Much more important than simply reiterating the nature of these risks, however, I quantified the degree of risk involved in each case and, even more important, quantified the level of tolerance to those risks.
In other words, although falling interest rates and/or poor investment performance undoubtedly have a negative impact on a drawdown strategy, this can be compensated for by the increase in annuity rates as the client gets older.
To remind you briefly of this issue, and to introduce the main point of this third and final article in this short series, the table below from the Government Actuary’s Department is useful to bear in mind (noting that these GAD limits broadly represent the level of market annuity rates at a given level of underlying interest rate).
I will return to the application of these rates later in this article but first I would like to highlight the final major risk involved in drawdown strategies – increasing life expectancy. Pension drawdown involves the client deferring the purchase of a conventional annuity from the date he retires to the final date of the drawdown contract – usually at age 75 as this is the cut-off point at which an annuity must be bought by the fund.
During that period of deferment, if there is an improvement in life expectancy (of the country as a whole, not simply the client’s own life expectancy), annuity rates can be expected to fall as the insurance company anticipates having to pay the lifetime annuity for more years. Put a bit more technically, the capital content within the annuity will fall.
Just as my previous articles dealt with tolerances to the other two risk factors, I will now evaluate not only the nature and likelihood of annuity rates falling due to increasing life expectancy but I will also seek to quantify the tolerances to this risk.
Looking at the mortality tables produced each decade, male life expectancy has increased by almost exactly three years in each of the last three decades. This indicates that a male aged 60 this year could expect – if he were to look at the latest statistics – to live nine years longer than 30 years ago. This is an astounding rate of improvement which is perhaps even more astonishing bearing in mind that this increase has occurred not just over a short period of time but consistently each decade.
It is also worth remembering that mortality tables are not predictive statistics, they are historical records. In other words, they should not really be used to infer future life expectancy as they only tell us what has happened in the past. However, this straight-line improvement could, it is generally believed, be expected to continue into the foreseeable future as the statisticians tell me that we are continuing to live longer than the last mortality tables indicate.
But what impact has this increasing life expectancy had on annuity rates in the recent past and what further impact could we expect it to have in the future? Looking at annuity tables, as a rule of thumb, a three-year improvement in male life expectancy (I will deal with the girls in a few moments) has roughly the same impact on annuity rates for a 60-year-old as a 1 per cent reduction in interest rates. This results in around a 10 per cent fall in annuity rates. In simple terms, the increasing life expectancy of recent decades has had the effect of reducing annuity rates by 10 per cent each decade or 30 per cent over that period, even ignoring reductions caused by falling interest rates.
Now, if life expectancy continues to increase at this rate in future, we would perhaps expect annuity rates to continue to fall by a further 10 per cent each decade. For a male aged 60 reaching retirement and entering into a drawdown contract, this could mean that annuity rates might fall a further 15 per cent or so over the period to the contract vesting at age 75.
To remind you of the rule of thumb I mentioned earlier, this would have roughly the same impact as a 1.5 per cent reduction in interest rates which, I am sure you will agree, represents a major risk.
Before moving on to look at female statistics, it is vital to note, as regards the degree of risk from increasing life expectancy, that the major annuity providers have informed me that they are already factoring into their rates the likelihood of further improvements. This means that – although none of the offices will tell me the actual numbers – if male life expectancy improves over the next couple of decades by, say, a further five or six years but then levels off, annuity rates can be maintained at current levels as that improvement has already been anticipated.
That said – and to perhaps confuse matters even further – if the improvement continues in a straight line, providers could be expected to continue to factor in further expectations of improvements, meaning annuity rates will indeed fall further. To cut a very long and complex story short, the risk to drawdown clients of increasing life expectancy must be highlighted in the advice process.
How can this risk be quantified? Simply by remembering the rule of thumb that three years’ extra life expectancy have roughly the same impact on annuity rates as a 1 per cent fall in interest rates. From there – and noting the GAD annuity tables repeated earlier – the tolerance to increasing life expectancy can be cross-referenced to the tolerance to falling interest rates and also the tolerance to investment performance. Thus, the table above enhances upon a small chart I produced in my last article.
Turning briefly to female life expectancy, this has risen by almost exactly two years in each of the last three decades. So, although not to the same extent as males, the impact of increasing life expectancy on annuity rates is very real.
Noting that male life expectancy has been improving faster than female life expectancy, the well known phenomenon of girls living longer than boys is fast converging. In fact, recent unpublished statistics indicate that we are only a couple of years apart and still apparently converging each year. Soon, the guys will be living longer than their wives. Ah, the bliss of being a single bloke again.