Adam Cadle examines the different tools available to manage longevity risk and how continental European pension plans can learn from the UK

It goes without saying that pension funds in the UK and across Europe are facing a considerable number of challenges and risks as a result of the current volatile economic environment that is sweeping across many countries. Inflation risk, funding deficits and investment risks are just a few of the hurdles that many pension schemes must deal with, but one risk in particular is causing a considerable headache for many – longevity. Over the past 15 to 20 years increases in life expectancy have been continually underestimated by European pension funds as official figures constantly assume that the growth will tail off. As a result, many schemes have not factored these increases sufficiently into their pension fund valuations, and have thus witnessed an increase in their liabilities.

Whereas in the UK, the Actuarial Profession’s Continuous Mortality Investigation (CMI) has conducted a vast amount of research over the last 10 years with regards to pension fund specific mortality tables, on the continent there has been a much greater focus on managing assets and not enough attention paid to dealing with pension fund liabilities. This is something which is only just starting to change. Principal consultant in Aon Hewitt’s global benefits practice Matt Wilmington says: “In the Netherlands until four years ago pension funds were allowing for no improvements in life expectancy going forwards, but in 2007 they started to allow for some improvements and then in 2011 new mortality tables were published which contained much more realistic projections. It has been estimated that acknowledging these increases in life expectancy has added around 15 to 20 per cent on pension fund liabilities in the Netherlands. In Germany and Switzerland the effects of improving longevity will start to emerge and some companies will be in for some large shocks.”

So having recognised the effects that longevity risk can have on pension funds, what exactly are the tools that can be utilised in many pension schemes’ risk planning strategies if they are to combat the threat posed by longevity?

One strategy that has come to the foreground mainly in the UK but also in the Netherlands is that of postcode modelling. Postcodes can be used effectively to pinpoint the geographical location of a pension fund member and a variety of marketing databases can be used to estimate a specific member’s socio-economic type. Based on this data, mortality rates can be estimated for each pension fund member and can be compared to that of the national average for example. Life expectancy can vary in some cases from street to street depending on the location, and levels of pollution in certain districts for example can also affect mortality rates. Aon Hewitt Netherlands has developed such a model after reaching an agreement with De Nederlandsche Bank and postcodes have already been used in the country for marketing purposes, the granting of loans and also for car insurance.

Prudential Retirement head of longevity reinsurance Amy Kessler is quick to highlight the important role that postcode modelling can have in reducing longevity risk. “The longevity market will continue to develop. Postcode modelling can be utilised effectively alongside robust analysis to see what is the proper mortality curve for a pension plan. This method is based on techniques and available data that can be adapted for the different European markets and for the US.”

This is a point also shared by Aegon Global Pensions director Martijn Tans. “As this topic becomes more pressing and more relevant there will be an increasing interest in granularity. Postcode modelling is not the holy grail but it may certainly be a good addition to analysing funds, and a good source of data is vital in managing that,” he says. It is important that pension schemes focus on identifying their own fund-specific risk, and postcode modelling is one of the tools available that can help them to do this.

According to JLT managing director Antony Barker, attention is turning towards the longevity threat which is harming European funds as countries look to catch up with UK preparations for dealing with this risk. “There are increasing amounts of quotations, structuring and pricing going on in Europe with regards to longevity risk at the moment,” he mentions. “A number of larger institutions across Scandinavia and the Benelux countries are exploring different strategies. The problem is that across Europe you have a lot of population migration so trying to put a fix on what the population is that is living and dying there becomes a challenge. You don’t have the same history and sophistication of records there that you have for the UK.”

Another solution that many pension funds are considering is that of longevity swaps. “Markets have already merged in the UK with regards to longevity swaps and that is an area which is being looked at from the Dutch market and has been for quite some time now,” Tans states.

A longevity swap offsets the risk of pension scheme members living longer than expected and makes regular payments based on agreed mortality assumptions to an invest-ment bank or insurer and in return the counterparty pays out certain amounts based on the scheme’s actual mortality rates.

In 2010 BMW used a longevity swap to offload £3 billion of risk from its British pension scheme to Abbey Life and recently British TV channel ITV signed a £1.7 billion pension longevity deal with Credit Suisse to offset the risk that its members will live longer than expected. “Over the next year or two years, particularly in the Netherlands, we will start to see a lot more interest in longevity risk hedging. We would probably be seeing it now if it wasn’t for the uncertainty around unclear legislation whether accrued benefits can or can’t be cut back depending on how long people live. If clarity is achieved and it turns out accrued benefits can be cut back depending on life expectancy there probably won’t be a longevity risk hedging market in the same way as there is in the UK because employers will just reduce benefits or push back retirement ages,” Wilmington adds.

Liability driven investment (LDI) strategies, which revolve around the necessary cash flows to fund future liabilities, can also be used. “Larger plans with sophisticated teams ought to be thinking about running a longevity swap alongside their LDI strategy,” Kessler notes. Through this combination, plans can reduce the threat that longevity poses for them.

The longevity market will no doubt continue to develop in the UK and across Europe. Small DB plans in Belgium, Luxembourg, Spain and France don’t have too much to worry about as they have a small membership and if life expectancy suddenly increased by five or 10 years it would not put the employers in great difficulty. For larger European schemes however, longevity swaps, postcode modelling, disease moni-toring in specific areas, buy-ins and buyouts will all be used as schemes and insurers keep a close eye on the strategies used in the UK. “In the German market, there is a relatively small segment of what we think as funded pension plans. Until the corporate plan sponsor has the obligation to fund the pension plan, the focus on the liability side will be minimised,” Kessler comments.

The longevity threat is still rife as medical advances and disease monitoring are progressing at an alarming rate. Pension plans and sponsors will have to remain fully alert to this and adapt their longevity risk planning accordingly if they are to avoid an ongoing surge in their liabilities.

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