Nov 11, 2013

QIS: Longevity Risk Sharing

In a recent discussion about the future and fundamentals of the Dutch pension system I discussed the importance of solidarity.

As expected, the participants quickly came up with the various forms of solidarity, including solidarity between:
– higher and less educated people
– women and men
– old versus young people

Longevity Risk Sharing
Remarkably non of the participants had any idea about the financial impact of one of the most fundamental forms of risk sharing in case of a life annuity: Longevity Risk Sharing. Let's call it in general 'mortality solidarity'.

When asked, most participants strongly underestimated the impact of mortality (mortality share) as part of the yearly payment in the form of a life annuity. On the other hand, they overestimated the impact of 'return'.

Some of the participants had the idea that they would be 'better of' with a traditional individual investment plan in combination with a little more investment risk (and return) ...

Life Annuity Composition
So let's do a mini QIS (Quantitative Impact Study) of 'mortality solidarity' by examining the development of the composition of an annual lifetime annuity, regarding three basic elements: Mortality, Return and Desaving.

Here is the result for a Dutch man, age 65, with a lifetime annuity based on an average 5% yearly return:




Translated in table form:

Yearly Payment CompositionCumulative Composition
AgeMortality Return DesavingMortality Return Desaving
6516%51%33%16%51%33%
6617%50%34%16%50%34%
6718%48%34%17%50%34%
6819%46%34%17%49%34%
6921%45%35%18%48%34%
7022%43%35%19%47%34%
7124%41%35%20%46%34%
7226%39%35%20%45%34%
7328%38%35%21%45%34%
7430%36%34%22%44%34%
7532%34%34%23%43%34%
7634%33%33%24%42%34%
7736%31%33%25%41%34%
7838%30%32%26%40%34%
7941%28%31%27%40%34%
8043%27%30%28%39%34%
8145%25%29%29%38%33%
8248%24%29%30%37%33%
8350%22%28%31%36%33%
8452%21%27%32%36%32%
8555%20%26%33%35%32%
8657%18%25%34%34%32%
8760%17%23%35%33%31%
8862%16%22%36%33%31%
8965%15%20%37%32%31%
9067%14%19%39%31%30%
9169%13%17%40%31%30%
9272%13%16%41%30%29%
9373%12%15%42%29%29%
9475%11%14%43%29%28%
9577%11%12%44%28%28%
9678%10%12%45%28%27%
9779%9%11%46%27%27%
9880%9%11%47%26%26%
9982%8%10%48%26%26%
10083%8%10%49%25%25%
10184%7%9%50%25%25%
10285%7%9%51%25%24%
10385%7%8%52%24%24%
10486%6%8%53%24%24%
10587%6%7%54%23%23%


Observations
As is clear from the table above :
  • Already at the start the start of the annuity, at age 65, 16% of the yearly payment is due to mortality risk sharing and 'only'  51% is related to the 'return'.
  • As a pension member continues to live, the  'mortality share' of the annual payment increases. At the age of 83 already 50% of his annuity is due to mortality effects and the 'return share'  is already down to 22%.
  • As from age 77 of, the 'mortality effect' on the annual payment exceeds the 'return effect'.

Conclusion
From some simple calculations, we can conclude that longevity (mortality) solidarity is a fundamental part of a life annuity.
 

AfterMath
Make your calculations with other interest rates, ages or life tables with the Pension Calculator (Excel).

You may download the pension calculator HERE

Links/Sources