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The Risk Of Not Risk Pooling

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For most of the 20th century, people who worked hard and remained loyal to the company were rewarded with a pension in retirement. This pension provided a systematic income stream, typically through an annuity. With it came the guarantee that this income stream would last as long as the retired worker lived.

Today, the number of retirees covered by a traditional pension or defined benefit plan has been steadily decreasing. Only about 20% of private sector workers are covered by traditional pensions, according to the Bureau of Labor Statistics. And approximately 44% of private sector workers have neither pension nor savings plan, according to the Employee Benefit Research Institute.

This movement away from defined benefit plans has set in motion some developments that require advisors and clients to be more involved in retirement planning than ever before–and to become aware of the associated risks.

For instance, it helped spur growth of defined contribution plans, most notably 401(k) plans. These DC plans place more emphasis on self-directed accounts and portability from company to company. They were developed in part to shift some of the burden of planning for retirement off of employers and onto employees.

While the shift to DC plans provided employees with more control over where their retirement funds are invested, employees unfortunately lost 2 very valuable benefits in the process:

1. The security that comes with a guaranteed source of retirement income.

2. The advantage of “risk pooling.”

Historically, when individuals received a pension, they were participating in a mortality risk pool, where plan sponsors assume that some retirees will die before life expectancy and others after life expectancy, and are therefore able to allocate benefits as if all retirees will live to life expectancy. Excess assets allocated to those that die prior to life expectancy are used to fund the retirements for those that live past life expectancy. (See Chart 1.)

The logic of this scenario, which at its most basic level functions because some retirees will live a long time and others will not, is essentially what makes risk pooling work.

The advantage gained through the participation in a risk pool is the ability for individuals to take income as if they were only going to live to life expectancy, and, at the same time, receive a guarantee that they will never run out of money, even if they live well beyond this date. This dynamic also benefits those who die before life expectancy, because they could not have safely taken out as much as they were able to with risk pooling since they did not know their deaths would occur before life expectancy.

Individuals in DC plans generally do not have this ability, because DC plans have no obligation to pay benefits throughout a person’s lifetime. With the dramatic advances in life expectancy over the last century, however, this reality presents a major challenge.

Consider: Today’s typical 65-year-old man and woman can expect, on average, to live to ages 85 and 88 respectively, and 50% of healthy 65-year-old couples can expect to have 1 member live to age 92 or beyond (based on the Annuity 2000 Basic Mortality Table.)

Without the inclusion of a guaranteed income stream, uncertainty about length of life carries the risk that retirees may outlive their assets or be forced to substantially reduce their living standards at advanced ages. As a result, an individual retiree must self-insure and plan for the worst-case scenario, which is that they will live past life expectancy.

“Self-insurance” essentially means taking significantly less income to reduce the risk of running out of money. This is known as longevity risk.

Fortunately, a financial product exists that allows individuals to protect themselves from longevity risk and obtain the benefit of risk pooling.

This product is the lifetime income annuity (LIA). This is an insurance product that converts an up-front lump sum premium into guaranteed retirement income for life. The primary appeal of a LIA is that it recreates the risk pooling advantage found in pensions, and allows retirees to shift some of the burden of insuring against the risk of outliving their assets onto the insurance company.

Similar to pension plans, by pooling these individual premiums, insurance companies are able to pay income to customers as if they will live to life expectancy, but guarantee it for as long as they live. As a result, the insurers can provide retirement income more efficiently than retirees can on their own.

Without the benefits of the LIA’s risk pooling, retirees will need substantially more money than in the LIA to self-insure. This is because they will need to set aside enough money to last throughout their entire lifetime rather than simply enough to last their expected lifetime.

The net effect? With the LIA, consumers get a greater income stream from the same assets, which translates into more money today. (See Chart 2.)

Assuming there are sufficient assets, the purchase of a LIA could provide an income stream to cover basic living expenses.


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