,036 per annum for life. Bequest is higher than under 4% Rule at higher ages. 16 May 2018 28

Real income withdrawn at age Example 2: income withdrawn 4,500 Investment returns = inflation+0% p.a. 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 65 75 85 95 105 115 Age (years) 4% Rule (no pooling) 50% pooling 16 May 2018 29

Bequest if die at age Example 2: Bequest 120,000 Investment returns = inflation+0% p.a. 100,000 80,000 60,000 40,000 20,000 0 65 75 85 95 105 115 Age (years) 4% Rule (no pooling) 50% pooling 16 May 2018 30

Overview of entire session I. Motivation II. One way of pooling longevity risk III. Classification of methods & discussion IV. A second explicit scheme V. An implicit scheme VI. Summary and discussion 16 May 2018 31

II. One way of pooling longevity risk Aim of pooling: retirement income, not a life-death gamble. DGN method of pooling longevity risk Explicit scheme. Everything can be different: member characteristics, investment strategy. 16 May 2018 32

Longevity risk pooling Pool risk over lifetime Individuals make their own investment decisions Individuals withdraw income from their own funds However, when someone dies at time T 16 May 2018 33

Longevity risk pooling Share out remaining funds of Bob. Bob 16 May 2018 34

Longevity risk pooling rule [DGN] λ (i) = Force of mortality of i th member at time T. W (i) = Fund value of i th member at time T. Payment (longevity credit) to i th member λ (i) W (i) σ k Group λ (k) W (k) {Bob s remaining fund value} 16 May 2018 35

Example I(i): A dies Member Force of mortality Fund value before A dies Force of mortality x Fund value Longevity credit from A s fund value = 100 x (4)/Sum of (4) Fund value afer A dies (1) (2) (3) (4) (5) (6) A 0.01 100 1 10 10 = 100-100+10 B 0.01 200 2 20 220 = 200+20 C 0.01 300 3 30 330 = 300+30 D 0.01 400 4 40 440 = 400+40 Total 1000 10 100 1000 16 May 2018 36

Example I(ii): D dies Member Force of mortality Fund value before D dies Force of mortality x Fund value Longevity credit from D s fund value = 400 x (4)/Sum of (4) Fund value afer D dies (1) (2) (3) (4) (5) (6) A 0.01 100 1 40 140 = 100+40 B 0.01 200 2 80 280 = 200+80 C 0.01 300 3 120 420 = 300+120 D 0.01 400 4 160 160 = 400-400+160 Total 1000 10 400 1000 16 May 2018 37

Example 2(i): A dies Member Force of mortality Fund value before A dies Force of mortality x Fund value Longevity credit from A s fund value = 100 x (4)/Sum of (4) Fund value afer A dies (1) (2) (3) (4) (5) (6) A 0.04 100 4 20 20 = 100-100+20 B 0.03 200 6 30 230 = 200+30 C 0.02 300 6 30 330 = 300+30 D 0.01 400 4 20 420 = 400+20 Total 1000 20 100 1000 16 May 2018 38

Longevity risk pooling rule q (i) = Probability of death of i th member from time T to T+1. Unit time period could be 1/12 year, 1/4 year, 1/2 year, Longevity credit paid to i th member q (i) W (i) σ k Group q (k) W (k) {Total fund value of members dying between time T and T + 1} 16 May 2018 39

Example 3: larger group, total assets of group 85,461,500. Age x of member Prob. of death from age x to x+1 Fund value of each member Number of members at age x (1) (2) (3) (4) 75 0.035378 100,000 100 76 0.039732 96,500 96 77 0.044589 93,000 92 78 0.049992 89,500 88 : : : : 100 0.36992 12,500 1 Total (S1MPA) 1,121 16 May 2018 40

Example 3: larger group, total assets of group 85,461,500. Age x of member Prob. of death from age x to x+1 Fund value of each member Number of members at age x Prob. of death multiplied by Fund value = (2)x(3) Per member, share of funds of deceased members = (5)/sum of (4)x(5) (1) (2) (3) (4) (5) (6) 75 0.035378 100,000 100 3,537.80 0.00056 76 0.039732 96,500 96 3,834.14 0.00060 77 0.044589 93,000 92 4,146.78 0.00065 78 0.049992 89,500 88 4,474.28 0.00070 : : : : : : 100 0.36992 12,500 1 4,624.00 0.00073 Total (S1MPA) 1,121 16 May 2018 41

Example 3: larger group, total assets of group 85,461,500. Age x of member Prob. of death from age x to x+1 Fund value of each member Number of members at age x Observed number of deaths from age x to x+1 Total funds released by deaths = (3)x(7) (1) (2) (3) (4) (7) (8) 75 0.035378 100,000 100 2 200,000 76 0.039732 96,500 96 2 193,000 77 0.044589 93,000 92 0 0 78 0.049992 89,500 88 5 447,500 : : : : : : 100 0.36992 12,500 1 0 0 Total (S1MPA) 1,121 97 5,818,500 16 May 2018 42

Example 3: larger group, total assets of group 85,461,500. Total funds released by deaths = (3)x(7) (8) 5,818,500 16 May 2018 43

Example 3: larger group, total assets of group 85,461,500. Total funds released by deaths = (3)x(7) (8) 5,818,500 16 May 2018 44

Example 3: larger group, total assets of group 85,461,500. Age x of member Prob. of death from age x to x+1 Fund value of each member Number of members at age Prob. of death times Fund value = (2)x(3) Per member, share of funds of deceased members = (5)/sum of (4)x(5) (1) (2) (3) (4) (5) (6) 75 0.035378 100,000 100 3,537.80 0.00056 76 0.039732 96,500 96 3,834.14 0.00060 77 0.044589 93,000 92 4,146.78 0.00065 78 0.049992 89,500 88 4,474.28 0.00070 : : : : : : 100 0.36992 12,500 1 4,624.00 0.00073 Total (S1MPA) 1,121 16 May 2018 45

Example 3: larger group, total assets of group 85,461,500. Age x of member Prob. of death from age x to x+1 Fund value of each member Number of members at age Prob. of death times Fund value = (2)x(3) Longevity credit per member = (6) x sum of (8) (1) (2) (3) (4) (5) (9) 75 0.035378 100,000 100 3,537.80 3,237.33 76 0.039732 96,500 96 3,834.14 3,508.50 77 0.044589 93,000 92 4,146.78 3,794.58 78 0.049992 89,500 88 4,474.28 4,094.28 : : : : : : 100 0.36992 12,500 1 4,624.00 4,231.28 Total (S1MPA) 1,121 16 May 2018 46

Example 3: larger group, total assets of group 85,461,500. Age x of member Prob. of death from age x to x+1 Fund value of each member Longevity credit per member = (6) x sum of (8) Fund value of survivor at age x+1 Fund value of deceased at age x+1 (1) (2) (3) (9) (10) (11) 75 0.035378 100,000 3,237.33 103,237.33 3,237.33 76 0.039732 96,500 3,508.50 100,008.50 N/A 77 0.044589 93,000 3,794.58 96,794.58 3,794.58 78 0.049992 89,500 4,094.28 93,594.28 4,094.28 : : : : : : 100 0.36992 12,500 4,231.28 16,731.28 N/A 16 May 2018 47

Longevity risk pooling [DGN] - features Total asset value of group is unchanged by pooling. Individual values are re-arranged between the members. only Expected actuarial gain = 0, for all members at all times. Actuarial gain of member (x) from time T to T+1 = + Longevity credits gained by (x) from deaths (including (x) s own death) between time T and T+1 - Loss of (x) s fund value if (x) dies between times T and T+1. i.e. the pool is actuarially fair at all times: no-one expects to gain from pooling. 16 May 2018 48

Longevity risk pooling [DGN] - features Total asset value of group is unchanged by pooling. Individual values are re-arranged between the members. only Expected longevity credit = Prob of death of x {Fund value of x } 1 Prob of death of (x) {Fund value of x } σ y Group Prob of death of (y) {Fund value of y }. Expected longevity credit tends to Prob of death of (x) {Fund value of x } as group gets bigger. 16 May 2018 49

Longevity risk pooling [DGN] - features There will always be some volatility in the longevity credit: Actual value expected value (no guarantees) But longevity credit 0, i.e. never negative. Loss occurs only upon death. Volatility in longevity credit can replace investment return volatility. 16 May 2018 50

Longevity risk pooling [DGN] - features Show evolution of fund value and income 16 May 2018 51

Longevity risk pooling - features Increase expected lifetime income Reduce risk of running out of money before death Non-negative return, except on death Update force of mortality, periodically. 16 May 2018 52

Longevity risk pooling - features Actuarially fair for any group of people (via payment to Bob, too) ``Cost is paid upon death, not upfront like life annuity. Mitigates longevity risk, but does not eliminate it. Anti-selection risk remains, as for life annuity. 16 May 2018 53

Longevity risk pooling - features Under certain conditions*, can re-create a life annuity. *e.g. correct forces of mortality, Law of Large Numbers holds,... Comparing: a) Longevity risk pooling, versus b) Equity-linked life annuity, paying actuarial return (λ (i) Fees) x W (i). Fees have to be <0.5% for b) to have higher expected return in a moderately-sized (600 members), heterogeneous group [DGN]. 16 May 2018 54

Longevity risk pooling - features Splits investment return from longevity credit to enable: Fee transparency, Product innovation. 16 May 2018 55

Longevity risk pooling some ideas Insurer removes some of the longevity credit volatility, e.g. guarantees a minimum payment for a fee [DY]. Allow house as an asset monetize without having to sell it before death [DY]. 16 May 2018 56

Longevity risk pooling some ideas Pay out a regular income with the features: Each customer has a ring-fenced fund value. Explicitly show investment returns and longevity credits on annual statements. Long waiting period before customer s assets are pooled, to reduce adverse selection risk, e.g. 10 years. More income flexibility. Opportunity to withdraw a lumpsum from asset value. Update forces of mortality periodically. 16 May 2018 57

Summary Motivation is to provide a higher income in retirement. May also result in a higher bequest. Reduces chance of running out of money in retirement. Transparency may encourage more people to annuitize. 16 May 2018 58

The Actuarial Research Centre (ARC) A gateway to global actuarial research The Actuarial Research Centre (ARC) is the Institute and Faculty of Actuaries (IFoA) network of actuarial researchers around the world. The ARC seeks to deliver cutting-edge research programmes that address some of the significant, global challenges in actuarial science, through a partnership of the actuarial profession, the academic community and practitioners. The Minimising Longevity and Investment Risk while Optimising Future Pension Plans research programme is being funded by the ARC. www.actuaries.org.uk/arc

Bibliography [DGN] Donnelly, C, Guillén, M. and Nielsen, J.P. (2014). Bringing cost transparency to the life annuity market. Insurance: Mathematics and Economics, 56, pp14-27. [DY] Donnelly, C. and Young (2017). J. Product options for enhanced retirement income. British Actuarial Journal, 22(3). ONS Statistical bulletin: Occupational Pension Schemes Survey, UK: 2015 Purple Book 2016, Pension Protection Fund, UK Willis Towers Watson. Global Pensions Assets Study 2017. 16 May 2018 60

Questions Comments The views expressed in this presentation are those of the presenter. 16 May 2018 61