Issue: December 2012 / February 2013
Expert Opinion

Not all with-profit annuities are created equal

Twané Wessels, marketing actuary at Momentum Employee Benefits (Investments), illustrates how retirees pay the cost for poor risk management.

Many retirees invested in traditional with-profit annuities have suffered a decline in the purchasing power of their pensions over the past five years. Others, however, have managed to keep track with inflation. What’s the reason for this difference in being able to meet pensioners’ expectations?

Recent volatility in investment markets has clearly shown that it is imperative to understand that not all with-profit annuities are created equal. The newer generation of liability-driven investment techniques provide distinct advantages over the traditional approach in managing with-profit annuities.

In a with-profit annuity an insurer promises to pay a retiree an income for life. Future increases, however, are not guaranteed. The level of the increase in income a retiree or annuitant can expect from year to year is determined by the performance of the asset portfolio relative to what is needed to fund expected future pension payments.

Poor performance equals poor increases. It means an annuitant faces inflation risk to the extent that investment returns aren’t strong enough to provide inflationary increases.

Insurers in SA traditionally managed assets independently from liabilities. These less sophisticated, partial matching techniques rely on a ‘bet’ that risky assets will outperform the assets needed to replicate liability movement. When they don’t, it impacts dearly on the future financial wellness of pensioners.

In the traditional approach, to prevent the value of the asset portfolio relative to the expected future pension payments from falling further in times of uncertainty, the insurer has limited options: (1) declare smaller future increases and/or (2) use more conservative investment strategies to protect the assets.

The problem is that, when such management action is taken, it is often too late and asset protection is often required when it is most expensive. Ultimately the annuitant pays for these decisions through lower future pension increases.

What’s the solution? Dynamic hedging (also known as ‘delta hedging’) is a liabilitydriven investment technique that has been used by investment banks worldwide (including SA banks) for many decades. In the insurance industry it is widely used internationally with over $700bn of variable annuity guarantees being hedged by North American insurers alone.

In 2007 Momentum Employee Benefits became the first SA insurer to employ this technique in managing with-profit annuities. The benefits were reinforced when another SA insurer followed suit afterwards.

Dynamic hedging is proactive rather than reactive: protection against market volatility is purchased throughout in the asset portfolio rather than in adverse conditions when it is the most expensive. By synchronising assets and liabilities, and reducing the tug of war between the interests of policyholders and shareholders in times of pressure, dynamic hedging eliminates many of the inefficiencies in the traditional approach of managing with-profit products.

This strategy of dynamic hedging is beneficial for both shareholders and policyholders. In SA, the Financial Services Board requires all local insurers to hold minimum capital reserves to ensure that pension liabilities can still be met, even in exceptional adverse circumstances. Dynamic hedging manages investment risk significantly better. This results in shareholders being less exposed to downside risk and thereby allowing the insurer to hold lower capital reserves.

For policyholders, the lower capital requirements result directly in lower ongoing costs in pension products. The efficacy of dynamic hedging also leads to more accurate pricing and higher expected pension increases in the long term.

The graph shows that, using dynamic hedging, the Momentum Golden Growth With-Profit Annuity (for example) protected the purchasing power of pensions over the past five years. And it significantly outperformed the traditional approach through both market boom and crash scenarios.

Dynamic hedging better ensures that the income from your life savings meets your expectations, just as you want to be sure that your car insurance pays out what you expect when you need it most.