What can be done to address ‘survival pessimism’ in pensions?

Those choosing to draw down their retirement savings instead are taking on the risk of living longer than expected, rather than being able to pool that risk with others. But are they equipped to handle this?

Dealing with uncertainty

We know that people are bad at estimating their life expectancy. A survey of 50 to 65-year-olds in the UK conducted by Hymans Robertson showed that men underestimated their life expectancy by around five years and women by around eight years.

Pension experts need to do a better job of communicating these risks

But underestimating life expectancy is only part of the problem. Even if we know our life expectancy, the range of actual outcomes is incredibly wide and there is a good chance of living significantly longer than expected.

While a typical 65-year-old man has a life expectancy of 88, he has a one in 10 chance of living a further 10 years.

This uncertainty is not conducive to a healthy retirement ecosystem. On one hand, individuals who are ignorant of this risk could end up spending their entire retirement savings years before they die, becoming a strain on the state or their families.

On the other hand, this uncertainty could paralyse more cautious individuals, leading to hoarding, more straitened lives than necessary and reduced consumption levels and tax-take in the wider economy.

How can we address this problem? The answer is two-fold.

Firstly, we as pension experts need to do a better job of communicating these risks. This could be done by communicating the uncertainty in future lifespans rather than focusing on life expectancy.

Secondly, and most importantly, the pensions industry needs to provide products that help people manage this risk, and in particular the tail risk associated with living well beyond your life expectancy.

If we consider the level of outgo for a pensioner, it will typically follow a ‘U’ shape. At retirement, individuals often have a high level of expenditure as they pay off debts and enjoy their autumn years. As they grow older, expenditure tends to reduce.

Towards the end of life there is often an increase in spending as individuals meet their care costs. Conventional annuities completely fail to capture this shape.

The great thing about pension freedoms is the ability to tailor income in the early-to-middle part of retirement. However, running down your pension pot makes running out of money likely if you are fortunate enough to exceed your life expectancy and particularly if you require end-of-life care.

A collaborative approach

One solution is for pensioners to purchase upfront protection against living unexpectedly long lives. This could take the form of a deferred annuity from a trigger age – perhaps the age at which they have a one-in-three chance of surviving to – in our example at age 92.

Even better, individuals could also purchase an insurance policy at retirement that will cover care costs towards the end of their lives if required. In both cases, costs are kept down via a risk-sharing mechanism and individuals who survive into old age or require care are subsidised by those that do not.

The state has a role here too for example, by implementing the findings of the Dilnot Commission government review into funding for care and support in England, and effecting a cap on care costs paid by the individual.

So the challenge for us all is to do a better job of communicating this risk with individuals. And providers, with the help of supportive legislation and regulation, need to start designing products that help individuals manage their tail risk.

In combination, these actions would go a long way to making pension freedoms a success.

Nick Chadwick and Erik Pickett are longevity consultants at Club Vita