Living annuity risks: scarier than you think

When it comes time to retire you will have (hopefully!) saved up enough money to purchase an annuity. Here you have two choices:

  • A Guaranteed Annuity (GA) or
  • A Living Annuity (LA)

In South Africa, around 85% of those who purchase an annuity at retirement choose to purchase a LA.

So, are these the better option?

As with all financial contracts, it is important to consider which risks you are transferring and which risks you are retaining. And when it comes to LAs, you are retaining some scary risks!

1. A quick recap of GAs compared to LAs

Before we start let’s briefly recap the basics of GAs compared to LAs:

  • If you purchase a GA when you retire, you pay the insurer a lump sum upfront. The insurance company will quote you a monthly income. This monthly income amount is guaranteed to be paid for the rest of your life. Once you die, payments cease. So if you die the day after you purchase the annuity, you lose out. If you live a long time, you score.
  • If you purchase a LA, the insurance company invests your lump sum for you. You are able to choose (to a degree) where your money is invested. You draw down a monthly income from the accumulated value of your investment. When you die, the remaining value of your investment is paid to your dependants. You are only allowed to draw down a maximum of 17.5% of the accumulated value of your investment in any one year, so technically you cannot exhaust your investment. However, it is possible that the accumulated value of your investment is so low that even at the maximum draw down rate of 17.5% the monthly income it provides you is insufficient.

So, looking at the above, there are two clear risks that you retain if you choose to purchase a LA over a GA. These are:

  • You live so long that even drawing down 17.5% of your investment is insufficient because you have already drawn down most of your investment (Longevity risk)
  • The returns you earn on your investment are poorer than expected, leading to lower than expected growth of your investment and insufficient monthly payments even at the maximum draw down rate (Investment risk)

Mayur Lodhia and Johann Swanepoel presented an excellent in depth paper comparing GAs and LAs. You can read the paper here. It’s fairly technical, but very well written.

Most people are aware of the above two risks involved in choosing a LA, but I don’t think they are fully aware of their magnitude. Insurance companies are terrified of the above risks when they hold them themselves. I’m not going to try to recreate the excellent work of Messrs Lodhia and Swanepoel, I just want to illustrate why mortality and longevity risks are so scary. Let’s look at each risk in turn:

2. Longevity Risk

One of the biggest risks that insurers worry about is longevity risk. To the insurer, longevity risk is the risk that someone lives longer than expected. Insurance companies take on longevity risk when they sell a GA. If you purchase a LA, you retain the longevity risk yourself. In most parts of the world people tend to be experiencing higher life expectancies. Insurance companies are nervous of any agreement where they need to make payments for the rest of someone’s life, because it is incredibly difficult to estimate how long someone alive today is expected to live. This is because the insurer is required to make  an assumption about how much of a difference advances in medical technology and lifestyle changes will impact on the rates at which people die. For all of our advanced statistical methods, estimating improvements to life expectancies is a very tricky and somewhat subjective exercise.

However, an insurer  is still better equipped to deal with managing your longevity risk than you are. This is because the insurer can pool thousands of policies. The average future lifetime of these thousands of policies is a lot more predictable than the future lifetime of just you as an individual.

When determining the ideal draw down rate, someone suggested assuming that you will live until an age that 90% of people of your age are expected to die before. This may be a suitable tactic for an insurer (an insurer could probably use 60% instead of 90% actually), but it is not acceptable for you as an individual. If you adopt this strategy, you still have a 10% chance of living to an age for which your draw down rate is too high, and this is just too big of a risk to take on in my opinion.

3. Investment Risk

When you purchase a GA, the insurance company takes the amount you pay them and it invests them in bonds, such that the payments it receives from investing in bonds match the payments it expects to pay on the annuities it has sold as closely as possible. If there was an insurance company that decided to match its GA payments with equities, they would be branded as reckless mavericks by the rest of the insurance industry.

And yet, this is what they expect you to do when they sell you a LA. Why is it that an insurance company will always hold bonds to pay annuities for life, but they expect you to invest in equities in order to provide for yourself?

4. Summary

So, in summary, purchasing a LA is risky for you as an individual because:

  • If insurance companies struggle to determine life expectancies, how can you be expected to do this yourself? Moreover, how can you pool and thus manage your own longevity risk?
  • If an insurance company would not hold equities to pay you an annuity because it is too risky, why should you?

The five attributes that separate GOOD actuaries from GREAT actuaries

As a recently qualified actuary, this is a topic I think about often. I have been fortunate to be exposed to some great actuaries in my relatively brief career, and I consider myself quite lucky to have learnt the game from some very unique characters.

Before I start, let me clarify two things:

  • This is my attempt to define the attributes of GREAT actuaries, not the average actuary. It goes without saying that in order to become an actuary, you have to be analytically strong, hard working, good at solving problems and self motivated. These attributes (and others) just get your foot in the door, but they don’t make you special.
  • I am 26, and I qualified just over a year ago. Just as I am not the finished article, so is this list not necessarily the opinion I will have once I am more experienced!

So, without further ado, here are the attributes that I believe separate good actuaries from great actuaries.

1. Humility

This is possibly not on any list of characteristics attributable to actuaries anywhere, but I feel quite strongly that this is an important value that actuaries should look to adopt.

While I feel that all human beings should endeavour to be more humble, I have not included this here as a feel good factor. There are very practical reasons that this a beneficial virtue for actuaries to have:

  • We live in a changing world, and an actuary is only as good as his or her ability to make assumptions about the future. Overconfidence can lead an actuary to get too comfortable in the assumptions that they set. A lack of humility arguably led to the credit crisis in 2008. Hindsight bias and confirmation bias are both rooted in arrogance.
  • Treating Customers Fairly requires actuaries to design products that consider the expectations of the policyholders. I see far too many benefits that have been designed that will mislead policyholders – and the buck stops with the actuary who developed those benefits. We often don’t think about the very person we are designing these products for and make brazen assumptions about how our benefits will be interpreted.

Ultimately, when working with risk, the riskiest thing you can do is fail to admit “I don’t know” when you don’t know.

2. Good communication skills

This is by no means a recently noted quality for an actuary to have. At the ASSA convention last year there was an excellent presentation that showed that a number of actuaries have realised this.

While the profession is improving on this by requiring actuaries to pass the Communications exam (It is still one of the least passed exams), we as actuaries need to constantly strive to improve our communication skills. The days of an actuary speaking a seemingly different language to a non-actuarial audience are over. An actuary needs to be willing to explain any actuarial concept, with an approach tailor-made for the person they are addressing. Great actuaries never hide behind jargon!

3. Pragmatism

This tends to be an area more lacking in younger actuaries, but it is an area all actuaries need to consider. We often work in ivory towers, very far away from the coal face of where policies are sold. We need to allow for the fact that sometimes:

  • The information that we would like in order to price benefits is not practical to collect
  • We have to make do with less than perfect data
  • The well meaning theories we learn in varsity don’t fit the problems we are dealing with

Balancing the theoretically correct approach and the practical approach is intertwined with an actuary’s ability to exercise good judgement. Knowing when to cut corners and when not to is an important skill for an actuary.

4. Confidence

This attribute may seem at odds with the first attribute, but an actuary who is not confident is always going to struggle to make their mark. We make assumptions for a living, and as such, there is often no single right answer. If you don’t have the confidence to sell your approach to a problem, your approach is probably not the approach that will be used.

More importantly, actuaries are often in the minority where they work and they will be put under considerable pressure to price aggressively or allow benefits that are too risky to be developed (especially by sales staff). In these situations the actuary needs to stand firm and develop products that are in everyone’s best interest.

5. Judgement

The most important skill for any actuary. We are thrown into a myriad of different situations with different problems, each requiring its own solution. While it takes years of experience to develop excellent actuarial judgement, the better actuaries seem to be able to demonstrate this very early on in their careers. Great actuaries are able to see the whole problem in its entirety and from everyone else’s perspective, and develop well thought out and practical solutions.