With the baby-boomer generation now reaching retirement age, expect to hear a lot more about the need for protection against longevity risk. The issue has already been recognised by the Super System (Cooper) Review, which recommended the following:
- MySuper products must include one type of income stream product, and
- Trustees must devise a separate investment strategy for post-retirement MySuper that has regard to longevity risk (among other things).
The government's Stronger Super reforms have proposed further consultation with relevant stakeholders on these recommendations.
In this article, we explore the nature of longevity risk that retirees face and how trustees can address this risk within MySuper.
Properly allowing for longevity risk within a MySuper post-retirement strategy will require a shift in the way trustees think about investment risk. In particular, the concept of investment risk for retirees will need to encompass the sustainability of retirement income and the risk of retirees outliving their savings.
Using Australian population mortality (with some allowance for socioeconomic factors and for future mortality improvements), we would expect the following:
- On average, a male aged 65 today will live until 87 and a female aged 65 today will live until 89.
- However, only one in 25 males aged 65 today will die at the male average life expectancy age of 87.
- One in three males aged 65 today will actually die before reaching age 84, one in three will die beyond age 92 and one in three will die between 84 and 92.
Protection against longevity risk may be less important for those retirees who have relatively modest retirement balances, who may expect to fully consume their retirement savings in the earlier years of retirement.
At the other extreme, those fortunate enough to have very large retirement balances may never have to worry about outliving their savings. However, for those retirees who expect to exhaust their private savings if they survive into old age, will MySuper meet their need for longevity protection?
The mortality statistics above illustrate that an individual retiree's dominant longevity risk is the considerable variation in the age at which they will die. Let's call this natural statistical variation 'micro' longevity risk.
For society as a whole, the dominant longevity risk is the 'macro' longevity risk that arises from uncertainty over the rate of future improvement in mortality for the overall population. This risk impacts on average life expectancies and, hence, the cost of age pensions and lifetime annuities.
However, this risk is less important to an individual retiree because the potential variation in life expectancy stemming from this macro risk is modest compared to the much greater statistical variation in an individual retiree's age of death.
Well-designed investment strategies that balance the pursuit of higher returns against the risk of exhausting assets may offer some protection against macro longevity risk. However, a MySuper post-retirement strategy that is solely investment-focused will not address the more dominant micro longevity risk faced by individual retirees.
Similarly, incorporating some element of capital protection within the post-retirement investment mandate will not (by itself) address micro longevity risk. This is because, in each case, a retiree would remain completely exposed to the natural statistical variation in the age of death.
To address micro longevity risk would require some form of insurance or pooling solution to be incorporated within a MySuper post-retirement strategy. A number of such solutions already exist around the globe, although only a subset has emerged to date in the Australian market:
- OnePath, Challenger, Macquarie and Axa have already introduced innovative retirement income solutions to the Australian market. These provide longevity protection while addressing retirees' concerns over the loss of capital upon early death.
- Some innovations overseas have unbundled the investment strategy from the longevity protection. This means, in effect, that a trustee can purchase 'pure' longevity protection for members while retaining control over investment strategy.
- Other innovations have approached longevity protection by pooling micro longevity risk among members. Each individual member is protected against the dominant micro longevity risk, but is not protected against macro longevity risk. This lessens the overall cost of delivering the protection. However, such 'longevity pooling' poses a number of implementation challenges.
Recent analysis by Towers Watson has also highlighted the potential merit of embedding an element of deferral within a post-retirement longevity strategy; deferring the purchase of longevity protection beyond the point of retirement and/or deferring the point at which the longevity protection commences paying benefits.
Unfortunately, current Australian regulations impose a number of barriers to innovation involving longevity protection. These barriers can create pricing and/or tax disadvantages (compared to account-based pensions) and can introduce undesirable design complexity.
Hopefully, these barriers will be removed in order to give trustees more scope to respond innovatively to the Cooper review's MySuper recommendations.
