Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Decumulation phase of retirement savings

During the last couple of decades, pension reforms have focused much attention on the accumulation phase in which individuals build up their retirement savings. Well designed defined contribution schemes have incorporated insights from neo-classical finance and behavioural finance to create low cost well diversified savings vehicles with simple default options. Much less attention has been paid to the decumulation phase after retirement where the savings are drawn down.

A report last month from the National Association of Pension Funds (NAPF), and the Pensions Institute in the UK argues that investor ignorance combined with lack of transparency and undesirable industry practices lead to large losses for the investors. According to the report:

Each annual cohort of pensioners loses in total around £500m-£1bn in lifetime income. This could treble as schemes mature and auto-enrolment brings 5-8m more employees into the system.

This represents 5-10% of the annual amount consumers spend on annuities.

The report makes a number of excellent suggestions including creating a default option for annuitization. I would argue that a more radical approach would ultimately be needed.

In the accumulation phase, the key advance was the distinction between systematic/market risk and diversifiable/idiosyncratic risk. By restricting choice to well diversified portfolios, the investor’s choice is dramatically simplified – the only choice that is required is the desired exposure to market risk (proxied by the percentage allocation to equities).

The corresponding distinction in the decumulation phase is between aggregate mortality risk (what I like to call macro-mortality risk) and individual specific mortality risk (micro-mortality). Given a large pool of investors in any defined contribution scheme and some degree of compulsory annuitization, it can be assumed that micro-mortality risk is largely diversified away. Compulsory annuitization eliminates adverse selection to a great extent and large pools provide diversification.

What is left is therefore the risk of a change in population-wide life expectancy or macro-mortality risk. It is not at all self-evident that insurance companies are well equipped to manage this risk. Perhaps, capital markets can deal with this risk better by spreading the risk across large pools of investment capital. In fact, it would make sense for many individuals in the accumulation phase to bear life-expectancy risk (as it increases the period during which their savings can accumulate). At least since the days of the Damsels of Geneva more than two centuries ago, pools of investment capital have been quite willing to speculate on diversified mortality risk. Shiller’s proposal regarding macro futures is another way of implementing this idea.

If we separate out macro mortality risk, then the decumulation phase of retirement savings can be commoditized in exactly the same way that indexation allowed the commoditization of the accumulation phase.


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