Analysis: Will shifting mortality assumptions kickstart longevity hedging?
UK - Improving longevity has become an increasingly important issue for pension trustees, as while schemes can hedge inflation and interest rate risk, pensioner longevity is not an easy liability to offset.
As a result, both the Pension Protection Fund (PPF) and The Pensions Regulator (TPR) have focused over the last week on the longevity issue by introducing changes to pension scheme valuations.
While TPR has published a consultation introducing a new mortality funding "trigger" based on the "long cohort" improvement rates, just a few days earlier the PPF revealed it planned to change the mortality assumptions for scheme valuations to be based on the "medium" cohort.
In the notes to its consultation, TPR explained the difference in assumptions was because the PPF had decided to take current market experience into account and were "deliberately erring on the side of optimism".
The "long cohort" projection method is a fixed mortality projection based on the "cohort" of pensioners born, broadly speaking, between the two world wars whose longevity appears to be improving at a faster rate than those born earlier.
Short, medium and long-term projections have been developed by the actuarial profession to estimate improvements in mortality/life expectancy based on whether the increase continues into people's 80s, 90s, or beyond.
But if the two main UK pension bodies cannot agree which mortality assumptions to use, how are trustees and scheme managers meant to understand which assumptions and "cohort" is best for their scheme?
As Danny Vassiliades, principal at Punter Southall, claimed TPR's decision to use a mortality trigger for all valuations from March 2007 "could leave many schemes blighted by the impact of this guidance and potentially unable to complete valuations".
He points out valuations completed over the last year may already have an agreement between trustees and employers, but if the final documentations have not been issued many trustees will be left wondering whether they should wait to see if the mortality trigger is adopted before finalising their funding agreement.
Many consultants such as Watson Wyatt, Aon, and KPMG have criticised the proposals for potentially adding anything between £50-75bn to UK pension liabilities, but the move could apparently provide the right incentive for the development of longevity hedging tools. (See earlier IPE story: Mortality 'trigger' could increase liabilities by £75bn)
Following the continuing expansion of the pensions buyout market, since Paternoster first broke the Legal & General and Prudential duopoly in 2006, more employers are being tempted by the increasing flexibility of a full or partial buyout, while firms such as Citigroup and Pensions Corporations have gone a step further to actually buy pension schemes to make a profit.
The PPF said the changes to mortality assumptions were to bring valuations in line with the buyout market, and admitted this could mean a reduction in schemes entering the PPF as higher benefits than the existing level of compensation could be available from the buyout market.
But as not all schemes can afford buyouts. Even in an expanding market, there is an increasing need for specific tools to address longevity risk, such as longevity bonds - where the return is linked to future pension longevity. Changes to the survivor rate of 60-year old males, for example, would result in adjustments to the bond's payment rates.
Danny Wilding, partner at Barnett Waddingham, pointed out longevity is not just a UK problem, but noted schemes are starting to understand the issue is not a given and that it can't be measured with any certainty.
He said it is good to see schemes have increased buyout options, but suggests dedicated investment vehicles which deal with longevity risk will "come along soon" as it just needs someone to "kickstart" the longevity bond market, as it has already seen a couple of "failed attempts".
In the meantime, schemes will have to get to grips with the impact he PPF and TPR changes will have, not only on the financial side but also from a regulatory and reporting stance, as schemes will be expected to look at mortality on a scheme-specific basis rather than following the rest of the industry.
Steven Baxter, longevity consultant at Hymans Robertson, warned: "There is no doubt in our minds that we are living longer, but there is a great deal of uncertainty over the speed with which longevity is improving."
He added: "By imposing a trigger on improvements, TPR is at risk of giving off a dangerous message - one size fits all. All pension schemes are different so will experience different levels of longevity improvement. The danger of simply imposing a minimum is that this will become the default assumption that trustees will use without considering the demographics of their scheme. This is not what scheme-specific funding is meant to be!"
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