The essays of Stefan Lundbergh, director of Cardano Insights, are full of thoughtful and interesting insights. His latest essay titled “The Risk is Not Dying” is no exception.
The essay points out that half of us will live longer than the average life expectancy, which (when measured at the median) is true by definition, and because no one knows how long they will live, longevity risk pooling can be extremely beneficial. This is essentially the argument famously brought forth in Menahem Yaari’s seminal model of lifecycle finance 50+ years ago.
According to Lundbergh, longevity risk pooling “should be able to sell itself as easily as ice-cream on a hot summer day.” It is a colorful phrase – and one that I wish I had thought of because I agree wholeheartedly! Yet, economists have puzzled for decades over why more people don’t do exactly this. Several explanations have been offered for this puzzle (some rational, some behavioral), but Lundbergh’s essay hits at a very important issue that we at Nuovalo believe must, and indeed can, be overcome.
Value for money
Current lifetime income solutions in the form of guaranteed annuities are simply too expensive. To wit: a recent study by the Boston College Center for Retirement Research (BCCRR) showed that the “money’s worth” of payout annuities is only about 80% for immediate income annuities and only about 50% for deferred income annuities (a.k.a., longevity insurance), amounts that have remained stable since 2000.¹ You read that correctly… 50% money’s worth – 50 cents on the dollar!!
Now, the researchers at BC rightly point out that there is a difference between insurance value and insurance cost, and that because the value provided by longevity risk pooling is very high, it can be worth the cost. That being said, it should come as no surprise that any income product with an expected payback of only 50 cents on the dollar is a tough sell. Imagine how much better it would be if longevity insurance could be supplied at a much higher money’s worth. That could be a game changer!
The point is that lifetime income guarantees are expensive. This is not the fault of insurance companies – it is just the way it is. There is no getting around the fact that the cost to hedge and reserve against the risk is what it is.
What is going on here?
Let’s take a 10,000-foot view and consider what a lifetime income annuity provides. Depending on the country in which one lives, those who retire with savings from a defined contribution plan may generally have two high-level options. One option is to invest and draw down their assets on their own, which offers no longevity protection. The other option is to purchase a life annuity of some flavor (to borrow from the ice cream analogy).
Figure 1 illustrates the choice, showing the relative advantages (in green) and disadvantages (in red) of these choices. The annuity provides the benefits of risk pooling, mortality credits, and a guaranteed income amount. On the downside, it is generally irrevocable, offers little or no control to the buyer, and comes with costs and counterparty risk. Self drawdown has none of these advantages or disadvantages, but instead has the advantage of giving the retiree full control to do whatever they wish. Most people chose the self-drawdown approach, which is not only risky, but also highly inefficient. To borrow a quote from Jose Herce: “If you survive your pension savings, you will be poor! If your savings survive you, that’s equally inefficient.”
Figure 1: The Dilemma
But it doesn’t have to be this way. Consider what you get with an income annuity. Figure 2 provides a high-level illustration by decomposing the value into two simple components: longevity risk pooling and a third-party guarantee.
Figure 2: Value Decomposition
Longevity risk pooling is high value and attainable at low cost. Doing so is utility maximizing in the language of economists such as Yaari. Or as Lundbergh puts it – the eighth wonder of the world. Experts widely agree: most people would be far better off if they pooled their longevity risk using at least some portion of their retirement savings, even if it is a small portion.
Guarantees are also highly valuable. However, they are expensive and typically priced very opaquely. As a result, their value is much more subjective. To some, the cost and restrictions may seem worth it. To others, they may not.
So, why not let people choose among these components separately? Why not let people choose longevity risk pooling without having to purchase a high-cost guarantee along with it? Can’t these components be separated?
Of course, they can! Figure 3 illustrates that a Modern Tontine (or longevity pool or whatever one wishes to call it) does exactly that. A tontine provides a unique blend between self-drawdown and guaranteed annuities – offering some of the advantages and disadvantages of each.
Figure 3: Modern Tontines – an Innovation with High Value and Low Cost
No single product is ideal for everyone. But risk pooling is highly beneficial to most, and tontines represent a low-cost way to achieve it. Moreover, modern tontines can allow investors to retain control over how their assets are invested and how their payouts are designed.
Regardless of what one chooses to call it, the principle of modern tontine finance provides us the potential to allow consumers an attractive “middle ground” option between self-drawdown and guaranteed annuities. Providing retirees with a low-cost way to pool their longevity risks may be utility maximizing not only for individuals, but for society as well.
Richard Fullmer is CEO of Nuovalo, a B2B pensiontech company specializing in sustainable retirement pension solutions through longevity-risk sharing.
Endnotes
¹ The money’s worth of an annuity represents the ratio of the expected present value of the annuity’s income benefit to its upfront cost.
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