The cost of any promise to provide someone with an annual pension for life depends on how long that person lives. Improvements in mortality have meant that people are living far longer than was anticipated. In the past 40 years, life expectancy at age 65 has increased on average by one year per decade.
This will continue. It is estimated that in Europe life expectancy for both sexes will increase from 74.2 years to 80.5 years by 2050.
Longevity risk - the risk that people will live longer than expected - is now arguably a bigger risk to occupational pension funds than investment risk.
There are two ways that governments can mitigate longevity risk for their own pension systems. They can raise the retirement age or they can adjust the pension system to take account of improved mortality rates.
Some European countries, such as Finland, plan to raise the retirement age as part of their pension reforms. Others, such as Switzerland, are adjusting the actual mechanism of their second pillar pension systems.
Employers who sponsor defined benefit pension schemes have similar options. They can raise the retirement age, reduce the rate of future accruals, or even switch from a defined benefit (DB) to a defined contribution (DC) type of scheme to reduce their exposure to longevity risk.
Pension fund managers say that longevity risk is the one risk they cannot hedge. But perhaps governments could help by issuing longevity-indexed bonds. Or maybe the asset management industry could do more to develop longevity-matching products?
We wanted your views and they are evenly divided. Only a small majority of the pension fund managers, administrators and trustees who responded to our survey agree that longevity risk poses a greater threat than investment risk to DB pension schemes in Europe.
One manager suggests that “increasing life expectancy at age 65 of one year per decade should be more predictable and less volatile than investment return”.
Yet a clear majority, three in four managers, agree corporate sponsors of pension funds have underestimated the impact of longevity risk. One manager argues that the impact has been “compounded by more early than late retirement”.
Some managers think that it is not only sponsors that have underestimated the impact of longevity risk. Actuaries, trustees, and governments are also to blame.
A substantial majority - four in five - thinks that longevity risk will encourage companies that sponsor DB pension schemes to switch to DC schemes. Most, however, add that this is only one of a number of reasons for the switch. As one UK manager observes: “It shouldn’t be the only reason.”
Some suggest that longevity risk could threaten the entire occupational pension systems of developed countries such as the UK. There is some scepticism about this suggestion, with only two in five managers agreeing. The manager of a Swiss pension fund says that the threat exists “only if adequate measures are not taken”.
What should pension funds do to protect against longevity risk. Seven in eight managers say they should invest in asset classes other than long-dated bonds. One speaks for many when she says “long-dated bonds do not provide protection for young deferred pensioners whose pension payments timescales will be way beyond what bonds can provide. Also the return on bonds at present is poor; paying pensions is not about whether you have enough in bonds, but whether you have enough assets overall.”
Managers suggest a wide range of alternatives to long-dated bonds, including emerging market equities, private equity, project finance, and mortgage-backed securities. A Danish manager points to “asset classes with the highest expected returns, eg emerging market equities and debt”.
Ultra-long-dated bonds are dismissed as ineffective. “The one attempt to issue a 50-year longevity bond was not successful as the time period is just too long for prognostication, and it therefore came with a price that funds and their advisers found too high,” a UK manager observes.
A Swedish fund manager points out that “in an environment of low interest rates the security in bonds is overrated. Equity and hedge funds should do the trick”.
A Hungarian pension fund manager comes up with the brightest idea, however. “Real estate linked to long-term care provision is the perfect match,” he suggests.
Yet the manager of a Swiss pension fund argues that matching asset classes with longevity risk misses the point. “Longevity risk is easily foreseeable. It is not volatile like the return of most asset classes. It just represents an additional cost, equivalent to 0.5% extra return, to be embedded in the total pension expense.”
Opinion is evenly divided on whether governments should create an asset class of longevity-indexed bonds to enable pension funds to manage their exposure to longevity risk. A Swiss manager asks: “Why not?” And the manager of a Nordic fund says: “This could be part of the solution.”
However, a UK manager suggests issuing longevity-indexed bonds is dealing with “symptoms rather than causes”, while the manager of a Belgian fund objects that if governments issue longevity-indexed bonds “society will have to pay for the risk”.
The state is a natural provider of annuities, the manager of an Irish pension fund argues. “The state should provide annuities rather than longevity bonds.”
Most managers - four out of five - think it is the business of the asset management industry, rather than governments, to provide pension funds with instruments to protect them against longevity risk.
Whether it is, in practice, possible for investment managers to hedge effectively against longevity risk is a moot point. Some believe that instruments like interest rate swaps can square the circle. Others feel that investment managers have yet to find a solution.
For governments, raising the set retirement age is one solution to longevity risk. Three in four managers support this tactic.
A Swiss pension fund manager points out that later retirement will also be necessary “because within a few years Europe will lack manpower and will need to employ older workers”.
Yet there are caveats. The manager of a Swedish scheme says that later retirement should be optional rather than obligatory.
It may be preferable to adjust pension systems actuarially to take account of increased longevity. Opinion is divided here. A Nordic manager suggests: “For younger people this will be the best solution.” However, a UK manager disagrees: “Reducing the amount of money the pensioner gets will increase other related costs. There needs to be better education of why retirement ages need to rise or substantial increases in saving levels would be needed to support current retirement ages.”
A Belgian manager points out that the option is simply the other side of the same coin: “A higher pension with increased pension age, or lower pension with same pension age.”
Can governments be certain enough about future improvements in mortality for them to be able to match the improvements by raising the retirement age? Three in four managers think they can. “The impact of most improvements is an evolutionary process that enables the raising of the retirement age to be planned,” the manager of a UK scheme argues.
Another UK manager is more emphatic. “There can be no argument that people are living longer and fitter/healthier lives than 10, 20 or 30 years ago, ie when retirement ages were, if anything, a bit higher than today. Something needs to be done and done sooner rather than later.”
There is some cynicism about the ability of actuaries to forecast improvements in mortality. “Considering it is supposed to be the key to the actuarial profession’s skills, they seem to be inept at doing it and only tell us about improvements after they have happened,” one manager says.
The manager of a French fund points out that in the US the rate of longevity increase has slowed, “so we cannot be sure of the pace of longevity increase for future”.
The problem of increasing longevity could resolve itself if future generations take less care of their health than earlier generations. That is the view of one manager. “My personal theory is that currently increasing longevity is down to the ‘healthy generation’ born in or near World War II,” he says. “Current patterns of eating and lazing about will be reflected in earlier mortality in due course.”
In future, perhaps, longevity risk will be cancelled out by obesity risk.