The risk of longevity
Written by Adam Bernstein
Adam Bernstein looks at the effect of increasing longevity on pension schemes and the attempts to address this problem
Thanks to betterment in living standards, technology and radical advances in healthcare we’re all living longer. That’s the good news. The bad news is that with great expectations in pension returns yet poorer returns the financial world has to face a reality that isn’t pleasing many scheme members.
According to the UK’s Office for National Statistics, males born in the UK in 1985 had a life expectancy of 86 years. By 2013 that life expectancy had risen to 91 years and is projected to be not far off 94 years by 2035. These statistics are backed up by data from Prudential Financial. Senior vice president and head of longevity reinsurance at the company Amy Kessler says: “For UK males, the average age of death has increased by more than three years over the last decade, translating into an increase in pension liabilities of 10 per cent or more, depending upon the pension scheme.” Lifespan increases around the world are just as dramatic.
This increase in longevity combined with poor economic performance is having a huge impact on the way that pension provision is working and is causing states and employers alike a global headache. But as Kessler says, actuarial advisers are working with pension schemes to understand the magnitude of the risk as well as their risk transfer options. She says that the insurance and reinsurance community are building flexible pension risk transfer solutions that give pension schemes the choice between transferring all risks or longevity risks alone.
Kessler sees the greatest risks being in pension schemes that are still open and accruing benefits, and in pension schemes that offer generous cost of living adjustments. She says: “This is because longevity risk and inflation risk compound each other over time and therefore are the greatest in pensions for younger plan participants.”
JLT actuary and director Charles Cowling agrees and thinks the underlying problem is simple to see – “pensions are massively more expensive than they were 20 years ago”. He says that low interest rates are compounding the problem of increasing longevity.
State Street Global Advisors head of LDI UK Howard Kearns says that by definition each pension scheme is exposed to longevity risk and reckons that each one year increase in life expectancy adds circa 3 per cent to the liability value (around £300 million at a macro level). “However,” he adds, “the extent to which an individual pension scheme is affected by longevity risk depends on what, if any, longevity hedging has been done and how prudent their longevity assumptions already are. For most pension schemes the biggest longevity risk comes from their actuary updating their longevity improvement assumptions. Many smaller schemes also suffer from idiosyncratic longevity risk, for example 10 per cent of scheme liability relating to a single retired CEO.”
Cowling says the drive to find solutions and make settlements is only going to increase (as life expectancy is increasing by around two years every decade). In his eyes, individuals either have to work longer, contribute more or receive less.
Kessler believes a number of pension schemes in the UK, US and Canada are now turning to pension risk transfer where “longevity risk can be transferred through pension buyouts, buy-ins and longevity insurance or longevity swap transactions”. Kearns expands: “A number of insurers, reinsurers and banks are developing longevity hedging solutions, although they tend to be focused on larger schemes and typically do not cover active and deferred pensioners.”
Much research is being done regarding the likely level of future longevity assumptions in order to reduce the risk of under reserving.
Kessler reports that the International Monetary Fund and the Joint Forum have been studying emerging longevity markets and both have recently released papers on pension longevity risk and the regulatory considerations for the market. She adds: “The Society of Actuaries in Canada and the US have released more up to date mortality and improvement tables (as the UK has already done) and these updated tables will be used to value pension liabilities in each country.” These steps, she says, suggest that policymakers are focused on properly measuring longevity risk and ensuring there is a well regulated market for longevity risk transfer.
Cowling details the options – DB schemes being closed down to stop liabilities building up; individuals being forced into DC schemes; a move away from equities into bonds to lower risks (five years ago equities represented 70 per cent of a portfolio – now it’s nearer 50 per cent); and longevity swaps where there’s been a large increase in activity (and other buyout contracts where firms are buying insurance to hedge against risks, occasionally via derivative contracts). He’s also seen whole pension funds passed over to a third party even though it can be an expensive procedure.
This last option might be why Kearns believes that trade structures are seen as less time consuming and expensive to implement while structures aimed at the smaller pension scheme market could help growth.
Aon Hewitt head of risk settlement Martin Bird says that from an investment perspective, longevity swaps and annuity policies are much more common in the UK than in the rest of Europe primarily as they can look expensive unless a realistic longevity assumption has been made to value the pension plan.
It is Kearns belief that in the UK most pension schemes manage longevity risk by measuring their solvency based on a set of longevity assumptions that they hope will be prudent. Only a small number have so far taken steps to hedge their longevity risk. He says: “Pension increase exchange programs, under which inflation-indexed pensions are traded in for a higher pension with no increase, also go some way to control longevity risk.”
Cowling summarises some of the activity in longevity swaps. “A few years ago,” he says, “there was no trade in longevity swaps. Now the trade is around £3 billion a year.” But he thinks that with £1 tillion of liability it could take 20-30 years at the rate of £50 billion a year to remove the liabilities entirely. Can the market take that volume? Cowling thinks the market can absorb £25 billion a year but not every year (until the liability has been removed).
Kessler does see a bigger role for capital market solutions. “While pension funds will continue to gravitate toward insured indemnity solutions that cover their real members, real spouses and real benefits for the whole of life, the capital markets may emerge with some good solutions for insurers to manage their exposures through new instruments like ‘longevity cat bonds’ which have too much basis risk and too short a maturity to be truly ideal for pension funds.”
The longevity risk market is, says Bird, still globally very immature. “Obvious areas for growth are for it to become more multinational. The reinsurers backing the market are spread around the globe in the UK, continental Europe, North America and Australia – however, to date, the vast majority of risk transfer transactions involving pension funds have been in the UK. Germany, Switzerland, the Netherlands and Canada all have significant defined benefit liabilities and are potential markets for transactions.”
But could longevity risk ever present a systemic risk of failure? Kearns says that there are very few market participants who wish to take longevity risk at prices that would be palatable to pension schemes. “Consequently, the vast majority of longevity risk is passed to reinsurers who often view it as an offset to their mortality risk. There is potential for systemic risk in the event that the two risks do not offset.”
As long as the longevity risk transfer transactions are fully collateralised, Kessler thinks the potential for systemic risk in longevity risk transfer markets is mitigated. She says though: “There is, perhaps, much greater systemic risk in leaving longevity risk underestimated and unmanaged in pension funds.”
Written by Adam Bernstein, a freelance journalist