Tag Archives: pay as you go

Retirement Funding, Inequality, Insurance

The current low-yield environment creates a major challenge for people who have to save for retirement. At the same time, in many countries, political efforts to limit public pension obligations increase the need for retirement savings. This makes the current low-yield environment especially harmful and raises questions about the efficiency of the pension reforms. Furthermore, there are indications that the combination of low interest rates and a greater reliance on retirement savings contributes to economic inequality. It will be important to address the growing inequality problem, and insurance can significantly contribute to this goal.

Why are interest rates so low?

Simply speaking, nominal interest rates should equal inflation plus the real growth rate of the economy. The latter could again be divided into productivity growth, which influences the output per person working, plus the growth rate of the labor force. In principle, monetary policy should not interfere with this relationship, as it is looking at these variables as well (e.g. by following the Taylor Rule). However, there is of course some leeway leading to relatively tight (higher interest rates) or expansive (lower interest rates) monetary policy.

Hence, we have four main factors influencing interest rates: inflation, productivity growth, growth of the labor force and monetary policy. Inflation has declined in most advanced economies over the past 40 years and is at a very low level. In spite of the digital revolution, productivity growth rates have been rather low over the past years. Due to low fertility rates, the growth rate of the labor force has significantly declined over the past decades in most advanced economies and has turned even negative in some. Finally, monetary policy has become very expansive to support the slow recovery in many economies. Hence, all the driving factors have worked in the same direction, leading to the current low-yield environment.

Given that the demographic trend of declining labor force growth rates is expected to continue and that higher inflation would not help to increase real returns, the only — albeit limited — hope for higher interest rates is a reversal of the productivity trend as well as a normalization of monetary policy.

Impact on retirement funding

Besides the low fertility rates, there is an additional major demographic development: an increasing life expectancy. This implies that we are living longer in retirement, and this in turn implies that we have to transfer more money from work life to retirement to keep appropriate living standards. There are basically two ways to do this: via a (public) pay-as-you-go system or via (private or occupational) retirement savings.

See also: Buckle Up: Monetary Events Are Speeding  

In a pay-as-you-go system, people in working life transfer a fraction of their income to the people living in retirement. In return, they get a fraction of the next generation’s labo- force income when they are in retirement themselves. Hence, the implicit return on the pay-as-you-go contributions is influenced by the growth rate of the individual labor income (inflation plus productivity growth) and the growth rate of the total labor force.

As we can see, the implicit return on the pay-as-you-go contribution is harmed by the same factors as the return on retirement savings (i.e. the interest rate). However, it is not affected by the very expansive monetary policy, which is only lowering the return on retirement savings. Hence, pay-as-you-go pensions should become relatively more attractive.

Nevertheless, most pension reforms lead to a decreasing relevance of public pay-as-you-go pensions. One reason for this might be that politicians fear that a pronounced increase in social security taxes would not be opportune for their political future. It is important to note, however, that as a result people will have lower public pensions and therefore have to put the dollar they are not investing in the one system (the pay-as-you-go system) into the other system (retirement savings). Whether people are happy with this depends on the relative returns on the two systems. Due to the expansive monetary policy, it is far from given that the retirement savings offer the higher return.

Social consequences

When people have to save for retirement, they are directly affected by low interest rates. Let’s look at a young household that saves $1.000 per year for retirement, which starts in 40 years. At an interest rate of 2%, the household would have a bit more than $60,000 available at the start of retirement. At an interest rate of 0% (currently, real rates are rather negative) it would be only $40,000. Hence, the household would have to increase its annual savings by 50% to $1,500 to still end up with the $60,000.

However, not everyone is affected by the low interest rates to the same degree. For comparison, we look at an older household that is saving $1,000 for five years. For this household, a reduction of interest rates from 2% to 0% translates into a reduction of the end sum from $5,300 to $5,000. Hence, this older household would not have to increase annual savings by 50% but only by 6%.

For the young household, one way to compensate the strong impact of the low interest rates would be to increase risk taking. Stocks, for example, typically have an excess return of about 5%. This implies that in the current 0% interest rate environment, the young household would not end up with $40,000 but with more than $125,000! Even though there has never been a long period where stocks fared worse than bonds, many people shy away from taking on financial risk and are still looking for guarantees. Richard Thaler associates this with behavioral biases that could be overcome with the right nudges. However, it is also true that richer people tend to be better able to live with income fluctuations and therefore to take on financial risks.

There is another reason why richer people might be better able to live with the declined interest rates: By definition, they already have wealth and therefore profit from the increase in asset prices that comes with decreasing interest rates. This capital gain is especially strong for long-term assets like very long-term bonds, real estate and stocks. As a result, for people with substantial wealth, the net effect of decreasing interest rates might well be positive.

Richer people also profit relative to poorer from the shift from the public pay-as-you-go system to a greater reliance on retirement savings. First, public pay-as-you-go pensions often include some redistribution from people with a higher lifetime income to people with a lower income. This redistribution is typically not part of private retirement savings.

Second, public pay-as-you-go pensions often provide insurance against some biometric risks that are not necessarily insured in private retirement saving products. One major risk is the individual longevity risk, i.e. the risk that a household outlives its savings. If people are rich enough, they never outlive their wealth but rather pass substantial amounts to their inheritor. However, this applies to far from everyone. Another biometric risk is the disability to work and to earn the labor income that is necessary to save enough for retirement. While richer people also have a disability risk, the financial consequences might be (relatively) smaller as they often also have capital income that is not (or less) affected by the disability. Others, however, risk outliving their savings even before reaching retirement age and falling into poverty due to disability.

What should be done?

As we have seen, the expansive monetary policy in combination with the shift from a public pay-as-you-go system toward a greater reliance on retirement savings affects people differently and will likely foster inequality. What can we do to address this social problem?

First, it is important that central banks are aware of and consider the effects of their monetary policy decisions on retirement savings and inequality. In fact, there are also indications that the relationship works in both ways and that inequality also affects the monetary transmission channel as well as financial stability. As a result, several central banks have already started to analyze the relationship between monetary policy and inequality.

Second, policy makers should reconsider the efficiency of shifting the focus of retirement funding from a pay-as-you-go system toward a pre-funded system based on savings. Retirement savings will always be an important pillar of retirement funding and a crucial funding source for long-term investments in an economy. However, there are limits to the efficiency of more savings, and we have to be aware that savings are affected by the same demographic factors that harm pay-as-you-go pensions. To make public pensions more sustainable, policy makers should rather aim to broaden the basis of contributors and to increase flexibility of labor markets and the retirement age.

Third, individuals should reconsider which risks they want to take and which not. Retirement saving products with a guaranteed interest rate are still very popular. However, by choosing guarantee products, people substantially reduce the return on their savings even though the long-term nature of their retirement savings would put them in a good position to take the risk themselves. Biometric risks, in contrast, are difficult to take individually but lend themselves to risk pooling. Yet many individuals do not appropriately buy insurance protection against biometric risks like disability or longevity.

What does this mean for insurers?

See also: 4 Insurers’ Great Customer Experiences  

By pooling individual risks, insurers not only support wellbeing of risk-averse individuals but also reduce inequality in a society. The degree to which insurers are fulfilling this valuable role depends, however, on the products they are selling to their customers.

When it comes to retirement savings products, it is important that products include protection against biometric risks and not protection against financial risks. Given that insurance regulation aggravates the provision of financial guarantees, supply does not seem to be the problem in this regard. It is rather the demand side that for some reason prefers buying protection against financial risks to products that insure biometric risks.

It will be important to increase our understanding of why this is the case and how we could overcome this bias. Further research is needed although behavioral economics already provides some first insights in this regard. Nudges to overcome the described behavioral biases are, for example, increasing the availability of risk information, limiting the number of alternative products and having appropriate default options.

How to Plant in the Greenfields

If insurance were a map, we would be surveying a whole new world. The fences and boundaries of tradition have fallen. The snow-capped mountains of certainty are melting away. The rivers of market share are changing course, and streams of data are coming directly to our doors. We know there are still products to plant and fields to harvest, but how will our planting change in the months and years to come?

Many insurers will be looking at greenfields for the answer.

Greenfields, start-ups and incubators are different ways of looking at the same essential concept — starting from scratch. Each is a new beginning. Greenfields are new initiatives often aimed at developing new markets. Start-ups are most often new initiatives that will reach existing markets. Incubators are designed to test new products within new or existing markets. For our purposes, we will lump them all together under the title of greenfields, because from an organizational perspective the need for them and preparation for them are similar.

See also: Start-Ups Set Sights on Small Businesses

Cultivating the soil

Think about how insurance has grown, just based on the questions we have asked ourselves over time. Insurers used to ask, “How do we do what we do better?” They were thinking of underwriting, selling and meeting market demand.

As the internet and the digital realm arose, they began asking themselves, “How do we do what we do differently?” They needed to know how to reach the same people with better channel management and improved customer service.

Now, they are asking, “How do we do what we don’t currently do at all?” They want to know how to identify, build and capitalize on new risk needs, new markets and social networks, how to use technology to its fullest, how to become a trusted resource for services outside of insurance and how to reinvent the organization and brand so that it is prepared to be profitable no matter what initiatives lie on the horizon.

It is the preparation that is an important first step. A great idea can’t take root in an organization that won’t support it. How can insurers prepare for greenfield development?

Abandoning silos

Greenfield insurance companies that are starting outside of a traditional insurance organization and those that are starting under the umbrella of traditional insurance companies both value “fresh air” and an environment that is unclouded by tradition.

Starting from scratch allows them to think without constraint, test without constraint and operate without constraint. They do have barriers. Most are operating within a window of opportunity, and all are operating under the assumption that investments need to pay off. But for the most part, greenfields take advantage of the fact that organizational politics, processes, traditional technologies and time-honored ideals are all open to reassessment, replacement or removal.

Organizational silos need to be bridged, if not completely abandoned. The new opportunities where greenfields will work best will be created by cross-functional teams that understand how to integrate new technologies with the best ideas. This is one reason hackathons have recently grown in popularity. They are simply borrowing a common concept from ad agencies, TedX events and jazz musicians…the idea that walls and ideas aren’t compatible. The best fertilizer for ideas is a diverse set of perspectives on how the idea will be constructed and how it will work in practice. Teams need functional area experts, but they also need general leadership with a holistic perspective as well as input from technology partners who grasp what is technologically possible.

Investing in seeds

Seeds are investments, and most investments have phases. The greenfields in insurance are ripe for these investments, and they are bearing fruit. But those that will be most successful will pay close attention to planting methods.

For example, farmers don’t take the newest seeds and plant 1,000 acres. They test them in plots. In insurance, our ideas need to be cultivated quickly, first in small pots, in our incubators and centers of excellence — we can call these our insurance greenhouses. If they appear to be working, we test them in small geographies, then roll them out to larger segments. Seed planting is speed planting. The idea works, or it doesn’t. We scale up quickly or toss the idea out. We invest wisely by investing small, until the investment proves itself and then we invest more.

As we watch seed money flowing into InsurTech, we know that some of these investments won’t pay off. Many venture firms will have invested more in a proof of concept than they should have. Some will attempt a rollout before the concept is mature. The best growth will happen through organizations that know how to phase greenfield investment.

See also: Investment Oversight: Look Beyond Scores!

Greenfields will be capitalizing on technology to save investment funding. This includes reusing technologies and sharing systems. Cloud platforms with a “pay as you go” pricing model are perfect for greenfield development because they answer the demand for agility, innovation and speed (low implementation time, quick speed to market, light or no customization) with lower investment and maintenance costs … allowing the investment to focus on the business, not the infrastructure. Greenfields are creative pursuits to new opportunities. Their back-end solutions will require just as much creativity as their front-end marketing, but they will want solutions that don’t require massive customization.

Greenfields will therefore capitalize on what they don’t need to build from scratch. Modern core platforms will allow them to use pre-built, integrated content and data sources, pre-built best practices and products and pre-built channel options. They will use their creativity to build new business models around pre-built infrastructures, instead of building new systems from the ground up.

The passion for planting

In the coming weeks, we will take a more in-depth look at greenfields, start-ups and incubators. We’ll look at the surprising growth of insurance innovation investment and what it means to existing businesses. We will discuss how deeply the choice of platform can affect insurer preparation, and we’ll also look at the greenfield spectrum that includes new value-chain technologies, new aggregator channels and completely new types of insurance.

Our goal is not to gawk at the high number of entrants into the market, but to glean a whole new perspective on opportunities. You may find that your unique position will allow you to have market-capturing ideas ahead of others. And you may develop a passion for planting your own seeds in the greenfields of opportunity. Is your organization ready for your team’s next great idea?