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Full individualization of pensions is maybe not the solution

17 May 2017

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What about pooled annuity funds?

Written by L.N. Boon (b)(d), M. Brière (a)(c)(d), B. Werker (b)

Institutions for occupational retirement are facing major challenges and have sustainability problems, with difficulties for sponsor companies to carry the risks related to their Defined Benefit (DB) pension funds. The individualization of pensions is a recent trend (in particular, switching from DB to Defined Contribution (DC), relaxation of certain guarantees, development of hybrid DB / DC funds, etc.). But fully individualized solutions have the drawback that individuals are subject to multiple risks: investment, capital conversion into an annuity, but also biometric risks if individuals choose to decumulate their capital by themselves.

How to reduce these risks?

For investment Risk: solutions exist, in particular manager-guided funds adapted to each individual's profile (life cycle, enhanced target date funds, etc.)

Biometric risks comprise longevity, which is the risk of misestimating the probability of future survival and mortality, which is the idiosyncratic risk that the date of death of the individual is different from the anticipated one, given a known probability of survival.

To fully cover these two biometric risks, individuals can purchase a life annuity contract from an insurance company. The main advantage is that biometric risks are fully hedged. Mortality risk is pooled among participants. But this protection comes at a cost. Shareholders of the insurance company require a remuneration to carry longevity risk. Moreover, the insurance company is subject to default risk, even if in practice, capital requirements imposed by Solvency II regulation or government guarantees limit that risk.

Our research (1) shows that an intermediate solution, a pooled annuity fund (or group self annuitization) might be more attractive for individuals than a life insurance annuity.

In practice, this is a collective scheme where the risk of mortality is pooled, but the longevity risk is on the individual. Pension benefits may slightly fluctuate (in practice, benefits adjustments are in the range of a few percentage points) compared to traditional annuity (nominal or variable) because they adjust to changes in longevity. However, benefits are on average slightly higher than with the life annuity involving an insurance company, where upward adjustments are captured by the shareholders. We show that from the individual's point of view, this solution is attractive, offering a slightly higher utility than in the case of life annuity, under various longevity scenarios and hypotheses on individual's characteristics.

a) Amundi, b) Tilburg University and Netspar, c) Universit?© Libre de Bruxelles, d) Universit?© Paris Dauphine.

1 Boon L.N., M. Brière and B. Werker (2017), "Longevity Risk: To Bear or to Insure?", SSRN Working Paper N?2926902. Also available on Amundi Research Center: http://research-center.amundi.com/page/Publications/Working-Paper/2017/Longevity-Risk-To-Bear-or-to-Insure