Longevity risks, & lump sum payouts

The U.S. Treasury recently issued a rare and crucial Notice that constrains U.S. corporations in the process of paying lifetime defined benefits to offer the option to instead receive a de-risked product, termed “lump sum” payouts.  This is an alternative where the in-pay status recipient forgoes their lifetime pension annuity, and instead receives a single payment worth the expected value of what would be their future pension.  It’s tempting to take it!  You get all of this money today, and then can enjoy the freedom to make more independent choices about your current cash flow needs, as well as your retirement investment decisions.  However buried within the complexity of choosing this alternative product are some “hidden” risks that generally make the option a perilous decision for recent employees and retirees.  Also to some degree, this framework is also true when applied in other variations of advance payment options that one might take in their lifetime (e.g., a lottery prize, or premature social security payout.)  This action is an example of how our government has championed on behalf of all Americans.

Understand that as an individual, you will likely live longer or shorter than the expected time of your cohorts.  In fact, at precisely the year the company expects the average pensioner to die, only ~4% of these people will actually die that year.  Everyone else (~96%) will die either before or after this year.  And that’s a large age risk that an individual will not be able to cheaply diversify away.  So this becomes actuarially unfeasible particularly for various people, many of which are not intuitive: women, single survivors, those in healthier companies, or during low-return (relative to the discount rate) and more volatile financial markets.  Since the company will not continue to pay you any additional amount of benefits if you survive beyond the expected age, you would therefore be taking on “longevity risk”, a foundation for an even more complex risk we’ll discuss in another article, termed superannuation (outliving your savings, as opposed to your life expectancy).

Let’s see this risk in action by consider someone born in 1950 who is just now approaching retirement.  We have the death table for this age (per semi-decade intervals).

First (in blue), we see that for every 100 people born in this year, 32 are expected to die by age 65 (by 2015).  On an aside, about 10% of these 32 happen in the initial year after live birth.  Now of the 68 remaining (100-32) at the onset of retirement, the life expectancy is an additional 14 years, to age 79.  But look at the shape of the deaths occurring in the retirement region.  We can see (in green) that 52% of retirees will die prior to age 79 (year 2029).  This group obviously can die as early as age 65 itself (of course14 years earlier than expected).

On the other hand, a not insignificant 48% of retirees (in red) will instead die after the expected time.  Retirees in this latter group have a “long tail”, in that they could die as late as 110 (in 2060, 31 years later than expected!)  This sort of centenarian risk creates asymmetry one can not diversify (the benefits of dying in the green are always much less than the risks of dying in the red.)

One’s company on the other hand, has already been diversifying this risk across many more individuals at different ages and economic cycles, and for a set of their employees' spouses as well.  You should be optimistic!  Consider yourself a hard worker, worthy of a long and happy retirement (to age 110 if single and averaging late 90s if a couple).  Don’t let your company short-change you at this time, by beguilingly “de-risk” your future benefits away.

The government’s decision is a triumph for hard working American pensioners, who were previously put into an awkward position of quickly grappling with the pros and cons of a lump sum option, coquettishly dangled before them.  Now controlling executives are required to continue to provide you simply what you have earned, and not cut corners at this time of economic recovery.

Don’t take on the asymmetric risk of guessing your own death, unless you are guessing the “over”.  Be positive, and spend your time instead thinking about how you will invest your non-pension assets, and more importantly, how you will live out your retirement!