Can longevity be an asset as well as a liability?
Written by Sally Ling
Sally Ling explores whether longevity risk can be managed by becoming a tradeable asset
There is no doubt that life expectancy is increasing and that this poses an increasing risk to defined benefit pension funds, many of which have funding deficits. A recent survey by Mercer of FTSE 100 pension funds found that in 2011 alone, life expectancy assumptions for pensioners increased by around three to six months, adding an estimated 1 per cent to schemes’ liabilities.
Pension funds looking to offload their longevity risk generally either take the buyout/buy-in route (which also addresses interest rate and inflation risk) or do so via a longevity swap with an insurance or reinsurance company. The latter involves the pension fund contracting to make a series of fixed and therefore predictable payments to a provider, which in return makes variable payments to meet pension liabilities as they arise. As Aon Hewitt head of risk settlement Martin Bird explains, such solutions are currently available because “the re-insurance market holds a lot of mortality risk in the form of life assurance and catastrophe risk. It is exposed to the risk of people dying earlier than expected so can benefit from the other side of the longevity hedge – people living longer than expected.”
There are a number of reasons why the current model is neither sustainable nor suitable for all pension schemes. First, it is widely accepted that the insurers’ capacity to take on longevity risk won’t last for ever. Second, swap transactions to date have been designed to match a fund’s specific longevity profile. As such these arrange-ments are complex and time-consuming to put into place and so are generally only available to larger schemes to just cover pensioners. Finally, insurers are reluctant to take on smaller schemes as the risk is concentrated among a few members, or to cover non-pensioners, where very long-term arrangements are required.
A tradeable asset
The solution favoured by Swiss Re is a longevity instrument that can be traded on the capital markets. This would allow a seller of longevity risk to pay a premium to investors and in return, investors would take on the risk of losing some, or all, of their investment if improvements in life expectancy outstripped a pre-agreed rate.
A secondary market for these securities should encourage participation by investors who would not want to hold such a long-dated instrument until maturity.
Bird believes there is potential for such a market to develop, saying: “If there was a way to package longevity risk up it could be attractive for diversification purposes as it is not correlated to the risk they are already carrying. Potentially this could appeal to a range of investors, sovereign wealth funds, private equity funds, hedge funds and the insurance-linked security market.”
There have, however, been previous attempts to create a liquid market for longevity that have not taken off as people might have hoped. Redington director ALM and investment strategies team Dan Mikulskis explains: “These have focused on the observation that a necessary condition for this in other asset markets has been the development of standardised contracts. This motivated the EIB longevity bond in 2004 and the J.P. Morgan q-forward instruments in 2007. Although there have been some transactions, neither instrument has become a market standard.”
The key issue is that there is a mismatch between what pension funds want and what would appeal to investors. At the moment the reinsurance market can provide a near-perfect hedge for longevity risk, so this is what schemes are buying. However, capital market investors are not familiar with the complexity of some pensions markets and would prefer a simple, transparent structure.
Therefore, says Bird: “In order to create a liquid market it will be necessary to come up with a really standardised product. Either pension funds will have to accept a simplified risk hedge or the providers will have to accept the basis risk and lay it off. At the moment pension funds are focused on customised solutions as they offer better value for money.” Mikulskis agrees, saying: “The barrier has been that longevity transactions are by definition large trades with a lot of effort and resource dedicated to them – not surprisingly perhaps clients then demand the extra benefits you can get from a bespoke transaction.”
Mercer principal Andrew Ward suggests that a standardised longevity product might produce cost savings and could therefore appeal to pension funds that are currently priced out of the market. “The proposed approach is to trade contracts with pay-outs based on an index driven by observable death experience across, say, the whole of England and Wales. Schemes buy as many contracts as they need to match their scheme requirements. This approach should, at least in theory, be cheaper but the downside is that schemes will need to be comfortable holding some basis risk as the contract does not cover their specific risk profile.”
Where are we now?
Although previous attempts to create a market in longevity have stalled, progress has been made. For example, there have been improvements in calculation techniques, with detailed analysis being completed on actual death experience and schemes segmented using postcode and other similarly granular techniques.
Mikulskis believes that the biggest step forward has been model-driven observing as for a long time there wasn’t even a standard approach to projecting longevity assumptions into the future. However, work carried out by the Continuous Mortality Investigation of the Institute of Actuaries has helped standardise the language around longevity transactions and this now forms the basis of pricing discussions.
Another development came earlier this year when the Life and Longevity Markets Association (LLMA), a non-profit organisation funded by a number of financial institutions, launched four longevity indices covering England and Wales, Germany, the Netherlands and the USA. The LLMA hopes that its indices will be used as a global reference for the transfer of longevity risk from hedgers to investors and other counterparties.
Despite all these advances, the main issue continues to be the inability to know how life expectancy will change in the future. As Ward observes: “On the one hand a cure for cancer or other medical advances could speed up the rate at which life expectancy increases, but then there is the increasing problem of obesity and related conditions, which could slow it down.”
Looking to the future
The potential demand for de-risking is huge. In the UK alone there is £1 trillion to £1.5 trillion of longevity risk that could be hedged given the right product. While the UK is currently leading the way in reducing longevity risk, as it has the most pent-up demand, there have been a number of high profile transactions in the Netherlands. Germany and Switzerland are also actively looking for solutions.
Given the complexity of the issues, it seems that there is still some time to wait before there is a liquid capital market for longevity risk.
In the meantime, Mikulskis believes that if things carry on as they are, then the default position will be that pension funds, and sponsoring employers, will continue holding the risk saying "if today’s projections do accurately represent future trends then it should be possible for funds to manage the run off of the liabilities, however it is hard to say with certainty this will be the case".
There is also the question of whether schemes will continue to offload longevity risk if investment returns pick up and funding levels improve. Ward thinks yes, saying: “For many years pensions were not seen as a risk. In recent years though, schemes and their sponsoring companies have been badly burned, so I would expect schemes that are already on the path of de-risking are likely to stay on it while they can.”
Time will tell whether longevity risk can be developed into a tradeable asset. What seems clear though is that, as with so many other issues affecting pension schemes, there is no one-size-fits-all solution.
Written by Sally Ling, a freelance journalist