Options at Retirement for Irish Pension Savers

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Options at Retirement for Irish Pension Savers

• Dermot Corry Managing Director, Life Strategies
  
• Insurance Institute of Dublin
• 15th October 2008

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Life Strategies

• Firm of Actuarial Consultants
• Not pension consultants
• Clients are mainly life insurance companies.
  Advise on
• Solvency and Financial Management
• Pricing of products
• Product Development
• Strategic Direction
• Also advise Government, especially on pension
  policy areas
• Pensions Board, Department of An Taoiseach,
  Department of Finance, Benchmarking Body on
  Public Service Remuneration, Comptroller and
  Auditor General
• Have also advised IIF and IAPF on pension policy
  issues

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Agenda

• Background
• Options at Retirement
• Annuity advantages and disadvantages
• ARF advantages and disadvantages
• How are annuities priced?
• Are annuities really expensive?
• New alternative products developing Variable
  Annuity

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Background

• The pensions market mainly focuses on the
  accumulation of pension assets before retirement
• Defined Benefit or Defined Contribution
• PRSA/Group Scheme/Executive Pension/Self
  Administered etc
• Mandatory/Soft Mandatory/Auto Enrolment/Voluntary
• Much less attention paid to post retirement how
  to use the cash after you retire
• Some focus on annuity rates pension consultants
  consider them to be too high
• In recent years trend towards using ARFs rather
  than annuities
• There is lobbying to allow greater freedom in use
  of ARFs
• Trend in the UK for DB schemes to buy out their
  annuity liability

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Volumes of Business

• Business written by Life Companies in 2007
• Annuity 379m
• ARF 731m
• Substantial amount of ARF business does not go
  through Life Companies
• Life Strategies/Indecon report to the Department
  on An Taoiseach indicated that assets at
  retirement will grow at 7 per annum in real
  terms

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What is an Annuity?

• Agreement from the Life Company to pay an
  annuitant a fixed amount for life
• Typically a level payment
• Can be increasing (at fixed rate, at CPI or
  other)
• Can be payable for a fixed period even if the
  annuitant dies (typically 5 or 10 years)
• Can have a reduced amount payable to surviving
  partner on death (e.g. 50 spouses pension)
• In any event life company is committed no matter
  how long the person lives
• Each payment is part return of capital and part
  interest
• Effectively the reverse of a mortgage (except
  that term is uncertain)

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What is an ARF

• ARF Approved Retirement Fund
• Maintain assets in unit linked fund after
  retirement
• Leave assets to build up and withdraw funds as
  needed
• Withdrawals can vary to suit the annuitants needs
• Pensioner takes longevity and investment risk
• Remaining fund on death goes to the pensioners
  estate can be tax efficient inheritance
• Heavy tax penalty unless at least 3 withdrawn
  each year

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Options at Retirement

• Defined Benefit Scheme
• Liability falls on the Trustees
• Trustees can purchase an annuity or pay the
  benefits directly from the fund
• No option other than taking benefits according to
  scheme rules i.e. no ARF
• Defined Contribution Scheme
• Employee can take a tax free lump sum
• The remainder must be used to purchase an annuity
• Executive Pensions/RACs/PRSAs/Self Administered
  Schemes
• Can take a tax free lump sum
• Balance can be used to purchase an ARF (subject
  to minimum income rules) or to buy an annuity

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Agenda

• Background
• Options at Retirement
• Annuity advantages and disadvantages
• ARF advantages and disadvantages
• How are annuities priced?
• Are annuities really expensive?
• New alternative products developing Variable
  Annuity

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Annuities - Advantages

• Customer is buying certainty
• Guaranteed to be paid a known pension for the
  rest of life
• It does not matter if stock market returns are
  poor
• Real value of this is more apparent now!
• It does not matter if customer lives for a long
  time
• Can build in a minimum payment period or a
  dependants pension

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Annuities - Disadvantages

• Pension fund no longer exists it has been into
  an income for life
• There is no flexibility once annuity is taken
  out customer cannot change it
• The pension will cease when customer dies (unless
  minimum payment period or dependants pension
  included)

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ARF Advantages

• Customer has flexibility and control
• Can invest in a wide range of assets with
  potential for the fund to continue growing
• Can choose the level of income he/she wants each
  year (though taxed on at least 3 of the fund)
• When customer dies the rest of the fund goes to
  the estate

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ARF - Disadvantages

• Customer is taking on a risk
• If customer withdraws more than the fund earns
  the value of the fund will reduce
• Pension fund could run out if investment returns
  are poor or customer lives too long
• Charges are generally somewhat higher

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Summary of Features
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Comparison of ARF and Annuity for a 65 year old
male (3 ARF investment return)
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Comparison of ARF and Annuity for a 65 year old
male (6 ARF investment return)
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Agenda

• Background
• Options at Retirement
• Annuity advantages and disadvantages
• ARF advantages and disadvantages
• How are annuities priced?
• Are annuities really expensive?
• New alternative products developing Variable
  Annuity

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How are Annuities Priced?

• In return for a single premium, life company
  agrees to pay a defined income for life
• To determine price life company needs to
  determine
• How long it will need to pay the annuity (i.e.
  life expectancy of the annuitant)
• What investment return it will earn
• What expenses it will incur
• What profit margin it requires
• Life company can only make assumptions about
  these real profit margin will come out after
  annuitants have all died
• Life Company will need to set aside additional
  capital to ensure that it can pay annuities
  price will allow for the return on this capital

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Pricing of Annuities Findings
Trends in Annuities and Long-term Interest Rates,
1979-2007
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Pricing of Annuities Findings
age-standardised population mortality rates

• Recent years have seen dramatic reductions in
  mortality rates
• Uncertainty re future mortality is critical
• Annuity providers can lock-in the interest rates
  on which they have priced
• But cannot lock-in (or hedge) the mortality
  assumptions they have used in setting the price,
  other than through reinsurance

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Insurer assumptions

• Interest rates
• Mortality
• Mortality Improvements
• Expenses
• Commission
• Reserves required and solvency margin
• Cost of capital
• Profit margin

Determines life expectancy
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Are annuities expensive?

• Life Strategies and Indecon Economic Consultants
  did a report last year for the Dept of An
  Taoiseach
• Compared the prices in the market with a model
  price
• Table below shows comparative prices for a level
  annuity of 10,000 for a 65 year old man (5 year
  guarantee)
• Prices are all at January 15, 2007

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Are Annuities Expensive (2)

• Best price in the market is 1.7 higher than
  model
• Median price is 4.6 higher than model for this
  case (range from 3.9 to 7.5 depending on
  age/gender/escalation)
• 4.7 range from highest to lowest price
• Most business is transacted at or close to lowest
  price
• Some small profit margins but overall not very
  profitable considering the risks

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Other Pricing Findings

• Moneys Worth Analysis suggests approximately
  15 of the premium goes on expenses, profit and
  other costs
• This is very similar to the UK market
• We break down this 15 as follows
• Expenses and commission 2.6
• Cost of regulatory capital 5.2
• Margin for risk/profit 7.2
• Total 15.0
• Reduction in Yield for annuities ranging from
  0.9 to 1.25 - compares with 1.5 to 1.75 for
  ARF

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Some policy considerations

• Government should consider some easing of rules
  regarding DC members
• Some minimum level of annuitisation required for
  all and/or
• Some flexibility regarding timing of annuity
  purchase
• Government should consider issuing government
  bonds linked to CPI
• Would enable a better match between assets and
  liabilities for CPI-linked annuities (leading to
  less need for risk margins)
• Need for enhanced information to be supplied to
  consumers as part of overall set of measures to
  improve market transparency
• Consideration could be given to examining some of
  the current Revenue rules governing the types of
  annuities that may be provided e.g. newer
  flexible annuities

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Agenda

• Background
• Options at Retirement
• Annuity advantages and disadvantages
• ARF advantages and disadvantages
• How are annuities priced?
• Are annuities really expensive?
• New alternative products developing Variable
  Annuity

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New Variable Annuity Products

• Unit Linked products with guarantees
• Very popular in the US - 180bn sales last year
• Can range from simple guarantee at maturity to
  products which manage drawdown
• Most relevant for pension business is called
  Guaranteed Minimum Withdrawal Benefit
• Equivalent to an ARF with some guarantees
• Becoming popular in the UK sometimes called 5
  for life
• Many of the companies offering these products in
  Europe are based in Ireland Aegon, Allianz,
  AXA, Hartford Life, Met Life
• No company has offered these in Ireland yet

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GMWB provides return of principal through
periodic withdrawals over a number of years

• Guaranteed Amount the value that will be
  returned over time through withdrawals is equal
  to the initial premium or account value at time
  of election, even if account value drops to zero
• Often includes reset options in which the
  remaining guaranteed amount may be stepped up to
  the account value
• Benefit payment amount equal to a pre-stated
  percentage, is maximum withdrawal that may be
  taken each year

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Typical features

• 5 of premium guaranteed to be paid each year
  until death
• Guaranteed benefit increases if fund value
  increases
• Flexibility given to select from a range of funds
• Specific charge for the guarantee
• Client has flexibility in the amount that he/she
  withdraws but large withdrawals impact on
  guarantee
• Remaining fund is paid to estate on death

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Income from ARF Variation with Fund Performance
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Income from Variable Annuity Variation with
Fund Performance
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Benefits of Variable Annuity

• Client is protected against living too long
• Also protected to some extent against poor
  investment performance
• Maintains flexibility of withdrawals
• Will get an increasing income if investment
  markets do well
• Can control investment decisions
• Remaining fund goes to estate
• But
• Lower initial income than annuity
• Higher charges than ARF
• Customer must decide if the product is still
  worthwhile

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Summary

• The at retirement market will grow steadily in
  coming years
• Current choice between Annuity and ARF
• Volume of annuity sales has been low in recent
  years as ARFs became more popular
• Main benefit of annuities is that they give
  certainty
• ARF gives flexibility but moves investment and
  longevity risk to the customer
• Despite a perception of being poor value,
  annuities give quite good value
• New variable annuity products being developed
  which combine guarantees and investment/withdrawal
  flexibility

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Options at Retirement for Irish Pension Savers

• Dermot Corry Managing Director, Life Strategies
  
• dermot.corry_at_lifestrategies.ie
• Insurance Institute of Dublin
• 15th October 2008