Living longer, working longer?
Chris Madsen and Martijn Tans explain their concept of equilibrium retirement age as a tool to help individuals and employers manage longevity risk and plan for retirement
As people live longer, pension systems are feeling the pressure. The issue of longevity risk for defined benefit (DB) pension plans has received considerable attention over the past few years, with companies increasingly looking to insure their pension plans against further unexpected increases in life expectancy. However, the question of how individuals can protect their defined contribution (DC) pension against longevity risk has received relatively little attention. There are presently few tools available to help individuals to understand and manage longevity risk. In order to help individuals with DC pensions to plan for their retirement better (and to help stimulate them to save more), we propose a new concept – the equilibrium retirement age (ERA).
With occupational DC plans, all longevity risk is borne by the individual, not the company sponsor, so there has been little incentive for companies to protect their employees against this risk or to educate them about it. It is clear, however, that individuals are increasingly realising that their retirement savings are likely to prove inadequate. A number of recent surveys have revealed that the majority of employees now expect to have to work beyond their retirement date.
Research indicates that companies themselves are not adequately prepared for this change. In addition, at present, the most that individuals can do is to estimate what kind of annuity they might be able to buy with their estimated pension savings on retirement. Both companies and their employees would benefit from being able to calculate the effect of changes in life expectancy on their DC pension.
The ERA is intended to help individuals and their employers by enabling them to better calculate when individuals will be able to retire, given predicted life expectancy rates and on the basis of different savings behaviours. ERA is intended to provide a powerful explanatory tool to help companies to communicate with their employees on the implications of their savings behaviours and to help them to take active control over their retirement strategy.
With DC pensions, individuals need to contribute sufficient funds into their pension plan through their working lives in order to be able to provide either a sufficient or desired income throughout retirement. Clearly, as people live longer, either they have to save more, work longer or retire on a lower income. At present, people are living longer than ever before and are spending longer in retirement. This is inevitably raising the cost of retirement. As a result, retirees will necessarily receive a lower income in retirement from their lifetime pension savings. In order to counteract this undesirable reduction in income, a simple remedy is to delay retirement, re-adjusting the balance between working and retirement years. As longevity increases, increasing the retirement age would seem to provide a logical counterbalance, effectively restoring the balance between working life savings and income for retirement.
The concept underlying ERA is straightforward: we need to find the retirement age (RA) such that account value (V) at retirement is equal to the value of the annuity (A) that generates the required income stream.
Figure 1 shows how the account value (V) increases with retirement age, due to additional contributions and investment returns.
The intersections of the (green) account value line with the other lines indicating the required annuity value according to year of birth in figure 1 show the ERA – the retirement age at which there is a balance between wealth accumulated and capital required for retirement. As life expectancy continues to increase, the cost of retirement (at a fixed age) continues to rise, being higher for people who were born later. An individual born in 2005 will therefore have a higher cost of retirement than an individual born in 1915, due to higher life expectancy. Retiring later has a powerful amplifying effect on retirement savings, as the account value (V) continues to increase while the cost of retirement (A) decreases.
Postponing retirement by a year has a dual impact; it both decreases the annuity price and also lengthens the period in which DC assets can be saved and accumulated. Delaying retirement is an effective mechanism. In the current environment and in the future, with lower mortality rates and more expensive annuities, delaying retirement may become necessary simply in order to attain the required level of retirement income. The good news is that delaying retirement is a powerful way to balance pre-retirement savings with in-retirement needs.
There is clearly a direct relationship between life expectancy and retirement age. All other things being equal, adding one year to life expectancy should push the equilibrium retirement age upwards by somewhere between one and six months. If, for example, we take an individual who contributes 11% and wishes to achieve a replacement rate of 70%, life expectancy for that individual is 90 and we assume interest rates of 5%. For this individual, ERA is equal to 65, with a sensitivity of 0.25. This means that for every increase of one year in life expectancy, we should expect the retirement age to increase by about three months.
The issue with increasing longevity is that it weighs so much more heavily when interest rates are low. That also explains why longevity risk has received so much more attention recently.
In the example above, if we assume interest rates not of 5% but rather of 1%, the ERA jumps from 65 to 79. That is a huge difference. In addition, the sensitivity to increasing life expectancy is three times higher – 0.78. In other words, for every increase of one year in life expectancy, we should expect the retirement age to increase by more than nine months.
At the moment, improvements in life expectancy are approximately three months per annum, so we should expect the retirement age for individuals with a DC pension plan to increase by more than two months every year.
In the light of current demographic and economic data, the middle-aged and younger generations of today might well be forced to postpone their retirement significantly in order to balance their books. Delaying retirement is, in many ways, an obvious measure to take when faced with longer life expectancy.
In 1980, an individual turning 65 having contributed at an 8% contribution rate from the age of 30 and having achieved a 5% investment return, would have had the funds needed to purchase a 70% replacement rate annuity. However, as life expectancy has increased, this has changed. Today, an individual with the same characteristics needs to retire six years later in order to achieve the same results. While this may seem iniquitous, it primarily reflects the balance required between working life and time in retirement. As people live longer, we will either have to spend longer working or save more throughout the course of our working lives.
If we look at examples of life-cycle finance used in many DC plans, in most situations, life-cycle strategies start by fixing a target retirement age. However, a fixed retirement age removes a powerful means to mediate longevity risk for individuals. A flexible retirement age can help individuals to calculate and establish an optimal (and realistic) programme of saving, consumption and investments.
It is clear that increasing life expectancy will have a considerable impact on DC pensions, and that this is not a problem that will be solved quickly or easily. In addition to the tools already available, a variable retirement age and the concept of ERA may help individuals to fill their savings shortfall, shifting the balance between the accumulation and distribution phases. Delaying retirement may increasingly be used as a counterweight to increasing longevity. Some countries have already begun to adopt such an approach, even if this is not always explicitly defined. The ERA can play a useful role in helping individuals to understand the impact of longevity on their retirement savings and may provide a powerful stimulus to save more sooner.
Chris Madsen is head of risk transfer and pricing at AEGON NV, and Martijn Tans is director at AEGON Global Pensions