How to transform savings into lifelong security

The golden years come with wisdom, but not always prosperity. As the Asian population rapidly ages, adequate retirement planning is the need of the hour

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

Asian economies are grappling with an ageing society. Amid increasing life expectancy and low fertility rates, a fast-growing elderly population can be seen in Japan, South Korea, Singapore, and China. As the number of seniors increases and retirement savings dwindle, the issue of financial security becomes a harsh reality for many.

According to the World Health Organisation, China is expected to have 28 per cent of its population hit retirement age by 2040. To tackle potential demographic problems, the world’s second-largest economy plans to roll out a private pension mechanism nationwide this year to complement the current pension system, allowing insurance companies to offer individual retirement products. The mechanism has been trialled since late 2022 in 36 cities with mixed results.

“After retirement, the elderly will rely almost entirely on their accumulated wealth for a living, but how to spread this accumulative wealth over the rest of their lives?” says Johnny Li, Tan Bingzhao Professor of Actuarial Science at the Chinese University of Hong Kong (CUHK) Business School. “In the banking and insurance industry, there exist mechanisms that allow them to achieve this objective called retirement income products.”

Insurers and banks have been longing to tap into China’s private pension business, which is projected to grow to 4 trillion Chinese yuan (US$550 billion) by 2030, according to a 2023 report by Asia Securities Industry and Financial Markets Association titled China pensions reforms. These financial institutions offer rather complicated products with different objectives.

In an Inaugural Lecture of the Tan Bingzhao Professorship in Actuarial Science titled Landing safely in retirement: An actuarial researcher’s perspective in July, Professor Li shed light on several financial products designed specifically to solve the problem of length-of-life uncertainty. These products are meant to enable the elderly to turn their hard-earned savings into a more secure future.

Lifetime income from life annuity

Imagine a 60-year-old male with US$1 million in savings wanting to use his fund for the rest of his life. Assuming the investment performance is fixed at a five per cent annualised return, he may take three strategies below.

Firstly, he can consume the income from the interest rate of the principal investment and generate US$50,000 per year or five per cent of the fund. Secondly, he can purchase a portfolio that generates an annual fixed amount of cash for 50 years, and after calculating the present value of the cash flows from the portfolio using an interest rate, he may receive an annual basis of around US$55,500.

Thirdly, he can purchase a product called a life annuity from an insurance company. Assuming that the insurer does not take any profit and does not give additional features to the product, he can receive a higher annual income of US$70,500.

“This is because the provider sells multiple annuities to many individuals or annuitants, which come together to form a risk pool and financial resources to support those who are lucky enough to reach advanced ages,” says Professor Li.

For instance, less than 50 per cent of 60-year-old Hong Kong men can reach the age of 86. Among them, those who have purchased life annuities joined together to support the products by pooling their resources. They only need to pay half of the total cost to receive income beyond the age of 86.

“This arrangement significantly lowers the cost, while allowing individuals to receive a full annual income from their investments,” says Professor Li.

Market-linked payouts with variable annuity

For the elderly wanting to chase the opportunity to invest and grow their money, there is also a type of annuity called a variable annuity, which consists of the accumulation phase and the payout phase.

In the accumulation phase, the individual investment will be allocated to a fund, either a mutual fund or an equity fund, and the investment will grow according to market performance. At the same time, the product provider will benefit by collecting fees and management charges.

“In the end, this investment should grow to a certain value,” says Professor Li. “The accumulation phase is typically scheduled to end at a retirement age.”

“After retirement, the elderly will rely almost entirely on their accumulated wealth for a living, but how to spread this accumulative wealth over the rest of their lives?”

Professor Johnny Li

The payout phase starts upon the end of the accumulation phase, where the annuity holder is typically given two options. Option one is taking the accumulated amount as a lump sum maturity benefit, subject to a minimum guarantee.

“This guarantee gives protection in case of poor investment performance in the accumulation phase that results in the accumulated fund being less than the original amount at the end of the phase,” Professor Li explains. “If this happens, the product provider may give the original amount of investment back to the individual, depending on how the guarantee is specified”

In option two, the accumulated fund is converted to a “benefit base”. The product provider will provide a guaranteed lifetime income as a percentage of the base and charge fees periodically from the account. When death occurs, the remainder will be given to the beneficiary.

“There may be a case where the investment account is depleted before the individual dies, but due to the guarantee, the individual can still receive the income until the last moment,” says Professor Li. “Collectively, these investment guarantees form an important part of the variable annuity.”

Turning home equity into retirement fund

Another product that allows an individual to tap into the equity of their property is called a reverse mortgage, which allows elderly homeowners to receive lifetime income using their home equity. As the name implies, the individual must have a home loan frame from a reverse mortgage provider in lump sum cash, a life annuity, or both.

As the loan accumulates interest, its balance grows over time. The property ownership remains with the borrower and the borrower is not required to make any regular payments to the lender. Most importantly, the borrower can live in the property for the rest of their life.

“The essence of a reverse mortgage lies in the moment when the loan is repaid,” says Professor Li. “When the borrower dies, the property will be sold and then the sale proceeds will be used to repay the loan.”

When the property market is doing well and the property value grows bigger than the loan balance on the due date, the proceeds will pay off the loan and the remainder will go to the legal heirs. However, when the market is bleak and the sale proceeds is not sufficient to pay off the loan, the legal heirs are not liable for the loss, thanks to a non-recourse provision that comes with the reverse mortgages.

“Reverse mortgage has characteristics associated with financial products and is also related to insurance,” he explains. “There is no clear distinction.”

Market-linked payouts with variable annuity

Offering retirement products involves various risks to be managed. “From the provider’s viewpoint, offering an investment guarantee in a variable annuity is equivalent to writing the annuity holder a put option.”

A put option is a financial contract that gives the holder the right but not the obligation to sell the underlying asset on the maturity date for the strike price. Take an example of a put option written on stock A with a maturity day of 90 days, a current stock price of US$100 and a strike price of US$85. If the stock price in 90 days falls to US$70, the option holder can get an immediate profit by purchasing stock from the market and selling it using the put option for US$85. However, if the stock price rises to US$120, the option holder may not exercise the option as buying high and selling low would not make a profit.

“Put option is good for individuals as it protects them from downside investment risk, but not for the product providers as an option exposes them to significant systematic risk. In the context of variable annuities, providers typically sell multiple variable annuity contracts, where each of them includes some guarantees. In case of a global recession or market crash, most of these guarantees will demand a pay-off and create a significant financial strain if proper risk management is not in place,” says Professor Li.

Although investment guarantees behave like put options, they are more complicated than that of in stock markets for various reasons. For example, there is no uncertainty about maturity time and whether the individual can survive to the end of the accumulation phase.

Using a similar logic for investment guarantees, offering a non-recourse provision in a reverse mortgage is equivalent to writing the borrower a put option. “This is because the non-recourse provision says that if the property value goes below the loan balance, the product provider has to take the loss and shortfall,” says Professor Li.

Managing risk pools takes a lot of resources, and hedging risks associated with put options is quite costly. This justifies the fee the product providers charge towards the borrower. “Therefore, when considering these products, individuals should first know and understand their needs,” Professor Li adds.