In this blog I'm going to discuss two persistent pension topics:
- One of the most common misunderstandings in pension fund land is that an individual (member) investment policy weighs up to a collective investment approach.
- Is there a rule of thumb that expresses 'longevity risk' in terms of the yearly return?
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:
- Collective Pension Fund Strategy Approach: Constant Yearly Return
40% Fixed Income à 4% return + 60% Equities à 6% = 5.2% return yearly
- Life Cycle I Approach ('100-Age' Method)
Yearly Return (age X): X% Fixed Income à 4% + (100-X)% Equities à 6%
- 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:
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)
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).
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.
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!
Hope you liked it!