Longevity is a significant risk factor in pension plans. The actuarial world addresses longevity risk in DB and benefit-type plans using current life expectancy experience and probability. In DC and other Capital Accumulation Plans (CAPs) longevity is earmarked as an important issue but a DB-type of approach is lacking. Unfortunately, longevity risk in a DC plan is not simply about life expectancy: it includes other key fiduciary and retirement planning issues.
What is “longevity risk” ?
In its simplest form longevity risk is the risk of outliving your assets, i.e. running out of money during retirement.
Canadian life expectancy has increased dramatically over the past several decades: further advances in medicine and/or changes in lifestyle may further extend life expectancy and/or allow retirees to engage in more costly activities for longer periods. The life expectancy for the average active, healthy, non-smoker is 84-88 for men and 86-89 for women. These are averages which vary depending on the state of health, genetics, family history, life style or other risk factors. The type of employment and where you live are factors that may adversely or positively affect life span. Interestingly, from an actuarial perspective, life expectancy increases after age 65 .
Small improvements in life expectancy and/or periods of market or interest rate volatility can have a significant impact on annual retirement income. CAP members often have significant equity exposure in retirement but don’t understand the potential negative impact of longevity and volatility on retirement income particularly in the drawdown phase. Risk sharing mitigates the impact of interest rate and market fluctuations in DB plans but DC members don’t have a risk sharing safety net: longevity risk is a bigger and more complex issue in CAPs.
CAP members commonly overlook the fact that their retirement savings must be sufficient to cover themselves and their spouse’s expected life span. As a result their estimate of the level of retirement assets needed is often low. For example, the potential overall cost of requiring special care or being in a seniors home for a significant period of time may be overlooked.
Another common error is that DC members don’t have a good idea of the amount of savings (disposable assets) they need at each stage of their retirement plan in order to achieve their desired level of retirement income. This could be addressed by highlighting the funded position of a CAP member’s account (similar to DB plans) and moving away from the focus on investment return performance.
CAP members also tend to overlook the likelihood that their ability or interest in managing their retirement savings may decline or disappear as they get older. This situation does not necessarily occur later in life. CAP members are responsible for managing your retirement income throughout their life and an inability to do this is a risk to consider before it becomes a problem.
Sponsors often overlook the fact that that the CAP Guidelines require them to communicate with and educate retirees as well active members. This is a major challenge! Under the CAP Guidelines sponsors are expected to know the demographics of their plan and provide members with appropriate communications and tools. How many record keepers or sponsors assess the potential legal risk and have put communications programs and tools designed specifically to assist seniors?
How to approach the longevity Issue.
One of the key deficiencies with respect to longevity is a lack of appropriate information and tools to assist seniors and financial advisors. The estimates and probabilities regarding expected and extended lifespan (after age 65) are available in the actuarial world and could be provided on record keeper platforms. Would seniors use the information? From a prudence and fiduciary perspective it is obvious that seniors require specific information and assistance. With user-friendly tools and communications some retirees may, but unfortunately most wouldn’t. By providing better tools and information to deal with longevity sponsors would however at least mitigate their potential legal risk.
From a CAP member perspective having a plan in place is critical, but this often doesn’t happen. Using the tools and information available and/or seeking the assistance of a financial advisor is one viable approach. Education and communications programs are generally expensive and not particularly effective. Sponsors could encourage and/or provide incentives for retired CAP members to use a financial advisor or participate in tailored information and education sessions.
PRPP administrators will also have to deal with this awkward and expensive fiduciary issue. It will be interesting to see if (and how) they approach this thorny subject. Maybe another reason to convert a DC to a PRPP?