Two sides of the longevity balance sheet
For Peter Drucker, writing in the Harvard Business Review in 1997, demographics were “the future that has already happened”.
And the demographic balance sheet is firmly stacked against today’s mature DB pension funds. For every 12-month increase in life expectancy, an estimated 3-5% is added to DB pension fund liabilities, adding €500bn to the total liabilities of OECD countries.
Adding to the drag, mature DB pension funds in western Europe need to match their assets in the debt of the same over-indebted, ageing economies in which they are located.
Many financial directors and pension trustee boards would like to move swiftly along the “path to settlement”, as the jargon of consultants puts it – to insure their liabilities in part or in whole.
Financial innovation has provided some options to pension funds that wish to prudently hedge their longevity risk, for instance through longevity swaps. So far this has been limited to large UK schemes, with little further innovation in longevity risk transfer. There has certainly been discussion around tradable longevity indices, which would enable smaller pension funds to hedge longevity risk. But, despite the LifeMetrics project of JP Morgan, these have not come about.
Some commentators believe sovereign issuance of longevity bonds would add a new dimension both to the capital markets and to the toolkit of pension funds seeking ways to hedge longevity. In theory, these bonds would issue a coupon based on longevity trends in the issuing country. It is fair to recall that inflation linkers once also seemed far fetched but, longevity bonds still remain firmly in the realm of the fanciful.
So far, the bulk of the action in longevity risk transfer has been in traditional insurance. In the Netherlands, regulatory demands and the quest for scale mean that a steady stream of pension assets have been moving the way of pension insurance companies. And in the UK a new generation of specialist insurers has emerged alongside the established players Legal & General and Prudential.
Aside from full buyouts, annuities are still the staple tool for pension funds wishing to transfer longevity risk, with the bulk annuity market providing a useful outlet for UK funds wishing to settle part of their liabilities.
In the meantime, Britain is moving to a two-tier pension fund market. At the moment the bulk of assets are managed by closed DB schemes and although it is a reasonable expectation that these assets will slowly transfer to the insurance sector, low-risk investment strategies will predominate wherever they are managed.
However, consultants estimate that DC assets will soon outstrip DB in the UK, dependent on a few crucial variables such as the opt-out rate in auto-enrolment, of course. All things being equal, this inflexion point could take place this decade. These funds will be able to take advantage of the other side of the demographic balance sheet.
Elsewhere in his writings, Drucker noted that Japan excelled in robotics because the country correctly predicted the end of the baby boom and the shortage of blue-collar labour, and innovated ahead to take account of these changes.
Global population growth will bring with it many challenges, but a growing DC fund with a young membership should be able to diversify and capture the investment potential of innovative corporations, like those Japanese ones, that have the foresight to make demographics work to their advantage, and in emerging economies with favourable demographics.