It is a question that has been debated around the world for longer than I have been working in the retirement industry – should retirement benefits be provided in lump sum or in annuity form, or a combination of the two? Lump sum benefits have the advantages of flexibility and access to funds, allowing retirees to pay off any remaining debts such as their mortgages early in retirement. But with the exception of the most generous of lump sums or the most financially savvy retiree, lump sums are prone to running out – particularly as we are now living longer than anyone ever expected. Annuities, of course, are designed not to run out, but they are not the perfect solution alone, with some inherent difficulties such as inflexibility of payments, and a variable and sometimes expensive commercial market.
In order to allow flexibility to meet short-term commitments or desires, some countries allow a portion of retirement benefits – say, 25% – to be paid as a lump sum, while requiring the remaining amount to be used to purchase an annuity. In other countries where annuities are not mandated and not popular, a market for draw-down-type accounts has developed, allowing better management of a lump sum benefit (possibly with restricted draw-down amounts) but retaining individual longevity risk.
Singapore is one country where monies accrued in the Central Provident Fund (CPF) currently are not required to be used to purchase an annuity. However, in order to retain some form of careful management of retirement lump sums, Singapore has had the Minimum Sum Scheme (MSS). The MSS requires that an individual place the Minimum Sum (SGD123,000 from July 2010, or approximately USD89,000) into a scheme that gradually pays the benefit over a fixed period of about 20 years.
In 2007, however, the Singapore government first raised the idea of a national longevity insurance scheme and established the National Longevity Insurance Committee. Following this committee’s recommendations, the CPF LIFE (Lifelong Income Scheme For The Elderly) scheme was introduced. Commencing in 2013 (with an opt-in option for certain members as of 2009), CPF members with at least $40,000 in their retirement accounts when they reach age 55 will be automatically included in CPF LIFE and receive monthly payments for as long as they live.
How does it work?At age 55, the amount standing in an individual’s retirement account is used to join CPF LIFE. The monthly payment from CPF LIFE commences from the individual’s drawdown age, which is being gradually increased from age 62 to 65. The individual may choose from one of four plans, all of which have different mixes of monthly payments and bequest amounts. The payment comes from two components:
1. A portion of the retirement account is used to purchase an annuity, which commences either at the draw-down age of 80 or at age 90, depending upon the plan chosen.
2. The remainder of the retirement account is gradually drawn down until the Annuity Payout Start Age. Note that this component is zero for the two plans in which the annuity commences from the draw-down age.
Now you may be forgiven for thinking this looks just like a draw-down account with a deferred annuity attached to cover the longevity risk. There is one seemingly small, but high impact, difference – the exact amount of the draw-down payments and the exact amount of the annuity payments are not guaranteed. What is guaranteed is that the retiree will receive a payment for his or her lifetime.
Why does CPF LIFE work in this way? Well, we all know that the provision of annuities entails risk – the risk of investments under-performing or of retirees living longer. In a social security context or in a commercial provider context, there is an entity that takes on this risk – either the government or the commercial insurance provider. There is no such entity with CPF LIFE. Rather, in CPF LIFE these risks remain with the membership, on a pooled basis. Hence, should experience differ (for better or worse) from that expected, the monthly payments from the draw-down account or from the annuity will be adjusted accordingly.
CPF LIFE is effectively a mutual insurance product for retirement income.
Stability is keyThe payments from the draw-down account will be managed in a way that helps ensure that these payments last until the deferred annuity date. That is, if investment experience is worse than expected, payments may be reduced such that the account will continue to be sufficient. In addition, the structure and calculations of the draw-down and annuity are configured so that the draw-down and monthly annuity payments will be comparable.
So if the draw down is managed so that it lasts until the deferred annuity date, and the annuity then commences with similar payments, why even separate the payments into two components? Why not just commence the annuity immediately for all four plans? To answer this, let’s think of one of the reasons (apart from perceived cost) why annuities may not be popular in countries where they are not mandatory. One reason is because many retirees do not wish to “wager” their longevity with an insurer – they feel that if they were to die early, their annuity premiums would have been wasted. In CPF LIFE (at least for two of the four plans), the split payment structure means that if individuals pass away prior to their annuity dates, they will still have some of the remaining money in their retirement accounts (in addition to their unused annuity premium), which may be paid to their beneficiaries.
For CPF LIFE to work in practice, stability of experience is imperative. Income payments that fluctuate regularly will damage the confidence of retirees in the system. The two key factors that may create volatility are investment and longevity experience.
In order to stabilize investment experience, CPF LIFE assets are invested in Special Singapore Government Securities, which have fixed coupon rates equal to the yield on 10-year Singapore Government Securities + 1%, and they incorporate a guaranteed minimum rate of return of 2.5% p.a. Furthermore, the rate of return that the CPF LIFE assets earn is the weighted average interest rate of the entire portfolio of Special Singapore Government Securities. Hence, investment returns should remain very stable, although some volatility will still exist.
Being such a long-term factor, the impact of longevity is harder to assess.