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Communicating Longevity Risk: Beyond the Definitions

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Communicating Longevity Risk: Beyond the Definitions Communicating Longevity Risk: Beyond the Definitions Liaw Huang and Tom Terry* TTerry Consulting LLC, Chicago, United States Corresponding author: [email protected] August 26, 2013 Abstract Despite persistent efforts to educate and communicate about longevity risk and its potentially harmful effects, the marketplace for longevity risk mitigation solutions has been slow to develop. We propose that, in part, the problem stems from the lack of a common definition and the resulting lack of a consistent understanding of longevity risk. We examine and critique various definitions used by financial and policy communities, as well as the public at large. Finally, we suggest that a concerted effort to address this semantic murkiness is an essential ingredient for the success of marketplace solutions and broader public policy initiatives. ___________________________________________ *We are grateful to professor David Blake for his invitation to contribute this paper to the Longevity 9 conference in Beijing, China, and to Carol Daskais Navin for her many helpful comments which have improved this paper. Communicating Longevity Risk: Beyond the Definitions `When I use a word,' Humpty Dumpty said in rather a scornful tone, `it means just what I choose it to mean -- neither more nor less.' `The question is,' said Alice, `whether you can make words mean so many different things.' `The question is,' said Humpty Dumpty, `which is to be master - - that's all.' -- Lewis Carroll, Through the Looking-Glass Introduction Despite the well-intentioned effort to raise awareness of longevity risk in both the financial community and with the public at large, the concept of longevity risk remains elusive. It has proven to be a difficult concept to communicate. Longevity risk seems to take on a different meaning depending on the context. What do we mean when we say “longevity risk”? Is there a master definition, as Humpty Dumpty would ask, that trumps all the others? Consider the following statements: “If retirement assets are able to achieve higher rates of return, then longevity risk will be reduced.” “Pension plan sponsors realize the magnitude of the pension plan’s longevity risk when the pension liabilities are measured using realistic mortality improvement assumptions.” “When asked about longevity risk, the survey participants indicate that declining health is their number one concern.” “Can individuals purchase longevity bonds or other capital market instruments to hedge against their longevity risk?” The validity of the above statements depends on what is meant by longevity risk, and in each case longevity risk appears to take on a different meaning. These examples are illustrations of what we perceive to be two related problems: The multiple meanings of the term longevity risk create barriers in communication. Individuals and institutions often misunderstand the nature and characteristics of longevity risk. This impedes the understanding and acceptance of the various so-called longevity risk solutions. 2 Regardless of the context, people’s behaviors are influenced by their perceptions and presuppositions about longevity and about risk. If we want to optimize the effectiveness of longevity risk solutions, we first need to appreciate how people understand longevity risk. A risk management theory from social anthropology, called plural rationality, may offer helpful insight into the different perspectives on longevity risk – and so may be useful in addressing the communication and understanding gaps. In this paper we will examine: • The various meanings of longevity risk • Some presuppositions and implications about the nature of longevity risk • Four different “worldviews” of longevity risk as suggested by plural rationality theory • Suggestions for moving forward What Do We Mean by Longevity Risk? What is longevity risk? How is the concept of longevity risk communicated? Longevity refers to a long life.1 So, in general, longevity risk may be construed as risk associated with a long human life. Our scanning of public discussions and writings on this topic reveals four broad categories of meaning as suggested here. • Longevity risk as individuals outliving their financial resources (also called individual or idiosyncratic longevity risk); • Longevity risk as mortality improving more than expected, or uncertainty about future mortality improvements (also called systematic, aggregate, or pooled longevity risk); • Longevity risk as the additional cost to a society or, more narrowly, a pension system, when mortality improvements are underestimated; • Longevity risk as the adverse consequences of living a long time. These four categories suggest four frames in which longevity risk may be understood. We depict these four frames by the curves in the table below. 1 Definition from the Oxford Dictionary. 3 Representation Description Common Symptoms !!!!!!!!!! !!!!! Individual Longevity Outliving one’s retirement Risk: variability in an assets individual’s lifespan !! ! Uncertainty in a pension Pooled Longevity plan’s benefit payments due Risk: uncertainty in to mortality; inability to mortality improvement manage all risks in a pension system !! ! Additional Cost to a Underreporting of pension Society or a Pension and retiree health liabilities; System when much higher financial burden Mortality than expected in a country’s Improvements are social insurance program Underestimated !! ! Health risks, inadequate retirement savings, risk of Adverse elder abuse, loss of Consequences of companionship, long-term Living a Long Time care needs, and other !! ! problems associated with a long life We now examine each of these four frames in more detail. Individual or idiosyncratic longevity risk A common use of the term longevity risk is to describe the likelihood of an individual outliving his or her financial resources, or his or her failure to leave behind intended bequests due to increased lifetime spending. Employing the term “longevity risk” here is an essential ingredient in building the case for the purchase of annuity products and other lifetime income solutions. 4 Typically, the discussion begins with an assertion about a retiree’s life expectancy, and is followed by an assertion that there is a significant probability that the retiree will outlive his or her financial resources. This probability is then defined as longevity risk. Used this way, longevity risk is an individual risk, also known as idiosyncratic longevity risk. It is distinct from systematic longevity risk, which is associated with the pooling of individual risks. Here are two examples of this usage: The United States government has announced steps to make it easier for families to save for retirement. In attempting to promote greater public understanding of lifetime income needs, the government defines longevity risk as the risk of retirees outliving their assets:2 Particularly as the baby boomers approach retirement, and as life expectancies and retirement periods lengthen, Americans are increasingly confronting the risk of outliving their assets in retirement (“longevity risk”) and are seeking more help and better strategies for managing their savings in retirement. Similarly, financial advisors promote lifetime income product solutions in news articles and online blogs by referring to longevity risk as the risk of outliving one’s assets. A typical example is Fidelity Investments’ discussion of annuitizing a portion of one’s retirement portfolio:3 Annuitizing a portion of your portfolio can provide a source of guaranteed income that may help protect you against longevity risk— the risk that you will outlive your money. Notice that this use of the term longevity risk is closely aligned with a consequence of longevity: outliving one’s assets. This consequence is a financial concern. Assuring that one’s retirement assets last a lifetime will be directly impacted by the length of the planning time horizon, but it also depends on other factors such as asset allocation and investment returns. To understand how longevity impacts the likelihood of outliving ones’ assets, retirees need to understand and appreciate the variability of their own life span. 2 “Treasury Fact Sheet: Helping American Families Achieve Retirement Security by Expanding Lifetime Income Choices”, United State Treasury, p.1. 3 “Don't take a lifestyle cut in retirement: Five ways to help close your income gap, no matter what your age”. Fidelity Viewpoints. Available https://www.fidelity.com/viewpoints/retirement-readiness 5 The main characteristic of individual longevity risk is the variability of the individual lifespan. For example, the following realities can be readily calculated from standard mortality tables, but these realities are seldom communicated to retirees. • The standard deviation of the life span of an individual age 65 is between nine and ten years. Translated: there is a wide range of death ages for an individual age 65. • For an age 65 retiree with a life expectancy of twenty years, the probability of dying at the life expectancy age is less than 4.5%. Between age 80 and 90, where the retiree is most likely to die, the probably of dying during any one year of age is approximately 4%. !!!!! We represent individual longevity risk by a curve with wide variability (a “Flat Curve”). The arrow below the curve represents the fact that an individual’s actual life span can be either longer or shorter than expected. When financial advisors ask retirees to consider life expectancy, they unintentionally
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