Problems with Pensions - Longevity Risk
An article by New York Institute of Finance instructor Larry Morgan.
I don’t want to die. Call me crazy, but I bet that you don’t want to die, either. Although that inexorable fate awaits us all, we don’t know when.
This fact can be a source of mythology (the Roman parcae, for instance), and poetry, and religious reflection. For us in the prosaic financial world, though, it is the starting point for statistical calculations, and increasingly it prompts the realization that we not only do not know how long each of us individually will live, but we are no longer so confident how long the average person will live. More and more we see, though, that the average person will live longer than in past periods and probably longer than anybody thinks. I’ve seen a guess that the first person to live 150 years has already been born. This leads to the problem of “longevity risk”.
“Longevity risk” is simply the likelihood that one will outlive one’s financial resources, or that a pensioner will outlive what the pension planners have planned for.
Pension funds, insurance companies, even individual savers have “models” of how long investments will be required to support their beneficiaries. For the funds and the insurers these are sophisticated statistical, financial, and demographic calculations but individuals also have an idea how long they will have to rely on social insurance and their own savings. And that length of time has been growing pretty rapidly for decades. In the United States, life expectancy at birth was 47.3 years in 1900, 68.2 years in 1950, 76.8 years in 2000, and 78.7 years in 2010 (all races, both sexes) – that is, an increase even since 1950 of about 2 months per year. Even more striking, life expectancy at age 65 was 13.9 years in 1950 and 19.1 years in 2010 – an increase of about 1 month per year. (These figures are all from the U.S. Centers for Disease Control and Prevention). In fact, such numbers probably understate the rate of increase in longevity.
As a consequence everyone involved with making pension, insurance, or investment decisions based on how long people will live are aiming at a moving target and have to guess at the Kentucky windage to use in leading the target.
Actuaries expend a lot of effort to estimate the future increase in longevity (or, put another way, the decrease in mortality at various ages). There are several methods and substantial disagreement regarding whether medical advances will continue to extend lifetimes as they have in recent decades. But historically such projections have usually underestimated improvements in longevity. An underestimate here can imply a similarly big underestimate of a pension fund’s or insurance firm’s liabilities. This sort of thing is usually measured with reference to annuities. Suppose a 25-year old worker is entitled through a pension to a life annuity which will begin paying out when the worker becomes 65. If the pension fund or the insurance company which sells the annuity assumes this worker will live for 20 years after retirement every dollar of the annuity payment has a present value of about $1.95 (using a 5% discount rate), so this much would have to be invested. If in fact the worker will live for 25 years after retirement $2.21 would have be invested. That’s a 13.1% difference! Clearly a lot of money depends on getting the estimates right. Of course, no one will know if the estimates are right, not for years to come. Consequently, markets and regulators have devised ways to cope with this longevity risk.
It is one risk among many that is moving many pension plans toward defined-contribution (DC) status from defined-benefit (DB) status. This essentially transfers all the risk from the plan sponsor, such as the employer, to the worker-who-hopes-to-retire-some-day. In the United States regulators are studying whether and how to incorporate longevity risk into risk-based capital charges (this is already done in the United Kingdom).
Capital markets have also come up with techniques to transfer at least some of this risk from pension plans to somebody else. The most interesting of these techniques is a “longevity swap”. Like other swaps, there is a transfer of cash flows over a long period. A pension plan (which wants to eliminate or reduce its exposure to longevity risk) pays a fixed amount periodically to its swap counterparty; the amount it pays is based on a measure of mortality for its pension beneficiaries (there are some standard indexes in use, as well as some propriety indexes devised by swap dealers; or it could be the actual experience of the population that the pension fund covers). The swap counterparty will pay a variable or floating amount at specified times in the future based on the difference between actual, realized mortality rates and the rate used in deciding the fixed payments. If realized mortality is lower (or longevity is greater) that the measure used in deciding the fixed side of the swap, the pension fund has to pay out more in pension benefits than it had planned for but it also receives payments from its swap counterparty. (If realized mortality is higher than the expected mortality, the fund pays out to the swap counterparty.) The net result – theoretical result, of course – is that the pension fund has hedged its longevity risk, more-or-less fixing the mortality rate it has to deal with.
Naturally there are myriad variations on these swaps, as well as other techniques used in capital markets or as insurance products, to come to terms with longevity risk. Currently they are more common in the U.K. and in Europe than in America. Both their geographic and technical scope is likely to grow as the good news of longer life continues.
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