An annuity is a reasonable solution to an obvious problem. You don’t know how long you will live in retirement, but an annuity provider can estimate this, take a risk, and sell you an income that lasts the rest of your life. In practise this hasn’t represented good value for money, so I welcomed the budget announcement to give retirees more choice in investing or disposing of their own money. Yesterday Janice Turner argued for the Collective Defined Contribution pension model as another solution to the same problem. I have my doubts about CDC and I want to suggest another alternative.
The purpose of an annuity is to ensure that you have an income for the rest of your life. If you don’t purchase one, and draw down prudently on your pension pot you would base the amount you draw on some estimate of how long you expect to live. And when you die there is likely to be money left, which you can bequeath, but is in a sense wasted in terms of providing yourself a pension. Or maybe not.
Suppose I place a bet with my neighbour, who is retiring on the same day as me, that I will outlive him, to the value of what is left in our pension pots when the first death occurs (the lesser of the two amounts). That bet would give the survivor an extra lump of cash to fund their longer retirement. No gilts, no actuaries, no profits, though we do have to trust each other not to murder.
There are two elements to the risk that annuity providers take:
- there is the risk that the individual will live longer than the average – insurance is good at protecting us from this sort of risk because these risks all average out; and
- there is the risk that life expectancies in general will rise more than expected – this is a big risk for insurers because they can’t average it against other claimants, they have to stand it with their own assets and so they will charge a big risk premium
From the point of view of the individual, the risks are more or less reversed. The variation between me and my neighbour is very likely, statistically speaking, to be considerably greater than any improvement in life expectancy over the next few years. The important risk from my point of view is the one that is cheap to insure, not the one I would be paying the biggest risk premium insuring against if I bought an annuity.
The solution is to turn my bet with my neighbour into a low cost, simple and comprehensible financial arrangement that protects me (unlike drawdown) from my own longevity, but not from increases in life expectancy in general. For want of a better name I will call it a mutunnuity: pensioners are mutually annuitising for each other, near enough.
If 1000 people of roughly the same age and health status all put £50,000 into a mutunuitty when they retire, that £50m is used to pay retirement incomes to those 1000 people using a prudent draw down calculation. As each of the participants dies, this leaves a greater share of the income for the survivors to balance the declining value of the pot.
This is not the fixed income of an annuity, but you would have to be extremely unlucky for it to drop below annuity levels. The chance of 30 people all living longer than average is 1 in a billion, so in a mununnuity of 100 or 1000 pensioners you are very well protected against this kind of bad luck.
Mutunnuities would allow, if desired, investment in shares for a higher return, at some risk – and this is surely the point of low interest rates, to encourage investment in real business.
The CDC pension model has some of these features, but is a complex feat of financial engineering that risks introducing new kinds of intergenerational unfairness. The mutunnuity is simple and requires no risk management from the provider, and is therefore very cheap to operate. It eliminates the greatest part of the longevity risk in a transparently fair way. Almost all the benefits of income drawdown combined with almost all the benefits of an annuity.
* Joe Otten is a councillor in Sheffield, and Friday editor of Liberal Democrat Voice
