How longevity hedging can throw you off course
If longevity risk is not hedged, the implications for a pension scheme could be significant – it could lead to a delay in reaching target funding or increased deficit contributions. A longevity swap could help a scheme avoid these outcomes.
The largest remaining risk for most pension schemes: longevity
Most pension schemes have now reduced their exposures to interest rate, inflation and asset risks to such an extent that longevity is now their dominant risk (see Figure 1).
Figure 1: Longevity risk is now the dominant risk for most pension schemes1
Why hedge longevity risk?
Pension schemes will have benefited from exposure to longevity risk over the last 10 years, as cohort life expectancy at age 65 has fallen by around 16 months2.
However, with longevity risk still largely unhedged, any future increase in life expectancy would have a significant economic impact on pension schemes.
For example, it is possible that the reduction in life expectancy observed over the last decade could be more than reversed, with life expectancy increasing by two years, say, over the next decade.
An increase in life expectancy on this scale would have major implications for pension schemes, dramatically increasing the required returns on a pension scheme’s assets.
To illustrate the potential impact of such a rise in life expectancy, we will look at an example of a pension scheme that is:
- 90% funded on a buy-out basis;
- all members will become pensioners in 10 years; and
- the scheme is targeting a buy-out (at a gilts plus 0.25% discount rate) in 10 years, with no additional contributions from the sponsor.
If longevity expectations are unchanged during the next 10 years, the scheme needs to earn gilts plus 1.70% pa on its assets.
- What happens if life expectancy increases by two years, and the pension scheme does nothing?
If the pension scheme continued to target gilts plus 1.70% pa, it would be underfunded after 10 years. The scheme would be in a worse position than at the start, being only 85% funded. The deficit contribution needed would be similar in real terms to the cost of funding a full buy-out on day one.
- If the two-year increase to life expectancy happens immediately, what are the implications for the pension scheme’s investment strategy?
In this scenario, the required return for the next 10 years increases from gilts plus 1.70% pa to gilts plus 3.00% pa. This is significantly higher than before, and while potentially still achievable, the scheme may need early deficit contributions in addition to taking more investment risk. The scheme might still have a relatively good chance of achieving a buy-out in 10 years (see Figure 2).
Figure 2: Rising longevity expectations can lead the required returns of a portfolio to rise
- What if the two-year increase to life expectancy happens after five years?
This is arguably a more realistic scenario, with the change in life expectancy happening in a future year rather than immediately.
In this case, the scheme would have been earning gilts plus 1.70% pa for the first five years, but it would then need to increase this following the life expectancy change in year 5. Specifically, if the scheme still wishes to target a buy-out in year 10, then the required asset returns will need to increase significantly for the remaining five years, to gilts plus 4.60% pa (see Figure 3).
Figure 3: For pension schemes nearing their endgame, the impact of unhedged longevity risk can be dramatic
This is a much more challenging target and would require significant asset risk-taking and a fundamental review of the investment strategy. Even with significant deficit contributions the return target would be very high, meaning that the most likely outcome would be for a buy-out to be pushed back several years and significant deficit contributions being paid.
- What would have happened if the scheme implemented a longevity swap on day one?
If the scheme entered a longevity swap with an assumed risk fee equal to 6% of best estimate liability cashflows3 at the start of the 10-year period, the required return on the pension scheme’s assets for the 10 years would increase from gilts plus 1.70% pa to gilts plus 2.10% pa. This would necessitate a small change in the investment strategy, but the scheme would not be required to take materially more asset risk.
With the longevity swap in place, the scheme would be unaffected by any future changes in longevity, thereby mitigating the significant risk that could arise from a step-change in life expectancy between now and the target buy-out date (see Figure 4).
Figure 4: Hedging longevity risk can mitigate the impact of increases in life expectancy
By remaining exposed to longevity risk, a pension scheme faces the possibility that a change in longevity expectations could knock their journey plan significantly off-course – with the most likely outcome being a delay to buy-out and significant deficit contributions.
By entering into a longevity swap, a scheme can remove that risk and increases the probability that they will reach their desired endgame.
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1Source: Club Vita, April 2021 (with risk being measured at the 95th percentile level).
2Source: Continuous Mortality Investigation (“cohort” life expectancy takes account of both current mortality rates and anticipated future changes).
3For more information on how to price a longevity swap, please read our paper.
Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
Associated investment risks
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