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OPINION

Longevity insurance

Longevity insurance
October 11, 2017
Longevity insurance

Immediately, the spectre of moral hazard conjured images of weekends spent stroking the new Ferrari or holidays spent gazing at sunsets over Sorrento. Pensioners would run through their defined-contribution pension pots at the pace of a burning fuse; but the bang would be more a whimper – declining years spent in miserable penury, dependent on the state’s diminishing generosity or the kindness of hard-pressed children.

Yet it’s as likely that pension freedoms will prompt oldies to underspend as to overspend. After all, we are dealing here with uncertainty; specifically, the uncertainty that comes from not knowing how many years the pension pot needs to last. For a cohort whose default response is not to rage against the dying of the light – old people are instinctively cautious – then the fear of this particular unknown seems as likely to cause too little spending as too much.

In its way, that’s as harmful as overspending. To see that at the aggregate level one only needs look at Japan or, increasingly, Germany. More to the point, for individuals it means a lower standard of living than need be.

At its core, the problem is what actuaries label ‘longevity risk’; what you and I would call ‘not knowing how long we’re going to live’. For example, the average 65-year-old Briton now has 20 years of life to look forward to, although there is a wide variation around this average. At the extreme, the variation would be zero years (obviously) up to, say, 40. More realistically, two-thirds of deaths will occur within a band 11 years either side of the average (one standard deviation). But even that means a difference of 22 years, from death at 74 to death at 96. How does each of us plan for that? Besides, at the aggregate level, as populations age further, the variations will widen, making it seem all the more likely that the money will run out in extreme old age, prompting less spending now.

True, it’s not a new problem. Go back to the 17th century and longevity risk was addressed by ‘tontines’, where, in return for receiving a lump of capital from a group of participating individuals, a borrower commits to pay a stream of dividends for as long as any participants survive. As each participant dies, the sum is divided among the remaining few until the final survivor gets the lot.

But tontines encouraged fraud and – like their beneficiaries – they eventually died out. However, according to Moshe Milevsky, a Canadian academic and expert on all things actuarial, they could be the 21st-century tool to deliver guaranteed income for the really long-lived. Since they pool risk, they can offer fat returns for those surviving longest, who, almost by definition, are most in danger of seeing the money run out.

However, the UK government also offers the potential for longevity insurance via the state pension. This is achieved by the simple expedient of deferring it. Do that and the amount of pension that can eventually be claimed rises the longer it’s deferred. One snag is that the rate of rise is arbitrarily dependent on age. For those who reached 65 before April 2016 the pension rises at 10.4 per cent a year; for those born later, the rate is only 5.8 per cent. Clearly, therefore, this tactic is much more attractive for the older ones. For those, the sums even work out half decently as an investment proposition.

First, let’s imagine Fred, who is in the happy position of having the means to defer and whose age falls on the 10.4 per cent side of the divide. In effect, Fred is buying longevity insurance – or a deferred annuity (same thing) – and his premiums are the state payments foregone. If we also assume that Fred’s marginal rate of income tax is already 40 per cent, then, on a basic state pension of £6,360, his annual premium is effectively just £3,816.

If Fred defers his state pension until he is 80, then, at current rates, he will get £16,300 a year and, in crude terms, £15,325 after tax, assuming that by then the state pension is his prime source of income. Assuming he draws that pension for five years before he spins off this mortal coil, then the return on his ‘investment’ will be 2.9 per cent a year. That return rises exponentially if he lives longer. It would be 4.9 per cent if he survives just another two years.

The sums involved also become much more attractive if additional state pension comes into the mix. Assume a starting point of £12,000 a year and the pension becomes £30,700 by the time Fred draws it – enough to make a hole in the cost of care that, most likely, he will need by then.

However, the key point is that this is less an investment and more a form of insurance that encourages the use of capital that’s there to be spent. It also comes with two big caveats. First – and obvious – it only works for those who can afford to defer their state pension. Second, it assumes that the government won’t change the rules midway so as to make deferral a bad choice.