Schemes need a clear strategy for managing longevity risk

Increasing longevity is an important risk facing the trustees of defined benefit pension schemes. By offering a promise for life to members, they bear the risk that members live longer than expected.

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Like other risks, trustees should quantify and assess any potential impact on their ability to pay out pensions. This can help them decide whether to manage these risks and how. As schemes mature and manage their investment risks, longevity risk can become more significant.

For many years, pension trustees have been plagued by the impact of rising longevity.

Today, thanks largely to improvements in healthcare and diet, a 65-year-old male can expect to live four years longer than was the case 20 years ago, according to data from the Office for National Statistics.

From the scheme’s perspective, longer lives correspond to worse funding positions.

The problem for scheme trustees is that longevity risks are harder to quantify than other risks they face.

Areas such as genetic medicine, 3D printed organs and better management of infectious diseases promise significant improvements in lifespan. Conversely, pollution, global warming and the challenges in managing obesity have the potential to upset this rosy picture for long lives.

The problem of gauging longevity risk is most acute for smaller schemes, where individual deaths have a more material impact, or where there is a significant proportion of liabilities in respect of a small proportion of members.

While longevity rates in general have been rising, there is evidence to suggest the pace of improvements has recently slowed.

For instance, the UK’s Institute and Faculty of Actuaries estimated that as at the start of 2018, a 65-year-old male would live on average 10 months less than expected three years earlier and a 65-year-old female 12 months less.

Managing longevity risk

All of this begs the question of what, if anything, trustees should do to mitigate their longevity risk.

In recent years, a number of ways to do this have emerged. However, none of these methods come without a cost, so before any decision can be taken schemes should attempt to analyse whether the benefits of employing one is likely to outweigh the costs.

The trustees might conclude the scheme should continue to bear longevity risk. If so, one prudent approach could be to target a financial buffer, which can act to offset any rise in longevity.

If instead they choose to mitigate longevity risk, the most established approach is to transfer it to an insurance company.

In the case of a buy-in, the insurance contract becomes an asset of the scheme, whereas a buyout contract fully discharges responsibility for paying pensions to the insurer. In either case the contracts are backed by a highly capitalised insurance regime.

Longevity swaps offer a different means of transferring risk. Here a pension scheme enters into a swap with an insurance company. In this case there is no money exchanged up front. Instead, the insurer agrees to pay the scheme if longevity rates rise, while a payment is made in the other direction if they fall.

The advantage for the trustees is that the scheme retains possession of its scheme’s assets – though some collateral is typically required – allowing the scheme to continue to invest to outperform liabilities.

Historically, longevity swaps have been the preserve of larger pension schemes. Over recent years, longevity swap arrangements have become more familiar, standardised and straightforward for a pension scheme to implement.

Schemes should ensure a clear strategy for managing longevity risk, and prepare to implement that plan when appropriate, including having complete and accurate member data.

Whichever route the trustees take, longevity should remain a regular feature of the ‘risk dashboard’ that trustees review periodically.

This article first appeared in Pensions Expert

© THE FINANCIAL TIMES LTD 2018.

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