Time to Take the Plunge?

By Mark Shemtob

Longevity pooling has the potential to offer real value for retirees looking for income

Retiree longevity pooling can broadly be thought of as an arrangement whereby a group of retirees receive payouts from a collective pool of assets. Those individuals who live the longest receive the most benefits. This is accomplished by discontinuing benefit payments upon the death of recipients, thus allowing greater benefits for those that live the longest. Longevity pooling is a fundamental feature of our Social Security program,^[1] traditional defined benefit plans, and insurance company fixed-income annuities. This article explores the financial advantages of an alternative longevity pooling program for retiree income.

Upon retirement, most individuals begin to draw down their retirement savings.^[2] This can be done through either a structured approach (e.g., fixed dollar amount or a percentage of retirement savings) or simply as needed. These individual drawdown approaches may work well provided the retiree has sufficient savings to last for an unknown number of years coupled with unknown financial markets. Planning for a longer-than-expected number of years and/or using conservative investments will reduce the income that the retirement savings can provide.

Through longevity pooling, individuals pool their retirement savings. Some individuals will die early on, which will inure to the benefit of those who live the longest. Those who die early no longer need the income personally,^[3] whereas those who live the longest do. Longevity pooling thus offers a more efficient way of providing retirement income among a group of retirees. However, there is a trade-off when compared with the individual drawdown approach—access to funds (liquidity). Longevity pooling programs are generally not designed to offer liquidity. The use of longevity pooling allows for larger benefits and/or longer benefit payout terms while taking on no more investment risk than under an individual drawdown approach.

Insurance companies sell products (life contingent income annuities) that incorporate longevity pooling. However, they differ from the concept we will analyze in this article. An insurance company guarantees a fixed monthly benefit for life, and thus price these annuities based on conservative investment and mortality assumptions. They also include other expenses that further erode the benefit/premium value. The longevity pooling concept we analyze in this article does not provide guaranteed income from an insurer.^[4] The risk (and reward) of smaller or greater benefits lies with the retirees participating in the pool. Toward the end of this article, we will briefly discuss and compare insured fixed-income annuities with the longevity pooling approach described.

Approach

As noted earlier, the purpose of this article is to measure the value of longevity pooling on retirement income. We do this on a theoretical basis for simplicity. The arrangement we analyze is not one that is currently available in the U.S.^[5]

The approach is as follows. Given a fixed amount of funds, a retiree considers two alternatives: an individual drawdown approach and a longevity pooling approach.^[6] We assume standardized investment and mortality assumptions and provide results based upon stochastic modeling. We will consider the four different income payout alternatives as noted below and for each of them determine:

1. The average expected number of years that income levels will last under the individual drawdown approach compared with the longevity pooling approach.
2. The average income level under the individual drawdown approach that is expected to last the same number of years as the longevity pooling approach.

Note that in our analysis benefit levels are not guaranteed for the life of the retiree.

We consider our test subject Sandy, who is 65 years old and gender-neutral. Sandy has $100,000 ($50,000 in the case of the deferred income alternatives C and D) to apply toward generating lifetime income. Sandy is presented with the two options as noted above (individual drawdown or pooling). We analyze the four following payout alternatives.^[7]

• Alternative A (100k): The annual payout level starts at $6,000 and increases by 3% per year.
• Alternative B: (100k): The annual payout is $7,500 per year.
• Alternative C (50k): The annual payout is deferred to age 80, at which point it is $14,000 and increases by 3% per year.
• Alternative D (50k): The payout is deferred to age 80, at which point it is $17,500 per year.
• The following assumptions are used to perform this analysis:
• Investment Returns: Randomized using a 5% return with a standard deviation of 11%.
• Mortality: IRC 417e unisex factors. It is assumed that all retirees will die upon reaching age 100. Note that based upon this table, Sandy’s life expectancy is approximately 22.2 years.

Results

The results for each of the four alternatives are as noted below. Table 1 addresses the years that income is expected to last (amount in parenthesis represents 25%-75% range of outcomes) and Table 2 the income levels that are expected to last the same number of years.

Comments

1. Simulations: The above is based on the average of 2,500 simulations.
2. Comparison: Using longevity pooling, Sandy can expect an additional five years of payments on average (under the immediate payout alternatives) and six to seven years additional (under the deferred payout alternatives). Alternatively, using longevity pooling Sandy can expect 21%-28% higher benefits under the immediate payout alternatives and 86%-94% higher under the deferred payout alternatives.
3. Life expectancy (mortality) assumptions: We are using the unisex table mortality factors that are mandated under qualified retirement plans. Based on this mortality table, the likelihood of Sandy living to at least age 80 is 77%, to age 85 is 60%, to age 90 is 37%, to age 95 is 16%, and to age 100 is 4%. It is probable that individuals in good health would be more likely to select a pooled longevity approach, though many healthy people may elect not to participate in this option if they have saved enough for retirement and need not rely on longevity pooling to enhance benefits. Having healthier­-than-average retirees would impact the results by reducing the gap in years or benefit levels between the longevity pooled and drawdown approaches.^[9]
4. Investment return assumptions: A 50/50 balanced portfolio of large-cap U.S. stocks and Core U.S. corporate bond indexes was assumed. The returns and standard deviations were based upon Horizon Actuarial 2021 Survey of Capital Market Assumptions.^[10] Because the above analysis is based upon a comparison that uses the same assumptions for each option, modifying them would not have a material impact on the results.
5. Form of benefit: This analysis has been performed on the assumption that Sandy does not have a beneficiary to receive survivor benefits, should Sandy pass away first. Not providing a death benefit maximizes the value of a longevity pooled benefit, although longevity pooling approaches can be designed to pay out death benefits to beneficiaries.
6. Expenses: None were assumed. A longevity pooled program would have more expenses than an individual drawdown approach. However, the pooled nature of the longevity pooling program may provide greater investment returns as a result of institutional pricing of investments and professional management that may not be available to individuals.

Analysis

It should come as no surprise that pooling longevity can provide a retiree with greater retirement benefits than an individual drawdown approach while assuming no more investment risk. The additional value is especially pronounced when using deferred payouts. The largest benefactors from longevity pooling approaches are those who live the longest.

However, the above analysis may not tell the entire story. Out of a goal for simplicity in comparisons of the two options, the four alternatives used were based on predetermined annual payout levels. Using predetermined payout levels has the potential to leave funds in the individual accounts or longevity pools at the end of the program, based on the actual investment and longevity (pooled) experience. Based upon the assumptions outlined, Table 3 shows for the longevity pooled and individual drawdown options the percent of times that it is expected that there will be a positive balance at age 100; this being the age we assume all retirees in the analysis will have died.

As shown in Table 3, the pooled options based on the predetermined income levels result in balances at the end of the program nearly 50% of the time, much more than the individual drawdown approach. Using predetermined income levels is not efficient for longevity pooling. Thus, a dynamic program wherein annual payouts are designed to fully liquidate the pool may be more desirable. Such a program would provide for variable benefits subject to the investment and mortality experience (applicable to the longevity pooling option).

Using the same investment and mortality assumptions as above and using a dynamic approach wherein all funds are distributed by age 100, the estimated accumulated amounts^[11] of the benefits under the longevity pooled approach and the individual drawdown approach is illustrated in Table 4. Note that results do not consider the value of any benefits available under the individual drawdown approach at death.^[12]

Table 5 illustrates a similar analysis, but with income payout alternatives deferred to age 80.^[13]

The results indicate that a dynamic payout approach would provide relatively more valuable benefits with the longevity pooling option. A robust analysis of how dynamic payout approaches might work is beyond the scope of this article.

Insured Annuities

The primary purpose of this article is not to compare the longevity pooling approach outlined with traditional fixed-income insured annuities, but to compare them with drawdown approaches without longevity pooling.^[14] Insured annuities that rely on longevity pooling provide a good option for those who want guaranteed lifetime income levels, which the pooled option analyzed does not provide. They are especially attractive when interest rates are high and annuity pricing is favorable to the annuitant.

The relevant value of an insured income annuity compared to the longevity pooling approach is highly dependent on actual investment returns and age at death. As an example, based upon the assumptions above and using a dynamic payout strategy Table 6 illustrates the comparison of the longevity pooling approach with an insured fixed income annuity that provided $7,020 per year which represented the payout based on a $100,000 premium.^[15]

Though the average payouts are more attractive using longevity pooling, there is a significant range in outcomes based upon age at death and investment returns as illustrated by the 25% and 75% ranges. Those retirees who are not able to withstand decreases in benefits should be more inclined to use a fixed-income annuity.

Conclusion

Those in poor health are not good candidates for longevity pooling arrangements. Neither should one use funds that may need to be liquidated or potentially used as an inheritance. However, retirees in good health will enhance lifetime income through a longevity pooling approach. The additional value increases as the actual lifespan increases and can be used to provide larger benefit levels and/or benefits for a longer period of time. Thus, a longevity pooling approach offers an alternative option that may appeal to certain retirees.

The trillions of dollars in individual retirement arrangements (IRAs), 401(k) plans, and similar arrangements generally cannot be invested in retiree longevity sharing pools.^[16] With time, perhaps such programs will become more commonplace. At least 15 countries in Europe use Collective Defined Contribution Plans as their primary employer provided retirement programs. These plans are based upon longevity pooling approaches.

Precisely how they may operate in the U.S. is uncertain. Among the many key issues that would need to be addressed include:

1. Changes in the law to allow them in IRAs and retirement plans;
2. Appropriate government oversight;
3. Creating a critical mass of participating retirees to make programs economically feasible and cost-efficient;
4. Whether open programs (allowing new retirees) can be used, or whether programs should only be closed;
5. Whether different aged retirees can be in the same pooled program using adjustments for differing mortality expectations;
6. Educating retirees on the pros and cons of retiree longevity pooling, individual drawdown approaches, and fixed-income insured annuities; and
7. How payouts would be structured to prevent issues that traditional tontines face.^[17]

Retirees may prove reluctant to enter into longevity pooling arrangements, as they have demonstrated with respect to income annuities. Income annuities’ lack of liquidity, discontinuance of benefits upon death, and pricing are among the main reasons cited for low usage of these products. Additionally, individuals have come to view their 401(k) plans and IRAs more as retirement savings accounts rather than programs that provide retirement income.

Unless a retiree feels a compelling need to leave funds to heirs, the individual drawdown approach is inefficient in delivering retirement income when compared with longevity pooling. Benefits can be significantly greater with no additional investment risk—especially when using a deferred income longevity pooling approach. Providing options that can cost-­efficiently convert retirement savings into retirement income is critical to the security of retirees. Longevity pooling offers just such an option.

MARK SHEMTOB, MAAA, FSA, FCA, MSPA, EA, is owner of MS Advisory Services.

Endnotes

[1] Without sharing of mortality risk, contributions would need to be higher to provide the same level of benefits.

2] Some may use a portion of their savings to purchase an insurance company annuity.

[3] Funds needed to support others should not be used in a longevity pooling approach unless the specific program provides death benefits.

[4] An insurance company, financial institution, or other entity could administer a longevity pooling program.

[5] Longevity pooling programs are generally not available.

[6] Insured fixed-income annuities provide value in delivering guaranteed income levels and are discussed later in this article.

[7] It is likely that longevity pooling arrangements will provide variable and not fixed benefits in order to avoid running out of funds early or having a large level of unpaid funds as a result of investment volatility. The fixed-income alternatives used in this analysis were selected due to ease of comparison of the options.

[8] Initial payment to increase by 3% per year.

[9] Using a 3-year set back in ages narrows the difference in years of expected payouts by approximately 1 to 2 years.

[10] https://www.horizonactuarial.com/uploads/3/0/4/9/30499196/rpt_cma_survey_2021_v0804.pdf.

[11] Benefit payout starts at $7,500 per year and is adjusted annually based upon future longevity, and past experience of the investments and mortality (under longevity pooled option).

[12] It is assumed that the retiree is interested only in maximizing lifetime income and not leaving an inheritance.

[13] Benefit payout starts at age 80 equal to $6,475 brought forward 15 years ($17,500 on average) and is adjusted annually based upon future longevity, and past experience of the investments and mortality (under longevity pooled option).

[14] Insurers sell other retirement income products where the benefits are based upon investments performance, and the annuitant can purchase for an additional fee a guaranteed income level for life. There is wide variety of these products, and they often have investment and distribution restrictions.

[15] Based on June 2022 Immediate Annuities.com average for males and females.

[16] TIAA-CREF and certain church plans can offer longevity pooling options.

[17] Under these programs, benefits are constantly increasing as the pool of survivors shrinks, leaving very large accounts to survivors.