Martijn Tans, Director, Aegon Global Pensions
Longevity risk may sound like a contradiction in terms but to pension funds it is becoming a familiar part of their vocabulary. While most people are delighted at the prospect of living longer, company pension funds are looking at their increasing liabilities with some trepidation. Hence the growing market for longevity swaps. But what's the hurry? Life spans have been steadily increasing for more than a century. And just how can pension funds protect themselves against longevity risk?
Over the past decades, life expectancy has continued to rise. Estimates vary, but life expectancy broadly appears to be increasing at a rate ranging from 1-5 months every year, depending on age group and geographical location. While the impact that this has on pension liabilities varies according to interest rate levels and the specific demographics of each pension plan, as a rule of thumb, 10% mortality improvement adds one year to life expectancy, and one year of life expectancy adds 4% to the required value of a pension fund's reserves.
According to the UK Office for National Statistics, male life expectancy at birth in the UK has increased from 70 in 1976 to 77.9 in 2009. This amounts approximately to an additional 32% of assets that pension plans need to have available in order to cover their liabilities. This trend poses a significant challenge for pension funds and sponsors.
A pension fund is exposed to three sources of longevity-related risk. The first source of risk - trend risk - comes from the expected decline in future mortality rates. For more than a century, mortality rates have decreased for all ages, both male and female. The rate of decline over any one decade, however, has not been stable. It is therefore difficult to estimate what the decline in mortality rates over the next decades will be.
The second source - experience assessment error or level risk - is related to the difference in mortality rates between the overall population and the pension fund-specific population. The risk here is that the fund comprises certain groups of the population that experience higher or lower mortality.
The third source comes from random fluctuations. Even if the mortality rate of an individual is accurately estimated according to the model, this person may outlive their predicted mortality range - purely due to chance. Although the impact of this final source of risk can be surprisingly large, it is often completely disregarded in risk assessments.
While most pension funds recognise the relevance of longevity risk, positioning longevity risk within a pension fund risk management framework is not straightforward. When viewed over the life of a pension plan, our analyses show that longevity risk is of a similar magnitude for a typical plan as interest rate risk and equity risk.
Many pension funds measure risk on the basis of one-year value-at-risk: in an extreme one-year event, how much will the funding ratio change? While this is a useful measure to demonstrate short-term sensitivities, it is insufficient for long-term pension plan planning.
On a short-term basis, the impact of longevity on a pension fund is never going to be extremely high. In one year, our assessment of future mortality is not likely to change dramatically. Longevity risk emerges over time.
Thirty years ago mortality rates were very different from today, and in another 30 years they may be different again. Even the correlations over time (serial correlation) around the trend tend to be quite high. In practice, this means that a one-year change in mortality rates is more likely to signal future changes than is the case for interest rates. Longevity risk is a different creature from interest rate or equity risk and should be treated accordingly - which brings us to the question of protection.
Longevity swaps - the exchange of a variable stream of cash flows for a fixed stream of cash flows - provide protection against longevity improving more than is presently being assumed. In looking at the benefits of longevity swaps, the key question is, how much protection is bought at what price.
Although it is impossible to provide a ‘one size fits all' price for a longevity swap, a risk premium above the revised best estimate cash flows (which are often different from the present best estimate plan valuations) typically ranges between 4% and 7% for a pensioner-based portfolio. For most plans, this can be seen as a fixed cost increase to provide complete protection against a worst-case longevity loss of between 10% and 30% of the plan value.
Not only do the plans protect themselves against this worst-case (and potentially unaffordable) risk, but, by implementing a longevity swap, they can also create an improved asset-liability matched portfolio. This improved portfolio can enable them to re-allocate the risk into other asset classes, potentially allowing them to recapture more than the risk premium paid.
There are two main types of longevity swaps: index- and indemnity-based swaps. Index-based swaps tie the swap payment to a specific country or segment mortality index, while an indemnity swap covers the actual plan experience. The two types can be compared according to effectiveness and cost.
The effectiveness of an index swap depends on the pension plan's performance relative to the chosen index. An index swap introduces an element of basis risk, as the basis of the plan necessarily differs from that of the index. Indemnity swaps introduce no basis risk as they indemnify the plan for actual experience. While an index swap may seem like a simple solution, it requires a complex strategy to create an adequate hedge for the fund (and even then it will not provide a complete hedge).
The pricing of indemnity-based swaps and index-based swaps in the market presently appear to be similar. The reason for this is that for a fully diversified pool of lives (such as an insurer's portfolio) it doesn't make a significant difference how the risk is assumed. However, from the pension plan's perspective, an indemnity swap is more valuable as it matches existing volatility better. So, in general, it is more beneficial for a pension fund to carry out an indemnity swap because it covers all risks, including basis risk, for a similar price to an index-based swap.
Although, in theory, index swaps should be more liquid and trade at a lower price than indemnity swaps, currently the market for longevity swaps does not exist and prices are similar. In addition, if liquidity is seen as the ability to exit the transaction, this possibility can easily be structured into an indemnity swap. Indemnity swaps provide better protection and, although not tradable, they are reversible.
Is now the time for action? As with all risks, there is a temptation to wait and see how the market - and mortality tables - develop. However, in the light of present demographic trends and regulations, it is a good idea to quantify the potential impact of longevity risk now. This involves re-examining how liabilities are presently evaluated and the risk around those estimates. This exercise alone may help identify a potential liability gap that needs to be filled.
Once a pension plan has a good picture of its future pension liabilities, it is possible to address the costs and benefits of protecting the plan from further longevity risk. Although the trend for longer life is still improving, there is nevertheless uncertainty, and the pension plan and the company sponsor have to judge whether they are willing to pay a risk premium to protect against a possible ‘worst case' loss.
Ultimately, the decision to de-risk will depend on both plan and sponsor risk appetite. The choice is not between the two extremes of no hedge versus a full hedge. Rather, the choice is where the company wants to be (or can afford to be) on the risk spectrum. Most plans have actively addressed the issue of equity and interest rate risk. Those plans should now include longevity risk in their deliberations.