Discussing Life-Cycle Pensions & Longevity

In this blog I'm going to discuss two persistent pension topics:

1. One of the most common misunderstandings in pension fund land is that an individual (member) investment policy weighs up to a collective investment approach.
2. Is there a rule of thumb that expresses 'longevity risk' in terms of the yearly return?  

1. Collective vs. Individual Investing Approach

In case of a 'healthy pension fund', new members will join as time continues. In a mature pension fund the balance of contributions, investment returns, paid pensions and costs will stabilize over time.

Therefore the duration of the obligations of a pension fund will more or less stabilize as well. The duration of an average pension fund varies often between 15 and 25 years. Long enough to define a long term investment strategy based on a mix of risky equities (e.g. 60%) and fixed income (e.g. 40%). Regardless of age or status, all members of a pension fund profit from this balanced investment approach.

In case of an individual (member) investment strategy, the risk profile of the individual investments has to be reduced as the retirement date comes near. In practice this implies that 'equities' are reduced in favor of 'fixed income' after a certain age. As the age of a pension member progresses, the duration of the individual liabilities also decreases, with an expected downfall in return as a consequence.

Let's compare three different types of investment strategies to get a clear picture of what is happening:

1. Collective Pension Fund Strategy Approach: Constant Yearly Return
   40% Fixed Income à 4% return + 60% Equities à 6% = 5.2% return yearly
    
2. Life Cycle I Approach ('100-Age' Method)
   Yearly Return (age X): X% Fixed Income à 4% + (100-X)% Equities à 6%
    
3. Life Cycle II Approach (Decreasing equities between age 45 and age 65)
   Yearly Return (age X) = MIN(MAX((6%+(44-X)*0.1%);4%);6%)

All visually expressed in the next chart:

Pension Outcomes

Now lets compare the pension outcomes of these three different investment strategies with help of the Pension Excel Calculator on basis of the next assumptions:

- Retirement age: 65 year

- Start ages 20 and 40

- 3% and 0% indexed  contributions and benefits

- Life Table NL Men 2012 (NL=Netherlands)

Results Pension Calculations (yearly paid pension):

Conclusion  I

From the above table we can conclude that switching from a collective investment approach to an individual investment approach will decrease pension benefits with roughly 10%. Think twice before you do so!

2. Longevity Risk Impact

To get an idea of the longevity impact on the pension outcomes, yearly paid pensions are calculated for different forecasted Dutch life tables (Men).

Life Tables

Forecast Life Table 2062 is calculated on basis of a publication of the Royal Dutch Actuarial Association.

The Forecast Life Table 2112 is (non-official; non scientific) calculated on basis of the assumption that for every age the decrease in mortality rate over the period 2062-2112 is the same as over the period 2012-2062.

Pension Outcomes per Life Table

Here are the yearly pension outcomes on basis of the forecasted life tables:

From the above table, we may conclude that the order of magnitude effect of longevity over a fifty to seventy year period is that pensions will have to be cut  roughly by 25%-30%.


Another way of looking at this longevity risk, is to try to fund the future increase in life expectation from the annual returns.

The next table shows the required return to fund the longevity impact for different forecasted life tables:

Roughly speaking, the expected long-term longevity effects take about 0.7%-1.2% of the yearly return on the long run.

Finally

Instead of developing a high tech approach, this blog intended to give you some practical insights in the order of magnitude effects of life-cycle investments and longevity impact on pension plans in general.

Hope you liked it!

Links/Downloads:

- Excel Pension Calculator including Dutch Life Tables 2012-2062 

- Excel Tables of this Blog
- Forecasted NL Life Tables  2012, 2062, 2112

- Original Pension Excel Calculator

- Publication Dutch Life tables 2012-2062 (Dutch)

- Excel Spreadsheet Forecast Dutch Life Tables 2012-2062

Actuarial Public Debt

The current definition of Public Debt is very poor. Only accrued past debt and current budget deficits are measured; no future obligations.

Hot from the press, the 'actuaries' behind the 83rd BIS Annual Report 2012/2013 show us the impact of the commitments to future spending on pensions and health care that are missing in current measure of public debt.

Age-related liabilities as a share of GDP, are projected to rise considerably between 2013 and 2040 in a number of countries.

Please notice that reforms enacted after December 2011, are not included in the next graph.

Actual Public Debt
End 2012, the impact of age-related liabilities on the actual public debt was calculated and analyzed by Stiftung Marktwirtschaft, in cooperation with the Research Centre for Generational Contracts.

In a report called "Honorable States? The Sustainability of European Public Finances in Times of Crisis" they calculated the effects for Europe as follows:

Reforming Social Security 
Without going into details, this graph makes perfectly clear that even an attitude of 'just managing debt' is hopeless and doomed to fail.

'Restructuring public debt' will only be possible if we have the courage to fundamentally restructure our social security system of pensions and health care. The sooner, the better.....

For those who still had hope on a positive U.S. outcome, just take a look at the debt-outcome of two non-EU countries:

Concluding Reflections
To get a sound picture of a country's financial sustainability, a first step would be to annually report real(istic) balance sheets on basis of actuarial public debt, e.g. debt including age related future obligations like state pensions and health care.

Ultimate, we need new market value based 'country state accounting principles' that include a complete set of  "future obligations" and "natural resources" (oil, gas, water power, etc.) on the asset side.

One of the main issues will be how to value a virtual and information society including fast changing and new future developments on basis of outdated valuation methods, developed in last decades of the last century.

Of course THE big challenge with such an ultimate country balance sheet will be how to value "human resources" as an asset. Why?

Because flexibility, responsiveness, education and entrepreneurship will eventually make the big difference in adapting a country's economy to a sustainable future. I suggest we start by valuing actuaries ;-).

Links/Sources:
- Spreadsheet with data used in this blog (xls)
-  83rd BIS Annual Report 2012/2013
- Report Honorable States? (2013)

Humor: Actuarial Mind

In July 2011 holidays  - instead of blogs - are ahead...

Just chew this month on the next actuary no-brainer:

The smartest actuary in the world

The Pope, a well seasoned actuary and a student nurse are flying on an airplane. The captain comes back and says that he has some bad news and some really bad news. The bad news is that the plane is going to crash! As he puts on a parachute and jumps out he says that the really bad news is that there are only 2 more parachutes.

The actuary says: “I am the smartest man in the world. I've just calculated my life expectancy to be more than fifteen years. Excuse me...” With that he puts on a parachute and jumps out.

The Pope says: “Well, my child, I would love to live, but I believe that my time is up. Please take the other parachute and save yourself.”

The student nurse says: “Not to worry Holy Father. Right now the smartest man in the world is trying to find the rip-cord on my back pack!”

Actuarial Model World Cup 2010 Winner

In 'The Actuary June 2010', Greg Becker (actuary) and Arminder Kainth (annuities pricing analyst) present the outcome of an actuarial model they developed, to  predict the probability of a country winning the Fifa World Cup 2010.

With Brazil as a clear winner, here's the outcome:

Perhaps trading on the World Cup 2010 Bet Market can become a new interesting alternative for traditional investment categories....
Anyhow, let's hope (fingers crossed) that actuaries are right and Brazil, Germany, Italy and England all end in the semi-finals. In this case we'll ask both actuarial whiz kids to develop a new actuarial investment model to settle (for ever!) the everlasting bonds-stocks discussion....

Place your own (free) bet
Meantime if you want to place your World Cup bets for free, join The Actuary World Cup PredictorPro game in association with Star Actuarial. For your chance to win an iPad register at Predictorpro.
Start right away, because betting already started....

Used Sources:
- The Actuary: Article 'World Cup fever' (pdf)
- The Actuary:Who will win the World Cup?
- Free bet at Predictorpro

Related:
- Estimating the Real Rate of Return on Stocks Over the Long Term (2001)

- Pension Fund Investments: Stocks or Bonds? (2004)
- Social Insecurity? (2008)

Actuagram

If you want something to chew on, something that challenges your actuarial brain and associative power, try to solve the next Actuagram.
This actuarial brain teaser is a mix of an actuarial crossword puzzle and a cryptogram.

How to play the puzzle:

1. Click on the word you would like to solve.
2. Fill in your suggestion, click on OK
3. Only if you do not know the answer, click on the 'solve button'

Can you manage, without using the 'solve button' ?

Congratulations! Actuaries, have fun!

[ If your browser doesn't allow you to play here, click on this link]

Actuagram

by Joshua Maggid
EclipseCrossword © 2000-2007

This interactive crossword puzzle requires JavaScript and a reasonably recent web browser, such as Internet Explorer 5.5
or later, Netscape 7, Mozilla, Firefox, or Safari. If you have disabled web page scripting, please re-enable it and refresh
the page. If this web page is saved to your computer, you may need to click the yellow Information Bar at the top of
the page to allow the puzzle to load.

Model Collective Behavior?

Take a look at the next picture:

It's clear that the little fish here, have a problem.

What's also clear, is that random actions of an individual fish are not likely going to change the situation.


In the next picture, by coordinating behavior, a way has been found to solve 'the problem' :



This solution looks very simple, the question is how to organize this kind of collective "big fish" behavior?

The problem is that often first movers will not benefit from a collective approach:

It turns out that one way to get individuals to coordinate their behavior is through morality.

Interested?
In an excellent essay called A Business Plan for Catalyzing Collective Action , The Point explanes how how these cooperative mechanisms can be created.

Actuarial Models
Collective (organizing) mechanisms are important stuff for actuaries. For example, they play an essential role with regard to all kind of solidarity aspects in pension- and insurance-contracts.

Moreover, collective rational or even emotional behavior often plays a decisive role in our society, as may be clear from the 2009 credit crisis turmoil and the escalating bonus madness.

Be aware, study "collective behavior mechanisms" and take them into account when you set up your actuarial risk model.

Actuarial aerodynamic careers

Did you know that actuarial careers follow the laws of aerodynamics?



Read more about this and find out whether you are a "Balloon Career Maker" or a "Wing Career Maker.

Source

Edelman Trust Barometer 2008

The credibility of a CEO doesn't seem sky high.....

More, in this interesting report of the Edelman Trust Barometer 2008.


What about the trust in Lawyers or accountants?

These are the Coredata results:



Pity an actuary isn't reviewed. So, what about the credibility of an actuary?

In short: It's at steak!

These are the recommendations the "Task Force On Actuarial Credibility"
as advised in a October 2007 presentation, based on the original CAS report 2005.

Task Force Recommendations

1. Enhance transparency of the actuary’s conclusions by identifying differences between the “best estimates” of management and the actuary.
2. Enhance the public’s understanding of actuarial estimates and to refine actuarial methodologies.
3. To improve the transparency of actuarial estimates by providing the changes from one reporting period to the next within the actuarial report.
4. To enhance the quality of corporate governance for property/casualty insurers by educating audit committees and/or boards of directors on the roles and responsibility of the appointed actuary.
5. To enhance self-governance of the actuarial profession with respect to reserve opinions by requiring the appointed actuary to provide an explanatory document with the ABCD whenever the change in the actuary’s reserve estimate over a defined period of time exceeds certain predetermined thresholds.
6. Incorporate the actuarial statement with the Jurat page of each property/casualty insurance company’s Annual Statement.
   

These recommendations could also apply to non-casualty actuarial areas.