Per UK Linnemann — First published in the Actuary Thursday 7th March 2024 — 8 min read

The smooth income annuity was born in Per UK Linnemann’s homeland, Denmark. Here, he advocates the non-guaranteed investment-based variety.

In a 2007 piece on innovation in annuitisation for Think Advisor, Canadian professor Moshe Milevsky noted:

“Other innovations involve repackaging variable (as opposed to fixed) immediate annuities so that their income stream does not fluctuate as much. And, although the sale of these products is on a steady decline, they actually make more sense to me. They provide mortality credits, plus the ability to gain the equity risk premium.”

For the millions of retirees (and soon-to-be retirees) who are anxious about market volatility, income volatility needs to be mitigated in a capital-efficient way. There is the opportunity to get help from the financial markets to finance a long retirement period.

It is not well known – even among pension and investment professionals – that an investment-based and capital-efficient approach may be used to achieve income smoothing over time, without the need for individual or collective capital buffer. This means all available means can go to participants, increasing pension incomes.

With non-guaranteed investment-based smoothed income annuities (SIAs), retirees do not have to accept lower expected investment returns as the price of smoothing income. On the contrary, SIAs can combine investment opportunities and expected higher investment returns with less volatility in retirement incomes, despite fluctuations in investment portfolio value.

SIAs provide both a savings vehicle and a regular smoothed retirement income, with or without longevity income management – and they may balance the trade-offs between overspending and underspending in retirement.

These products do not require guarantees, which reduces expenses, and the manufacturer does not have to assume investment and mortality risks. They are always fully funded in economic terms.

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Marrying the strategies

The full market-linked return is passed on to the individual’s investment account during both the accumulation and decumulation phases. Smoothing of retirement income is achieved through the individualised target date funds asset allocation approach, which you can read more about in my January 2020 interview  (bit.ly/The_pension_innovator ).

Each person is given a personalised and dynamically self-adjusting investment strategy. It is unique that the built-in payout and investment strategies work well together, adapting automatically and dynamically to each other over time. They are integrated and coordinated by scientifically derived and surprisingly simple mathematical formulae constituting a unified whole. The investment strategy is derived from the smoothing mechanism and supports the income-generation objective of smoothing retirement income.

It is a desired or default degree of smoothing and investment horizon pre-and post-retirement that determines the investment risk profile (high, medium, low) during accumulation and decumulation. Investment risk exposure falls as investors get older, avoiding excessive investment risk-taking at old age (people typically have less tolerance and capacity for investment risk as they age). The investment horizon may be a pre-defined period or may be designed to dynamically increase as the retiree ages.

Only two funds are needed; the algorithms and technology do the rest of the work by varying the asset mix in the investor’s account over time in an intelligent way. Asset allocations adapt automatically in response to investment market developments and the capacity to take on or limit investment risk (in other words, the actuarial funding status of the current level of retirement income). When the assets’ market value exceeds the actuarial value of the liabilities (the future stream of income), the investment risk level is increased, and vice versa. This all happens automatically using the built-in algorithms.

In this way, the balance between assets and future liabilities is adapted and payments can be smoothed while remaining responsive to financial markets’ performance. This is important for the sustainable payment of smoothed retirement income.

SIAs can overcome the shortcomings and inefficiencies of other retirement products where the investment strategy is disconnected from the payment mechanism, such as variable income payout annuities. This also includes products that are based on standalone smoothing mechanisms, where the investment and smoothing strategies are detached and the smoothing of income may stop working.

 

A more flexible income profile

SIAs can be structured to facilitate a seamless transition from accumulation to decumulation, eliminating the need for separate pre- and post-retirement products, which can create an artificial cliff edge at retirement. The income stream from SIAs is highly customisable, and they offer a choice between smoothed retirement income payment profiles, decided at retirement.

There is a trade-off between more income in the shorter term versus more income in the longer term. For instance, the retirement income profile could be weighted towards the first years of retirement, when retirees tend to be more active and may prefer a higher income – or it could be weighted towards the latter years to offset inflation. Retirees could even target a specific rate of increase in the yearly payments. SIAs may be designed to provide income for a pre-defined period where the investment account is exhausted at the end of the specific period with mathematical certainty.

They can also be designed to provide lifelong income through longevity pooling and risk sharing. SIAs may offer a seamless transition, avoiding a gap and abrupt change in income level between drawdown and longevity sharing. Retirees may opt out of a longevity option at any time during the drawdown phase, for example if their health is deteriorating.

Retirees have the flexibility to deal with unexpected expenses during the income drawdown period, and surviving relatives may inherit the remaining savings if the participant passes away during this period. Finally, spousal continuation may be added, where benefits continue until the spouse’s later death.

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Optional longevity risk sharing

People do not know how long they will live and thus how many years of old age they need to finance. It is very expensive to self-insure living into advanced old age. Affordable retirement income for life may be achieved by pooling participants’ longevity risk.

Participants share longevity risk during the longevity period, and a return on survival (‘mortality credits’) is added to the investment return as the remaining savings of those who die are equitably redistributed among those who live longer.

However, life contingent payments during the earlier years of retirement are typically regarded by retirees to be unattractive. While the probability of dying is relatively small during these earlier years, there will be a high impact if the retiree does pass away, leaving a large amount of money behind.

SIAs may offer a seamless transition, avoiding a gap and abrupt change in income level between drawdown and longevity sharing

It may be more appealing to combine income drawdown with longevity sharing and survivor benefits at a very old age, when they have the biggest impact. By that time, the bulk of the savings will have been paid out as retirement income. This may mitigate participants’ loss aversion when facing the risk of losing a large proportion of their savings if they pass away early in retirement.

Moreover, there may be greater appreciation that sharing longevity risk at a very old age can provide protection against running out of income, and ‘insurance’ against the costly risk of living into advanced old age.

The SIAs framework allows for longevity risk sharing at older ages. Survivor benefits become more significant and typically increase considerably as the retiree ages. The extra source of return in the form of mortality credits will have more impact than asset returns at the oldest ages – a compelling investment case.

The smoothing of life-contingent retirement incomes is supported by an innovative actuarial risk-sharing and equalisation mechanism, where experienced smoothed return on survival is distributed equitably between participants, avoiding abrupt changes in the level of retirement income. A capital buffer is not needed, as the effect of mortality experience is passed on to the participants.

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A flexible approach

SIAs are a comprehensive, holistic and personalised approach to retirement. One flexible framework can provide a platform for a family of products with different investment horizons, investment risk profiles and degrees of smoothing, as well as a range of smoothed retirement income payment profiles. Different versions can be tailored to local market conditions and modified to fit the needs of certain groups, such as low-to-medium earners.

Relying on a formula-driven and robust algorithmic framework, SIAs fit easily into an increasingly digitalised and mass-customised world. They can be delivered as fully automated and direct-to-consumer solutions. The algorithm-based product design allows scalability, low cost and portability (during an income drawdown period).

Demand for attractive investment-based retirement income solutions will only rise in the years ahead. There are exponential opportunities here for those who get it right, including opportunities to consolidate assets and attract a greater number of older investors. Non-guaranteed investment-based SIAs can also give firms key competitive advantages and a differentiated position in the huge retirement income market.

More importantly, SIAs represent an opportunity to benefit millions of people by giving guidance to their withdrawal decisions for a smoother retirement journey.