One of the biggest challenges facing the retirement system today is how best to transform accumulated capital into income, or to put it a different way, how best to enable retirees to spend their accumulated savings when they do not know how long they are going to live.
Superannuation funds, by pooling together enough members can reduce idiosyncratic longevity risk. Idiosyncratic longevity risk is the risk to individual members from living for longer or shorter than average.
Arrangements such as group self-annuitisation schemes (GSAs) aim to provide members with an income for life, giving retirees more confidence in spending their accumulated savings.
However, pooling individual risks doesn't protect against the risk of everyone living longer, or shorter, than expected. Systematic longevity risk results from the whole population or cohort of members living longer on average than assumed. When assumptions around how long members will live turn out to be incorrect, it can have detrimental impacts on member benefits and hence on their living standards. If life expectancy assumptions are too pessimistic, members' retirement incomes will be lower than expected or even run out in old age.
Life expectancies have been consistently underestimated
Assumptions around how long people will live are generally based on recent experience. For example, the widely used Australian Life Tables are released after each Census based on the most recent population mortality rates, that is, the proportion of people at each age who have passed away each year.
Unfortunately, projections of how long people will live into the future have often turned out to be off the mark. If the standard life expectancies
in the early 1970s, according to the Australian Life Tables 1970-1971 had been used to design a retirement product, they would have been based on male retirees living on average another 12 years.
By the late noughties, based on the Australian Life Tables 2015-2017, that had increased by two thirds to almost 20 years. Figure 1 shows how the commonly used Australian life expectancy tables have predicted for 65-year-old male retirees over the last century.
This inability to predict how life expectancies might change in the future has significant implications for superannuation funds designing solutions for retirees.
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