For Investment Professionals
January 2017 DC Dynamics
DC
DY N A M I C S
Longevity risk
and its impact on
DC investment
strategy
Focusing on the post-retirement part of the DC
journey, we look at the implications of longevity
risk on investment strategy and spending
decisions.
John Southall is a Senior
Investment Strategist in
the Solutions Group. His
responsibilities include
financial modelling,
investment strategy
development and thought
leadership.
EXECUTIVE SUMMARY
Simon Chinnery is Head of DC
client solutions. He joined LGIM
following 11 years at JPMorgan
Asset Management. He works
with DC schemes to develop
solutions for the fast-changing DC
environment, specifically around
pre and post-retirement planning.
• Longevity risk should be considered together with
This paper introduces a framework for measuring
investment risk when determining overall retirement
retirement outcome risk for a DC investor, and shows
outcome risk and designing drawdown solutions
that longevity risk is a large component of this risk.
We also outline potential implications for investment
• The impact of longevity risk on withdrawal rates is
strategies and optimal spending decisions in retirement.
likely to increase with age. This may have implications
In particular:
for when a pensioner chooses to buy an annuity
• We propose a metric for assessing retirement outcome
risk called Years Expected After Retirement Savings
(“YEARS”). A well-diversified multi-asset income
drawdown fund could help reduce YEARS
• Running out of money is a key risk. Longevity risk (living
longer than expected) is a large component of this risk
for a typical retiree entering income drawdown, and is
comparable in size to investment risk
In a future edition of DC Dynamics, we will look at how
investment strategies should evolve post-retirement.
January 2017 DC Dynamics
INTRODUCTION
For current retirees, their DC pots are typically not
The Freedom and Choice
a substantial source of retirement income, as many
pension reforms ended
current retirees have DB pensions. But looking to the
the requirement to buy
future, it is likely to be increasingly important to have
an
DC
a framework to manage investment and longevity risk
savings in the UK. We
in DC portfolios. In this paper we take some important
are moving from a world in which most UK retirees
steps towards outlining what that framework could look
annuitised (passing all risks to an insurer), to one
like.
“Longevity risk is
often brushed under
the carpet when it
comes to advice or
making strategic
decisions”
annuity
with
in which many individuals instead enter an income
drawdown solution and bear the investment and
WILL YOUR PENSION POT LAST AS LONG AS YOU WILL?
longevity risks involved. Investment risk is generally
There are two main questions to retirement saving – how
well appreciated by consultants and advisers, and
to invest and how to spend. In recent years the shift from
there is a plethora of tools to demonstrate the potential
Defined Benefit and earnings-related state pensions
impact of investment uncertainty. In principle, everyone
to Defined Contribution pensions has increasingly led
is also aware of longevity risk and their own mortality.
to the investment decision becoming a more personal
However, longevity risk is often brushed under the carpet
responsibility. “How to spend”, by which we mean the
when it comes to advice or making strategic decisions;
responsibility for the pace of spending has also moved
indeed, investment risk is often modelled in isolation.
to the individual since Freedom and Choice.
Given that longevity risk is comparable in importance
to investment risk for new retirees, and increases in
This leaves many retirees with complex financial
importance with age, this may lead to suboptimal
planning tasks. These need to be addressed throughout
decisions. In this paper we show how consideration of
retirement and not just at a single point in time. One
longevity risk may impact investment strategy.
important, if possibly uncomfortable, question investors
should consider when deciding on their pace of spending
Dealing with investment and longevity risks involves
or investment strategy, is how long they expect to live
selecting not just a sensible investment strategy but
for and the uncertainty around this expectation.
also a sensible spending pattern.
If an individual
requires high confidence that they will not run out of
According to the recent prospective mortality tables
money, then it will be necessary for them to adopt a
from the Office of National Statistics (ONS), a male1
lower rate of spending than if they knew their future
aged 65 can expect to live another 21 years (to age
lifespan or investment returns precisely. We show that
86). However, there is considerable uncertainty for an
a sensible margin for prudence in the level of income
individual around how long they will live, as shown
taken each year tends to increase with age and that the
in Figure 1. Indeed there is a circa 10% chance a male
primary driver for this difficulty is longevity risk rather
dies before his 72nd birthday and a circa 10% chance
than investment risk. This has potential implications for
he lives to see his 101st birthday. Of course, this reflects
the timing of annuity purchase.
the degree of uncertainty where nothing in particular is
known about the individual (other than their gender and
year of birth).
2
1. In our analysis we focus on a male retiree. However, figures can also be calculated for females where life expectancies are slightly higher. Indeed, a female aged 65
can expect to live another 24 years (to age 89).
DC Dynamics January 2017
sustain a pensioner for the rest of their life. This depends
Percentage of 65 year olds expected to survive
Figure 1: Survival chances from age 65
on both longevity and investment performance, so it is
important to consider the two together.
100%
90%
80%
The October 2014 “Retirement freedom: the principles
70%
and pitfalls of income drawdown,”2 written by our
60%
colleagues John Roe and Martin Dietz in our Multi-Asset
50%
Funds team, considered the key risks facing an income
40%
drawdown investor. The first of these is fund value risk.
30%
This reflects the variation of the value of an investment
20%
in the short term. The second is retirement outcome
10%
risk. This is the risk around the long-term outcome
0%
65
75
Males
85
Females
95
Age (years)
105
the investor experiences. Retirees using drawdown
115
generally require a retirement income that exceeds the
expected investment returns and so are likely to use
Source: LGIM calculations, ONS mortality rates.
up their capital over time. Retirement outcome risk is
Longevity uncertainty
“Longevity risk poses
challenges in deciding
both the pace at which
funds should be spent
and the investment
strategy”
poses
challenges
in
deciding both the pace
at which funds should
be
spent
investment
and
the
strategy
that should be adopted. In this paper we explore
the risk that their investment fund runs out earlier than
anticipated; in particular the risk that they outlive their
fund. These two risks are illustrated in Figure 2.
We now focus on retirement outcome risk and its
quantification, allowing for the interaction between
longevity and investment risk.
whether a pot used for income drawdown is able to
Fund value
Figure 2: Key risks facing an income drawdown investor
1
Fund value risk
Time (years)
2
Retirement outcome risk
Source: LGIM, for illustrative purposes only.
2. http://www.lgim.com/library/knowledge/thought-leadership-content/diversified-thinking/LGIM_Diversified_Thinking_OCT_14_ENG.pdf
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January 2017 DC Dynamics
MANAGING RETIREMENT OUTCOME RISK: YEARS
“The primary
objective of an income
drawdown investor is
likely to be a high level
of income for life”
pensioner is without an income for only a short period
We assume that the
(e.g. 1 month) or without an income for a long period
primary objective of
(e.g. 10 years).
an income drawdown
investor is a “life of
An alternative metric is what we call the Years Expected
income”. There may be
After Retirement Savings or “YEARS”. This is the
secondary objectives,
average, over many scenarios, of the number of years a
such as flexible spending and inheritance planning, but
pensioner is without an income because they have run
the main aim is to provide a high level of income for life;
out of money. A YEARS value of zero means that the
any money left behind is considered a bonus.
pensioner would never be left without an income. A low
YEARS measure is better than a high YEARS measure
Measuring the risk of failing to meet this objective
as it implies a lower expected period in which there is
is a somewhat challenging. In practice, pensioners
no income. We believe that YEARS provides a useful
are likely to adjust their spending habits over time in
measure of the ability of an income drawdown strategy
response to how their circumstances change. The pace
to provide a lifetime of income.
of withdrawals is likely to depend on how their wealth
and health develop and how much money they wish to
To begin with, we compare a few different investment
bequeath. In addition, the consequences of exhausting
strategies3 for a male aged 65 who withdraws at a rate
one’s pot are more severe for some individuals than
of 6% of their initial pot (i.e. if they start with a pot of
others. For those with a significant other source of
£100,000 then they withdraw £6,000 pa throughout
income, such as a DB pension, depleting their fund
retirement). In Figure 3 we show the values of YEARS
may not have a large impact on their standard of living.
for four different investment strategies.
However, as pensions gradually shift from DB to DC
there are likely to be fewer such pensioners.
We initially assume a fixed withdrawal amount per
annum, equal to 6% of the pot size at retirement (later
Figure 3: Number of years without income
under different investment strategies
we consider other withdrawal rates). This is higher
than the rate attainable from purchasing an annuity,
and also leaves the possibility of passing on wealth to
Cash
future generations. The downside is that there is a risk
of running out of money. We look at the consequences
Developed Equity
of such a spending pattern by looking at thousands of
different simulations of both investment performance
and longevity experience.
One metric to quantify the risk of a pensioner exhausting
their pot is the “probability of pot exhaustion”. This is the
Bond strategy
Multi-asset income
drawdown fund
chance of outliving the pot, calculated as the proportion
of simulations in which the fund is empty at the end of
the pensioner’s life. This is relatively easy to understand
but does not distinguish between scenarios where a
4
3. Underlying assumptions are given in Appendix B.
0
YEARS
1
2
3
4
5
YEARS values if retiree always died age 86
Source: LGIM calculations, at 31 March 2016.
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DC Dynamics January 2017
“The multi asset
income drawdown
fund is by far the most
efficient of the four
strategies tested”
As can be seen, the
would reduce from 1.4 years to 0.9 years4. However, the
multi
income
relative attractiveness of different strategies would not
drawdown fund is by
asset
change except for extreme moves. If, for example, gilt
far the most efficient
yields became so high that one could support the target
of the four strategies
withdrawal rate without needing to take investment risk,
tested,
YEARS
then bonds or cash would be preferred. The ranking of
around 1.4 years. The relatively poor values of other
with
the four alternatives shown in Figure 3 by YEARS is not
strategies can be explained by their low expected
affected by moderate changes in gilt yields.
returns, insufficient diversification or both.
PLANNING FOR A LIFETIME OF INCOME: SELFIt is interesting to compare these numbers with the
INSURANCE
numbers we obtain if we neglect longevity risk and
If a retiree chooses to enter an income drawdown
assume that the retiree always lives to age 86 (his
solution, as opposed to buying an annuity, this indicates
expected age of death from age 65). These are also
that they are willing to tolerate some investment and
shown in Figure 3. We see that ignoring longevity risk
longevity risk. However even when invested in the multi-
in assessing retirement outcome risk considerably
asset fund of Figure 3, there is roughly a 20% chance of
understates the overall retirement outcome uncertainty
running out of money5 . This is only likely to occur if the
involved.
pensioner lives well into old age, as Figure 4 shows.
This emphasises that in assessing the ability of an
Figure 4: Probability of pot exhaustion
income drawdown to provide a pension for life, it is
not enough to only consider how long an individual is
45%
expected to live; the variability of their future lifetime
is also important. Indeed allowing for this variability
To see this, note that high fund value risk (i.e. high
volatility) is of little consequence in terms of retirement
outcomes if the pensioner dies shortly after retirement.
However provided the risk is well diversified, it is likely
to be rewarded over the long-term should the pensioner
have a long retirement. However, there are limits to this
argument, which we explore in Appendix A.
A final point to mention is that the YEARS measure is
sensitive to the risk-free rate, assuming risk-seeking
assets are expected to earn a premium above that
Probability pot exhausted at death
tends to lead to more aggressive investment strategies.
40%
35%
30%
25%
20%
15%
10%
5%
0%
66
71
81
86
91
96
Age at death
rate. If, for example, gilt yields were 0.5% higher, then
YEARS for the multi-asset income drawdown fund
76
Source: LGIM calculations.
4. This is not to say that in most scenarios the pensioner would run out of money. Indeed there is a c. 20% chance of running out of money but if this does happen, the
pensioner can expect to be without a pension for c. 7 years on average.
5. Assuming investment in a multi-asset income drawdown fund as described in Appendix B. This assumes withdrawals from age 65 of 6% of the initial retirement pot
each year. The retiree is a male aged 65 in 2015, with mortality in line with ONS prospective tables
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January 2017 DC Dynamics
Figure 5: Withdrawal rates6 chosen so that retirement outcome risk equals one year using our YEARS measure7
Investment risk
ON
OFF
ON
Longevity risk
ON
ON
OFF
Age 65 years
5.8% p.a.
6.6% p.a.
6.6% p.a.
Age 75 years
7.4% p.a.
7.9% p.a.
9.8% p.a.
Age 85 years
12.3% p.a.
12.5% p.a.
17.5% p.a.
Source: LGIM calculations.
“The YEARS measure
may be used to
select an appropriate
withdrawal rate for
a given investment
strategy”
Other
than
choice
of
strategy,
a
careful
investment
one
way
to
protect against longevity
risk is to withdraw funds
at a pace that anticipates a
Figure 6: Self-insurance haircuts to spending
rate at different ages using YEARS
30%
25%
long future lifetime as opposed to a best estimate. Indeed,
20%
whilst the YEARS measure may be used to help select an
15%
appropriate investment strategy for a given withdrawal
rate, it may also be used to select an appropriate
withdrawal rate for a given investment strategy.
10%
5%
0%
Figure 5 shows the withdrawal rates investors may
choose assuming they withdraw at a rate such that
the YEARS measure is always equal to one year (i.e. a
relatively short period without income). The withdrawal
65
Impact of longevity risk
75
85
Impact of investment risk
Source: LGIM calculations.
rates have been calculated first allowing for both
haircut may be viewed as self-insurance against these
longevity and investment risk and then switching each
risks: a lower income is taken in case investment returns
off in turn8. This was done at three different ages – 65,
are lower than expected or income is needed for longer
75 and 85 – assuming that they are invested in a multi-
than expected.
asset income drawdown fund. Figure 6 then summarises
the haircuts to incomes (i.e. the pace of spending) that
Our first observation is that at age 65 the haircut from
result from this prudence to allow for investment risk or
allowing for longevity risk is comparable to the haircut
longevity risk.
from allowing for investment risk (around 13% if using
YEARS = 1). This indicates that for a typical retiree
As can be seen, allowing for investment risk or longevity
entering drawdown, longevity risk is just as important
risk leads to a “haircut” in the withdrawal rate. This
as investment risk.
6. As a percentage of the pot at that age
7. We note that in extreme old age, setting YEARS equal to 1 may be inappropriate. For example, if their future life expectancy is only 2 years.
8. Investment risk is switched off by setting the volatility of the fund to zero and assuming it grows deterministically in line with its arithmetic expected return. Longevity risk
is switched off by assuming the member survives for their future life expectancy.
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DC Dynamics January 2017
Our second observation is that the haircut from
For many individuals there are natural limits to the
investment risk decreases with age and the haircut
suitability of income drawdown products in old age;
from longevity risk increases. By age 85, the impact of
carefully choosing assets or pacing withdrawals can
longevity risk is so significant that the pensioner may
only help so much.
be withdrawing almost a third less each year than they
would in the absence of longevity risk. The haircut from
CONCLUSION
investment risk is almost negligible in comparison.
Income drawdown strategies offer a potentially higher
pension than annuitisation at retirement. However,
Running out of money is a risk. But there is also a risk that
they also carry additional risk, in particular the danger
pensioners only withdraw a small pension, worried that
of outliving one’s retirement pot. This arises as a
they outlive their pot, only to die sooner than expected
combination of investment and longevity risk. In this
with unused assets. The case for transferring longevity
paper we have seen the importance of allowing for
risk to an insurer may become more compelling as
longevity risk on asset allocation and introduced a
individuals get older. Once the prudent withdrawal rate
measure called YEARS to help assess overall retirement
falls below or is comparable to that possible from an
outcome risk. This measure may help support a
annuity, it may be a good time to buy one. However, an
framework for making investment and withdrawal
individual’s appetite for an annuity will also be impacted
decisions, including when might be best to insure
by their desire to potentially leave a bequest to their
against longevity risk.
heirs, which is not possible with an annuity.
APPENDIX A: MIXING THE INCOME DRAWDOWN FUND
WITH CASH
To examine a broader range of strategies than those in
Figure 7: retirement outcome risk for a part
cash, part multi-asset income strategy
Figure 3, we consider mixing the multi-asset income
5.0%
drawdown fund with a cash fund. In practice, many
4.5%
individuals find cash an attractive asset due to its
4.0%
simplicity, high liquidity and negligible risk of capital
3.5%
losses.
3.0%
2.5%
This is a somewhat crude approach, but gives an
2.0%
indication of how more diluted strategies fare in terms
1.5%
of retirement outcome risk. The blue line in Figure 7
1.0%
shows the YEARS metric for different proportions in the
0.5%
two funds.
0.0%
0%
YEARS remains slightly downward sloping at 100%
exposure to the income drawdown fund, implying that
retirement outcomes might be improved and investors
20%
40%
60%
80%
100%
Proportion in income drawdown fund (rest in cash)
YEARS allowing for longevity risk
YEARS if death aged 86
Source: LGIM calculations.
better off in a slightly more volatile (but equally risk
the yellow line, would suggest a lower risk strategy
efficient) fund. Neglecting longevity risk, indicated by
with around 50% in cash.
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January 2017 DC Dynamics
Should a typical investor adopt a more aggressive
Due to loss aversion, high short-term volatility is
strategy than the income drawdown fund? We would
psychologically uncomfortable, particularly for those
argue probably not. Adopting a more aggressive asset
who monitor their pot size frequently8. Although there is
allocation than the multi-asset income drawdown fund
no single correct way to trade the mental impact of this
would expose the pensioner to a substantially higher
against actual retirement outcomes, it seems it could be
short-term volatility i.e. more possible short-term pain,
a bad idea to take on substantial additional short-term
for little longer-term benefit on the YEARS measure.
risk if there is little benefit on longer-term measures
In other words, fund value risk would be substantially
higher, but retirement outcome risk would only be
APPENDIX B: FUND DATA
slightly lower. (To put some figures on this, extending
Calculations are based on simulations generated by our
Figure 8 to the right – i.e. assuming one could use
proprietary economic scenario generator as at 31 March
leverage – we find that one can reduce YEARS from 1.4
2016, adjusted to allow for alpha and fee estimates. The
years at 100% income drawdown to 1.2 years at 140%
expected rates of return and volatility of the funds we
income drawdown and -40% cash. The volatility would
considered are given in Figure 8.
increase from 8.6% pa to 12.0% p.a.).
Figure 8: Fund statistics/assumptions
GRP excluding
alpha and fees
(p.a.)
Fees (p.a.)
Alpha (p.a.)
GRP allowing
for alpha and
fees (p.a.)
Volatility (p.a.)
over 1 year
Multi-asset income
drawdown
2.8%
0.7%
0.7%
2.8%
8.6%
Bonds (UK IG
credit)
1.3%
0.5%
0.0%
0.77%
6.3%
Developed equity
3.6%
0.5%
0.0%
3.1%
14.2%
Cash
0.0%
0.25%
0.0%
-0.25%
0.1%
Fund
GRP = geometric risk premium above gilts, over 10 years. Source: LGIM calculations
8. The ‘In Focus’ section of our August 2015 LDI Monthly wrap explains the potential impact of loss aversion and the pain of monitoring on glidepath design.
Important Notice
Views and opinions expressed herein are as at November 2016 and may change based on market and other conditions. This document
is designed for our corporate clients and for the use of professional advisers and agents of Legal & General. No responsibility can be
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tolerance for risk. The information contained in this document is not intended to be, nor should be, construed as investment advice, nor
deemed suitable to meet the needs of the investor. All investments are subject to risk.
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