Longevity: Re-distributing the risks
Bernhard Brunner makes the case for government involvement to kick-start capital-market longevity-hedging instruments
People are living longer, but they are killing defined benefit (DB) pension schemes. Every time life expectancy rises by a year, another 3-5% is added to their liabilities. In OECD countries, this equates to an estimated €500bn ($652bn) of additional pension assets to maintain current funding levels.
In the scramble to mitigate such a severe risk, many OECD countries with developed DB plans are experiencing a strong shift to defined contribution (DC). But this simply moves longevity risk away from institutions to the individual. And this individual, if left with an inadequate annuity payout in retirement, will look to the state for social security top-ups and health care. Governments literally cannot afford to single-handedly carry the dragging weight that rising life expectancy is having on retirement systems.
Transferring longevity risk
One potential answer lies in sharing longevity risk by helping pension funds and annuity providers to offload it into the capital markets through longevity swaps. This could promote sustainability in the private DB pension sector, as well as help investors looking for alternative, uncorrelated asset classes.
Unlike buy-out solutions, a longevity swap allows a pension plan to keep control of all its assets. And unlike either a buyout or buy-in, it involves a pure longevity-risk transfer separate from interest rate or inflation risk. At present, the longevity-capital market is a small one.
Most over-the-counter (OTC) swaps might look like capital transactions with the involvement of an investment bank, but the risk is just passed on to a reinsurer, with the bank acting as a middleman. In their current form, these will, in any case, be limited in number due to restricted insurer capacity.
Attempts to hedge risk with the markets have mostly been made directly. However, the demands of pension funds and investors in relation to maturities and the underlying population have proved too difficult to align. In addition to missing standardisation and transparency in longevity deals, this is why so few transactions – the vast majority of which have taken place in the UK – have actually been completed. An injection of liquidity is, therefore, imperative.
This is where governments can come in. By issuing standardised longevity bonds index-based on the country’s own population, governments would make prices publicly available. These would then be used as reference points for other transactions and assist the growth of a longevity derivatives market, solving the problem of transparency that is also holding the market back in current over-the-counter deals.
Encouraged by government intervention, other parties could use the bonds to hedge longevity risk. The best-placed party to do this is a reinsurer. Reinsurers provide a vital link between pension funds and annuity providers, who prefer instruments with maturities of more than 30 years, and investors who are interested in asset classes with maturities of about a third of that time period. Reinsurers could then pool and select portfolio-specific longevity risk taken from a variety of pension plans and annuity providers, and transfer it to the capital markets. Government longevity bonds would also help investment banks link highly customised swap arrangements, which have an underlying index to a very specific population, to a standard index. This would help make them more attractive to investors.
The best type of government-issued longevity bond would be a deferred version. Coupon payments from this bond would depend on the survival rate of a given population, such as a cohort aged 65 in 2013, and are deferred so that payments start when the cohort reaches a pre-determined age. This provides more longevity exposure with less capital investment. Annual bond issues set at a face value of €5-10bn with maturities of only 10-15 years could be a massive boost for the longevity market. Governments could then gradually reduce their size in the market and, once investors flow in and increase liquidity, eventually exit.
Needed: better longevity indices
Apart from solving the problems of liquidity and transparency, government-issued longevity bonds could also help remove two other obstacles – standardisation and education.
Outside the UK, most of the rest of the DB market uses standard mortality tables that still largely ignore the positive trend in life expectancy. This puts them at a large variance when they look to hedge longevity risk because investment banks will have more realistic trends built into their calculations. As a result, hedging can look extremely expensive from a pension-plan perspective.
If government longevity bonds were to exist, then there would be an accurate national longevity index that pension plans would be able to use, bringing valuations between parties closer. The growing liquid market and the subsequent raised awareness of longevity hedging would take care of the education side of things.
One difficulty exists in a lack of uniform accounting rules. In Germany, for example, local regulations make longevity hedges unattractive for German insurance companies. Tackling this is necessary in order to ensure the creation of a truly global longevity market.
Attempts to issue longevity bonds have been made in the past. In Chile, an effort by the World Bank Group and local regulators to issue bonds in 2008 and 2009 were thwarted by reservations held by domestic insurance companies. Interest has also been shown in countries such as Canada, Israel and Mexico, The appetite is there.
Sceptics might recall that a similar situation existed with inflation hedging until governments began offering inflation-linked bonds, which was the starting point for inflation as a tradable instrument. Taking on more longevity risk may sound like a perverse course of action. But a brave government could be well-rewarded for its courage, both by the risk premium earned from issuing longevity bonds and by taking some of that risk off their shoulders in the longer term.
Bernhard Brunner, head of hedging and derivative strategies at Allianz Global Investors’ Risklab