Where it is the responsibility of the actuary, he or she uses appropriate methodology and assumptions to determine the conversion factors of lump sums to income. Unless these factors are set so as to meet specific policy objectives, they are determined as cost-neutral. If the factors are not cost-neutral, the actuary discloses this fully and determines and reports on the implications on adequacy and sustainability of the scheme.
The rate of conversion of lump sums into annuities is an important element of provident fund, notional defined contribution and funded defined contribution schemes. In a provident fund or funded defined contribution system, a lump sum based on the account balance of the scheme member at the time of retirement may be paid. In such situations, the post-retirement risks, namely investment and longevity risks, are fully borne by individual scheme members. When a provident fund or funded defined contribution system converts individual accounts to guaranteed income streams, the fund bears the longevity and investment risk. In a notional defined contribution scheme, the conversion of the value of the account is usually governed by the scheme’s rules and also has significant implications for sustainability and adequacy of benefits.
This guideline should be read in conjunction with Guideline 14 and with reference to Part E.
- In determining the conversion rate, the actuary should use the most appropriate investment assumptions. For example, the provident fund may seek to minimize investment risks by adopting a minimal-risk portfolio with adequate cash flows that will match the annuity payments. Such investment strategy should be reflected in the choice of assumptions used. Reference should be made to Guideline 21.
- The mortality rates to be used for the determination of conversion rates should be, in principle, based on those used in the most recent actuarial valuation, if any, and be representative of the covered population. Mortality rates to be used for the calculation of actuarial factors should take into account future mortality improvements. However, where the purchase of annuities is optional, the impact of anti-selection should be reflected in the mortality rates assumed. The impact of such anti-selection may be significant and needs to be quantified by the actuary.
- While it is important to reflect appropriately the investment and mortality environment in the assumptions used, it is likely that the institution and/or policy-maker will seek to ensure stable rates over time. Therefore, rates used are likely to differ from true cost-neutral rates at certain points and the actuary needs to assess the impact of these differences on the financing of the scheme.
- As an alternative to retaining the investment and longevity risks, the social security institution may seek to transfer some or all of these risks to an insurance company or other third-party risk provider through the purchase of a relevant product. Options include a full buy-out, buy-in, longevity swaps or bulk risk transfers. While the costs will reflect the rates negotiated with an insurance company, the conversion rate offered to beneficiaries is likely to remain fixed. Therefore, even if some of the investment and longevity risk is transferred to the third-party provider, there is an element of risk retained related to the difference between the implicit rate agreed and those provided to beneficiaries. In addition, there is a risk retained by the original scheme related to the possibility of bankruptcy of the insurance company, and the social security institution should select the insurance company using appropriate due diligence similar to the process discussed in Section D.2 of the ISSA Guidelines on Investment of Social Security Funds.
- The conversion rates should be set using appropriate investment and mortality assumptions that take into account future expected developments including mortality improvement rates. For provident funds and defined contribution schemes, these, in turn, will be set according to the underlying investment portfolio and based on the mortality table relevant to the covered population. For defined benefit schemes, these assumptions should be consistent with the actuarial assumptions adopted in the most recent actuarial valuation. Where converting a lump sum to a retirement income is voluntary, appropriate consideration of selection bias should be undertaken.
- The rates of conversion should generally be unisex in order to provide non-discriminatory benefits to males and females. When gender-specific rates of conversion are used, the actuary should inform the social security institution of the impact on benefits and, more specifically, on benefit adequacy. When unisex rates are used, the financial impacts and the risk these could pose to the programme should be properly assessed and communicated.
- Where the conversion rates are set or prescribed by regulation, the actuary should assess the financial implications on the programme of using rates that are not actuarially neutral.
- The impact of anti-selection and appropriate risk compensation mechanisms should be considered, particularly in programmes where conversion to retirement income is voluntary for some or all of the accumulated benefit. The anti-selection may arise as a result of using gender-neutral rates, as well as the difference in members’ health status, and therefore difference in mortality.