• Pooled annuity funds share idiosyncratic longevity risk, while systematic longevity risk is borne by individuals
• Financial benefits driven by decreasing life expectancy accrue to the provider
• Benefits are higher on average than with traditional life annuities but may fluctuate
Ling-Ni Boon, Marie Brière, Bas Werker
Pooled annuity funds, in which idiosyncratic longevity risk is pooled but systematic risk is borne by individuals, could be an alternative to traditional life annuities. These funds offer lifelong retirement payments adjustable to life expectancy. Although pooled annuity benefits are marginally more variable than conventional annuity payouts, they are on average higher than those of a life annuity. Under a life annuity, the upside of life expectancy mis-estimates is captured by the insurer’s shareholders, whereas the downside is borne by the insurer. As financial institutions are finding it more challenging to provide long-dated guarantees on non-diversifiable risks that are difficult to quantify, pooled annuity funds could be a promising decumulation solution1.
Retirement schemes are facing sustainability problems, as sponsors struggle to bear the risks related to defined benefit (DB) pension funds. The individualisation of pensions is a key recent trend with, in particular, the transition from DB to defined contribution (DC) plans, the relaxation of certain guarantees and the development of hybrid DB/DC funds.
While DB funds place too much risk on sponsors, they do contain effective mechanisms to share risk between policyholders. Fully individualised solutions have the advantage of being flexible and can be adapted to the preferences of heterogeneous individuals, but they also present risks related to investment, conversion of the capital into an annuity, as well as longevity risk if individuals choose to decumulate their capital during retirement.
Two forms of risk
There are two components to longevity risk: systematic longevity risk – which is the risk of misestimating the population’s future survival probabilities – and idiosyncratic longevity risk, which is the risk that an individual’s death may differ
from the expected date, given the population’s known survival probabilities.
Idiosyncratic risk is the largest risk for individuals. Actual lifespans within an age group vary widely, and it is hard to predict how long individuals will live. However, life insurers and pension funds can diversify this risk. For this, the pool of participants in the fund or life insurance product just needs to be sufficiently large.
Conversely, the systematic longevity component is small in magnitude for individuals as life expectancy surprises tend to be moderate from one year to the next. For the financial institutions, however, the systematic component is serious, as it cannot be reduced through diversification. It can only be transferred to a third party, such as a reinsurer or investor, through longevity-linked instruments (longevity bonds, longevity swaps, pension buy-out), or be borne on the insurer’s balance sheet against a capital buffer, as required by regulators (see for example solvency capital requirements under Solvency II).
While individuals can insure against longevity risk by purchasing a life annuity contract, this protection is costly. In practice, to offer insurance against systematic longevity shocks, an insurer requires reserve capital that is constituted either from contract loading charged to policyholders, or from equity capital contributions from shareholders. Shareholders who bear systematic risk expect to be remunerated, so equity capital contributions are costly. Moreover, insurers are subject to non-zero default risk2, even if, in practice, capital requirements limit that risk for policyholders.
Our research shows that an intermediate solution in the shape of a pooled annuity fund (or group self-annuitisation scheme3) might be more attractive than a life annuity. In practice, this is a collective plan where idiosyncratic longevity risk is pooled, but systematic longevity risk is borne by the individuals. The plan maintains solvency as pension benefits adjust to changes in life expectancy. Accordingly, relative to a fixed annuity, the collective plan’s benefits may slightly fluctuate.
Pooled annuity funds benefits are on average slightly higher than those of a life annuity. Any upward adjustment driven by decreasing life expectancy is captured by the shareholders of the insurance company offering systematic longevity risk protection. Our simulations show that individuals are indifferent between the two contracts when the life annuity is sold at a discount between 0.052% and 0.35% to the best estimate price.
From the individual’s point of view, the pooled annuity fund is attractive. It offers a higher utility than a life annuity when the pooled annuity fund and the life annuity have the same financial risk exposure (for example, in the case of fixed and variable annuities, or even when the equity risk exposure varies with time, as in a lifecycle portfolio). Results hold for immediate or deferred annuities, various longevity scenarios and individual characteristics (gender, risk aversion).
With the decline of DB pension funds, individuals are seeking alternatives for longevity protection. The ability of insurance companies to perform that role on a large scale is questionable because long-dated guarantees are difficult to price and hedge4. Pooled annuity funds, in contrast, are a viable candidate to fulfil that role and offer an attractive decumulation solution.
1 Boon L.N., M. Brière and B. Werker (2017), “Longevity Risk: To Bear or to Insure?”, SSRN Working Paper No. 2926902
2 In June 2009, the Hartford Group was bailed out under the Troubled Asset Relief Program after life annuity losses
3 Piggott, J, EA Valdez, and B Detzel (2005), ‘The simple analytics of a pooled annuity fund’, Journal of Risk and Insurance 72(3), 497–520.
4 Koijen, RS and M Yogo (2017), ‘The fragility of market risk insurance’, SSRN Working Paper No. 2972295.
Ling-Ni Boon is a management consultant at Accenture; Marie Brière is head of the Investor Research Centre at Amundi and affiliate professor at Paris Dauphine University; Bas Werker is professor at Tilburg Universit