Per Linnemann - Independent consulting actuary
“Smoothed income annuities could revive the pension fund industry”
The UK’s minister for pensions, Steve Webb, is attempting to reform his country’s pension system and has challenged the industry to seize the ‘gap in the market’ for innovative pension products. The Financial Times has reported that “the coalition is drawing up proposals for a radical reshaping of the private pensions industry”. A variant of Webb’s favoured defined ambition scheme, collective defined contribution (CDC), is already used in the Netherlands.
However, there may also be something to be learned from the developments in Denmark in the area of innovative defined contribution (DC) pension products. Denmark went down the DC road for occupational pensions decades ago. In 2012, its pension system was, for the first time, rated by Mercer and the Australian Centre for Financial Studies. It was the first system to be classified with an ‘A’ grade, ousting the Netherlands from the top position.
It is well known that US-based TIAA-CREF launched variable income annuities in 1952. This was an impressive achievement with ground-breaking significance. However, a new product class – smoothed income annuities – has finally been invented and launched in Denmark to overcome concerns over both fluctuations in payments from variable income payout annuities and the lack of transparency of with-profits policies.
Nobody thought this could be done. However, the unique design allows upside investment potential and partial downside protection over the lifetime of the policy. It is possible to maintain a high proportion of equities and other real assets throughout the pay-out period with high expected returns and high expected pension benefits, along with a great deal of stability in income payments.
On top of this, a holistic approach to pension plan design is offered, with seamless integration of the transition from wealth accumulation to retirement providing an effective bridge between accumulation and decumulation of retirement assets. Moreover, the income level set at retirement does not fluctuate with market conditions and unfavourable interest rates do not have to be locked into the product at the time of conversion to pension – annuitisation.
The next generation of DC and CDC retirement income products may be designed as formula-based smoothed income annuities. It has been demonstrated scientifically that these products have particularly attractive return – risk properties – also seen in relation to life-cycle products. For example, life-cycle products may also provide an opportunity for investing in equities and the achievement of high expected returns, but this results in substantial fluctuations in pension benefits.
Conversely, these fluctuations may be reduced with less risky investments. Such a step would also imply a reduction in expected returns and pension benefits. Our research shows that a life-cycle product investing exclusively in short-term bonds throughout the decumulation period is able to offer stability in retirement income payments in line with the stability offered by smoothed income annuities. On the other hand, the expected returns generated by such a life-cycle product are significantly lower than returns achieved with smoothed income annuities. These findings underline the importance of retirement product design.
Smoothed income annuities are a new retirement and wealth accumulation solution for the private and occupational pension markets. They have the potential to form the standard in retirement income solutions and the backbone of retirement income portfolios – also providing for attractive default solutions.
This new product includes, for example, the possibility of phased retirement, optional and affordable guarantees, combinations of joint, last-survivor and reversionary annuities, as well as guaranteed annuities (providing a guaranteed payment period) and deferred annuities; flexible and variable regular as well as single premium payments. A combination of flexible, death, disability and sickness insurance protection may be offered for all phases of life (for example, income protection, waiver of premium, lump-sum death benefit, joint life). It is possible to match closely the particular needs of the customer.
This new product class also provides exciting game-changing opportunities for companies seeking growth through innovation. Key competitive advantages may be obtained and there are possibilities to gain a considerable share of the growing DC market for retirement saving in the future. There is a considerable potential for designing attractive and unique DC and CDC smoothed-income annuities based on innovative approaches to formula-based smoothing of investment returns and risk sharing, respectively. So perhaps this could also lead to a revival of the pension fund industry and ease the transition from defined benefit to defined contribution and defined ambition pension products.
They provide an opportunity to improve the lives of millions throughout the world and could have a substantial impact on the retirement industry internationally.
*Jørgensen, P L and Linnemann, P (2012). A comparison of three different pension savings products with special emphasis on the payout phase. Annals of Actuarial Science, Vol. 6, part 1, 137-152.
Linnemann, P, Bruhn, K and Steffensen, M (2013). A comparison of modern investment-linked pension savings products. Submitted for publication in a scientific journal.