Longevity risk: The view from across the pond
Written by Amy Kessler, Senior Vice President, Head of Longevity Reinsurance Prudential Retirement, Prudential Financial, Inc
Defined benefit pension funds worldwide are facing a key challenge. As medical improvements increase the life expectancy of scheme participants, there is real uncertainty as to the cost of the pension promise. The result is longevity risk and in the UK, where pensioner longevity is rigorously studied and well understood, leading pension schemes are acting decisively to transfer the risk.
The UK is now the most vibrant market in the world for pension scheme de-risking, though its transformation only began six or seven years ago. The catalysts for change in the UK included: strict funding regulations, accounting transparency and risk awareness among pension scheme sponsors.
Specifically, an increased aware-ness of longevity risk in the UK has been a strong catalyst for the development and adoption of de-risking techniques. Such awareness does not exist in the US market. In fact, an understanding of longevity risk is the last missing piece in the puzzle for US corporate pension plans to more actively adopt de-risking strategies.
Today, UK longevity risk measurement techniques are being adapted for US pension plans and an increased awareness of longevity risk is on its way to America.
The UK market: Heightened risk awareness
Corporations in the UK have historically offered generous pension benefits including cost-of-living adjustments. These pension obligations, combined with increasing life expectancies, have created real funding challenges for sponsors.
Nationwide, concern for the retirement security of pension scheme participants led to a wave of regulatory and accounting change in the UK to align incentives for scheme sponsors to proactively manage their risks. As such, pension scheme sponsors have been motivated to change their risk tolerance and reduce their risk profile or face the financial consequences of failure to act.
In particular, scheme sponsors in the UK have come to understand the implications of longevity risk. The pension liabilities of UK companies have increased substantially as welcomed medical advances have caused life expectancies to rise faster than ever in recent years. The Continuous Mortality Investigation uses advanced statistical techniques to identify these developments quickly. Pension schemes are required to update their longevity assumptions frequently, creating an immediate impact of changing expectations on today’s pension liabilities.
Longevity swaps and insurance have emerged as an important de-risking tool in the UK to address these unique risks. These solutions were first launched in the UK in 2009 and today figure prominently in approximately two-thirds of all pension risk transfer market volume in the UK market.
The US market: A lag in awareness
It is evident that an increased awareness of longevity risk is on its way to the US. Longevity risk analysis tools and research methods, currently in use in the UK, are being developed for the US market. These tools will soon be available to help US pension plans understand and quantify their risk.
Many of the catalysts that led to change in the UK are also crossing the pond.
• Most US plan sponsors now face regulatory changes that shift the amortisation of the unfunded liability from long-term to short-term funding requirements. The consequences of risk now have a swift and significant impact on plan sponsors’ cash flow.
• What’s more, pension reporting has moved from off-balance sheet to on-balance sheet, enabling stakeholders to readily detect the emergence of risk.
• With corporate cash at risk and greater transparency, many plan sponsors’ investment goals are changing from maximising returns to minimising volatility.
• As such, many leading corporations in the US are preparing to transition from the position of bearing pension risk, to transferring it to a third party.
Pension risk transfer is emerging as a solution and US plan sponsors are learning from the many risk reduction strategies that have been successfully employed in the UK.
Despite the momentum building behind pension risk transfer, the US market is missing a critical component: awareness of longevity risk. This lack of awareness exists despite pensioners in the US having experienced well-documented and significant increases in life expectancy.
Among the questions US plan sponsors must answer when considering de-risking is the importance of longevity risk as well as when and how US plan sponsors will account for liabilities based upon the real life expectancy of their participants.
Population data shows that the retired lifetime — that is, the period of time from retirement to death — for the average US male has increased 34 per cent in the past four decades.
Since 1969, the rate of longevity improvement observed in the US population as a whole has been considerably more rapid than the improvement factors typically assumed to project and value US corporate pension liabilities. As a result, pension liabilities are likely to be understated.
Despite these trends, US pension plans are still using mortality tables, improvement scales and calculation methods that are, quite simply, obsolete.
A wake-up call is coming for US pension plan sponsors. The Society of Actuaries is working to release up-to-date data on pensioner longevity improvements using the latest technology already implemented in the UK; data that will challenge the assumptions currently in use and cause pension plans to rethink their approach as the financial impact of leaving longevity risk un-hedged will come into focus.
Given the lag in longevity risk awareness in the US it is not surprising that a 2010 Aon Consulting survey found that US pension plans are prioritising the management of interest rate risk and equity risk but have longevity risk near the bottom of the list of things they seek to manage.
There are three significant reasons for this:
1. Very few US corporate pension plans offer cost-of-living adjustments to their participants. Therefore, the impact of an increase in life expectancy is less significant on the liabilities of a US pension plan than it is on their UK counterparts.
2. Unlike firms in the UK, US pension plans have not been required to update their longevity assumptions based upon recent research.
3. Finally, most US plan sponsors are preoccupied with asset risk; longevity risk is not perceived as a material or immediate concern.
Longevity risk will not be recognised as a significant concern in
the US until plan sponsors fully examine their liability risks using updated life expectancy projections that are appropriate for each pension plan; and reduce their
As in any nascent market, some US plan sponsors are already preparing to transfer their pension risk. These leading companies focused on de-risking currently have two dominant attitudes:
• Some will act opportunistically to transfer pension risk; and
• Others are committed to pension de-risking and will act decisively on that commitment over the near to medium term.
For the opportunists, nearly all could have transferred their pension risk in 2000, and many could have transacted in 2007 as well. When their pension plans become fully funded again—whether because of favourable market conditions or due to mandatory cash contributions—they will de-risk.
Among those committed to de-risking, there are many plan sponsors that have led the transition to fixed income investing. Still others have recently amassed healthy levels of cash and find that accelerating plan contributions and de-risking the plan is a favourable, tax-advantaged approach for deploying their cash.
Crossing the pond
The UK experience demonstrates that as plan sponsors recognise the full scope of the risks and factors impacting their obligations, embracing de-risking solutions becomes an imperative.
In the US there is broad recognition that the risk position of pension plans is not sustainable. Techniques used in the UK for reducing and transferring pension risk provide the road map for US sponsors. In particular, as US plan sponsors become more focused on their longevity risk, we expect demand for longevity insurance in the US to follow. Like so many aspects of pension de-risking: longevity insurance is crossing the pond.
Reinsurance contracts are issued by Prudential Retirement Insurance and Annuity Company (PRIAC), Hartford, CT 06103. PRIAC is not a United Kingdom (U.K.) Financial Services Authority (FSA) authorized insurer and does not conduct business in the U.K. or provide direct insurance to any individual or entity therein. Prudential Financial, Inc. of the United States is not affiliated with Prudential plc. which is headquartered in the United Kingdom.