Australians have grown accustomed to having
their super accounts and pensions entirely linked to the investment markets, but
insurance-based products hold out the promise of more predictable outcomes.
ANDREW
ROBERTSON, of longevity risk specialist Ingevity, answers some commonly asked
questions about this new breed of offerings. In these turbulent economic times,
longevity risk is rapidly moving towards the top of the agenda for many
progressive super funds. In a survey conducted by Ingevity earlier this year
(before the worst of the market correction) only 7 per cent of Australian
middle-class pre- and postretirees were “very confident” that they would not
outlive their savings.
Over the last four years, Ingevity has spent significant
time helping its Australian super fund clients understand longevity risk and
develop products to manage it. In the course of that work, several questions
and issues are posed time and again. In the interests of building awareness and
encouraging debate, this article responds to these FAQ’s. What is longevity
risk? The simplistic answer is that it is the “risk of outliving your savings”.
Customer focus groups, however, reveal more complex issues including:
•
Avoiding “living poor dying rich” • Providing for “emergency” lump sum needs
(eg health, accommodation, care) • Protecting at least a minimum basic level of
income. These findings suggest longevity risk should be defined more generally –
for instance as “the financial risks of funding retirement needs and wants, as and
when they arise”. Clearly investment market risks, life-length uncertainty,
income planning, inflation and health events all contribute to the longevity
risk retirees are exposed to. Isn’t it the ad viser’s job to ma nage longevity
risks?
Certainly advisers can play a valuable role in helping retirees manage these
risks. In particular, research suggests that they strongly influence the “framing”
of income level expectations. Of course, for many retirees the adviser also
plays a significant role in selecting an asset allocation appropriate for the
retiree’s risk profile. We are concerned, however, that the Australian
superannuation industry – advisers, trustee boards and politicians – suffers
from a dangerous blind faith in the long term power of the markets.
We often
hear “don’t panic, superannuation is a long term investment and performs in the
long term”. Simple analysis shows that the adage “time in the market cures all
ills” is patently not true for retirees. In fact the volatility and risk of
markets is poorly matched with retiree’s primary liability – the desire for a
relatively stable income stream over an uncertain life length. No matter how
good the adviser, they can’t know firstly how the market will perform in the
future, or secondly how long their client will live.
These issues are fundamental
uncertainties – as we will see below, insurance style products can help manage
these risks. These products are currently available overseas but are largely
absent from the Australian market. All this raises a question of particular interest
to the industry fund sector – could it be that properly designed retirement
incomes products offer greater member value than expensive ongoing advice?
Ingevity
research shows that Australian pre- and post- retirees are very aware of how
long they might live. We believe baby boomer retirees have a “hierarchy of
needs” – for many basic life-long security comes first, discretionary income
early in retirement second, flexibility and the ability to deal with emergencies
third and bequest once everything else is taken care of.
The international success of the products
we discuss later in this article can be attributed in part to providing baby
boomers a little bit of everything. So what ca n funds off er these dema ndi ng
Memb ers? Ingevity’s research and experience suggests that the ‘account-based
pension’ (ABP) will be the basic framework on which any commercially successful
longevity risk management product will be built.
The ABP is an attractive
product – tax efficient, flexible and transparent. Its key shortcoming is poor
risk management. There are several options for funds that want to add longevity
risk management features to their ABP. In this section each option is described
separately – in reality they should be viewed as building blocks that can be combined
to provide solutions tailored to an individual fund’s member needs.
Optimised
Pension Planning: There are two key levers members and advisers can use to
adjust a pension strategy – asset allocation and withdrawal level. The question
of how to optimally trade-off levels of income early and late in retirement,
investment risk exposure and bequest assets is a hot area of academic research.
Various methodologies are emerging in the US – the best of which employ
dynamic techniques commonly used in institutional asset/liability management
programs. These adjust the asset allocation and pension income annually, based
on the realised investment performance information as it becomes available.
Several
US organisations are beginning
to use these tools – but given the slow uptake of even simple Monte Carlo
analysis techniques in Australia
these solutions seem to be a long way from commercial reality in our market. Longevity
Insurance: Longevity insurance works on the basis of pooling – all retirees
contribute a premium to a pool, the income needs of those that live longer are
funded by the unused premiums of those that pass away early. Typically premiums
are contributed between ages 60 and 80 – while a death benefit may be returned
to those that pass away early, some funds remain in the pool.
These help to pay
life-long income streams to those that survive beyond 80. Pooling diversifies
the otherwise expensive cost of “self-insuring” against the small chance that
any particular individual lives much longer than expected. This product allows
individuals to draw more income early in retirement (typically 20-40 per cent
more) with the comfort that they’ll not run out.
These products are gaining in popularity
in the US.
In Australia,
tax inefficiencies held back the commercial success of early attempts at this
product (such as Asteron’s ALIS) – however more recent innovations have
integrated the option into ABPs and solve the tax issues. Guaranteed minimum
benefit (GMB) riders: These are essentially flexible guarantees that can be
attached to ABPs.
Their attraction is that with a simple annual premium
retirees can purchase protection against long-term investment risk and
longevity risk, while retaining access to equity market upside and
account-based liquidity. In the US
the most successful of these has been the guaranteed lifetime withdrawal
benefit (GWLB), which has been a huge driver of sales in the US variable annuity market (roughly
the equivalent of the Australian ABP market). Furthermore, the success has been
replicated in many countries around the world (see side-bar GLWB- popular in the
US…
and spreading globally). In many of these countries, the products have enjoyed
such great success that they have shifted the strategic balance of the market –
those able to offer the riders (typically international life insurers) have
won, those unable to have lost.
Wi ll GWL B work in Australia and what are the risks? Despite
the undoubted successes of the GLWB it is not without its drawbacks. These
include: • Cost – GLWB fees are typically 1 per cent on top of 2.5 per cent
variable annuity expense • Complexity – US products have been stacked with
‘bells and whistles’ • Manufacturing risks – the rider is a complex, long-term,
mixed life insurance contract and capital markets option. Manufacturing
requires significant balance sheet and risk management capabilities Variants of
GWBs have already begun entering the Australian market.
AXA North is the first
Australian Guaranteed Minimum Benefit product (albeit without longevity
protection). It is also an open secret that several other major retail super
funds are at various stages of development of their own GMB riders. Those that
are tailored to meet the specific needs of Australian retirees will surely
enjoy success. We expect the actual underwriting of guarantees (which requires
significant balance sheet capability and financial risk management
sophistication) to be dominated by large international providers.
On top of
this, there remains complex and significant questions around benefit design,
pricing, regulation, IT, administration, distribution support and marketing
associated with getting this product ‘right’ in Australia. How are issuers of these
guarantees copi ng wit h the credit crunch? As mentioned earlier in this
article, issuing long-term guarantees requires significant balance sheet
capability and – increasingly – sophisticated financial markets risk management
techniques. Leaders in the field employ sophisticated hedging techniques – the goal
of these techniques is to purchase protection from the capital markets, when
markets fall, increasing the value of the guarantee liability the value of the
protection should pay-out.
This smoothes the impact on the issuing company’s
balance sheet – or at least that’s the theory! So how has the theory held up during
the recent turbulence? Several industry surveys have indicated that hedging
programs are performing broadly as expected protecting issuing companies from
large losses, which is encouraging. The crisis does, however, highlight the
critical importance of managing counter-party risk. AIG, a major player in this
space, needed to be rescued – not because of these products but because of
unrelated bets in the CDS market.
Because Australian funds are likely to
outsource the GMB rider, they are well placed to manage counter-party risks by
working with a pool of issuers. Why not wait unti l it s proven out? There are
three reasons why not – Member best interest: Earlier in this article, we have
demonstrated the fundamental mismatch between ABPs (the asset) and members’
lifetime income needs (the liability). Are you comfortable that your fund is
meeting its fiduciary obligations in marketing such a mismatched strategy to
clients?
Have you considered the risks if you are not? Even if you don’t accept
a fiduciary obligation, are you comfortable that ABPs are the best answer for
your members? Commercial imperatives: What proportion of your FUM is owned by members
aged between 50 and 65 with greater than $150k in their account? These members
will increasingly be the targets of aggressive retail funds. International
experience has shown that funds that are unable to offer guarantees are at
serious risk of churn to those that do.
The current plight of the mortgage fund
sector dramatically highlights that the Australian financial services industry is
not immune from the risk of large scale flight of capital. Strategic
positioning: If you come to the perspective that variants of these products are
going to impact the Australian market, then there are strong reasons for fast,
flexible action. Taking a leading role allows you to shape the design of
products, establish strategic and collaborative relationships that secure your
long-term position and, importantly, to move up the ‘experience curve’.
This
‘experience curve’ is critical for many reasons, to give one example – customer
behaviour (mix, lapse, asset allocation) has a significant effect on the cost
of the guarantee. Balanced against these reasons for early action, are the
risks of early stage product innovation. In Ingevity’sview, all funds should
invest to at least understand this emerging space and develop an explicit
strategy for how to react to it.
How should a fund look into this? Broadly
speaking, there are four key steps in the product development process: Concept/strategy
review; Product business case; Detailed product design ; Build, test and
launch. The resource commitment scales up with each step. A quality
concept/strategy review can typically be completed in one month, and nine to 18
months should be budgeted for the entire end to- end process. Andrew Robertson
is Managing Director of Ingevity Pty Ltd. Ingevity provides specialist
longevity and investment risk consulting to Australian superannuation funds.
Ingevity also offers a “plug and play” product suite to allow funds to develop
and issue products rapidly and cost-effectively.
