Many countries in Europe have tried to address longevity risk by mandating immediately upon retirement the full annuitization of funds accumulated within tax-supported personal or occupational pension schemes. But this strategy means pensioners could end up living on less than they would have had if they were free to follow an optimal dynamic life-cycle payout strategy that involves investment in stocks, bonds and annuities.

Due to aging populations and a trend toward funded individual retirement schemes of the defined contribution variety, a pool of assets potentially worth billions will be managed by the retirees over what promises to be a very long period, and gradually converted into retirement income. How these funds will be used will have tremendous impact on individuals, as well as their societies.

In a recent report, Rethinking Retirement Income Strategies: How can we Secure Better Outcomes for Future Retirees?, we studied the payout solutions available in seven European countries* and the United States of America. In every country except the US, annuities are favored over phased drawdown by the regulation of the designated old-age pension schemes, because the drawdowns are deemed to over-expose the retiree to longevity and investment risk, which cannot be adequately managed.

Typically, phased-drawdown plans provide periodic payments that diminish capital held in a diversified portfolio of stocks, bonds and money markets according to the personal circumstances and risk attitude of the retiree. However, they do not grant an insurance against the risk to outlive the available funds.

Yet, precisely in the context of longer life expectancy, the bias against these plans is not justified. Phased drawdown plans, or non-pooled solutions, offer potentially higher retirement income that results from superior investment returns and also provide a better hedge against inflation than most annuities do.

Likewise, the favored alternatives – namely annuities – also have significant disadvantages. Annuities are inflexible, usually do not protect against inflation, and they can be costly particularly early in retirement when the survival credit is not sufficiently high. What’s more, they also deprive an individual of bequest opportunities.

Which is better for sustaining lifetime consumption levels during retirement? After testing a range of scenarios within the dynamic life-cycle optimization model, our research determined that a strategy dynamically combining both annuities and drawdown plans provides the best solution.

According to our modeling, the best strategy is to invest a substantial part of the retirement savings pot into a well diversified equity/bond portfolio early in retirement, and then dynamically switch to annuities as retirement progresses, taking into consideration the already available individual level of annuity-like income, the risk attitude and the bequest motives. By shifting toward annuities later, retirees can profit from the increasing survival credit that rises with the age of the annuity purchaser, while still ensuring that they have sufficient funds to last their lifetimes.

Compared with full annuitization at retirement, the described optimal retirement strategy could provide substantially higher lifetime consumption levels while simultaneously controlling the risk. In our findings, up to 70% of individuals can expect to enjoy a lifetime consumption level that is up to a third higher by choosing the optimal strategy over full annuitization. In addition, an optimal strategy can provide additional utility by allowing for bequests.

And what about risk? Years ago, annuities were adequate for a shorter expected retirement period. But a successful investment strategy for longer retirement life spans currently observed allows – actually requires – a diversified portfolio of payout products. At retirement age, an individual is likely to have annuity-like or annuity income from a state pension or employer. Converting all accumulated pension savings into another annuity would defy the laws of diversification. No one would say to forgo diversification in the accumulation phase. Why neglect laws of diversification in the decumulation phase? One argument is the risk of market volatility, especially relevant for non-pooled payout solutions.

That risk can, however, be efficiently managed over long investment horizons, resulting from today’s longer life spans. In our model for the worst 10% of the possible capital market developments, the present values of probable minimum lifetime consumption are only 2% to 5% lower, in the case following the optimal strategy, than the values obtained by the full immediate annuitization. It is relatively low risk considering the flexibility, upside investment potential and hedge against inflation that a dynamic mix of annuities, stocks and bonds provides.

Across all variety of scenarios, our findings prove that compulsory full annuitization of retirement wealth at the age of 65 results in significant costs in terms of forgone consumption. Regulatory policies that strike a balance between requirement to annuitize and the possibility to use phased withdrawal products would support higher consumption levels for retirees and be additional motivation for participating in funded old-age programs.

More competition and relaxed restrictions regarding the product choice in retirement would likely spark the development of innovative products that suit the retiree’s needs best.

Admittedly, life cycle strategies and products combining the features of an annuity and a drawdown solution are complex. Individuals would need professional help to manage such dynamic portfolios. Regulations would need to be in place to ensure the quality of financial products, the skill level of professional advisors, the adequate financial education in the society and the acceptable default options for vulnerable or reluctant population categories. But with the prospects of an increasing share of the population becoming older than 100, the benefits for individuals and society will far outweigh the efforts.

*Austria, France, Germany, Italy, Switzerland, Sweden and the United Kingdom 

Published by PROJECT M in September 2009

(Photos: Michael Baumgarten/trunkarchives.com, Fritz Stockmeier/argum)