Articles - Finding a home for longevity risk

 By Steve Leake, Partner, Head of Demographic Research Team, XPS Pensions Group

  

 Base risk arises from the characteristics of a scheme’s membership not being precisely reflected in the actuarial assumptions, affecting smaller sized and immature schemes

  

 Trend risk is an uncertainty associated with predicting future improvements in life expectancy across the population, affecting all scheme sizes particularly immature schemes

  

 Idiosyncratic risk is the risk your scheme experiences lower than expected deaths purely due to randomness and small sample size, affecting smaller sized schemes or those with concentration of liabilities in a few members

  

 Measurement risk is a fourth risk which is not directly related to actual longevity but is closely connected as it relates to how predictions change over time. All schemes are impacted by measurement risk but schemes that update their assumptions triennially may see a bigger impact compared to annual updates.

  

 Bringing longevity risk into the frame

 Trustees are familiar with the concept of setting a risk budget for their scheme and looking to diversify sources of return within their investment portfolio. Is it possible for pension schemes to apply this rationale to managing longevity risk?

  

 Longevity risk is normally measured over the lifetime of a scheme, compared to other risks which are often measured over one or three years. It is therefore more difficult to draw comparisons between longevity risk and other risks such as investment, interest rate or inflation.

  

 The true cost of hedging longevity

 Longevity risk is unusual because it isn’t a rewarded risk in the traditional sense but there can often be a cost to remove it. For example, when the risk is hedged with a longevity swap a more conservative life expectancy assumption typically increases the expected benefit cashflows by between 5% and 8%. This cost means longevity risk can often be considered as being rewarded for the purpose of decision making – i.e. you don’t incur the cost if you retain the risk.

  

 However, this doesn’t in itself undermine the case for removing or hedging some or all of your longevity risk. This is the same principle as is employed in an efficient investment strategy which will seek to diversify return drivers rather than put all of the eggs in one basket. To complicate matters further, some ways of managing longevity risk do not involve cost at all. For example, some member option-based approaches implicitly reduce longevity risk whilst improving a scheme’s funding level.

  

 When using buy-in, longevity is one of several factors in the pricing. Buy-in pricing of pensioners often provides a return well above gilts, as is the case currently.

  

 Therefore, we need to break down the different sources of longevity risk in a scheme, understand the costs of removing them and weigh this up against the risk reduction this can offer.

  

 Longevity risk in context

 To build a full picture, longevity risk should be considered both in isolation and at an overall level to capture the dilution with other uncorrelated risks.

  

 Historic scenario analysis can be used to look at how a scheme’s funding level would have been affected by market factors including investment returns, interest rate and inflation. This can be compared alongside the impact longevity assumptions would have had on the funding level in each of the last 20 years.

  

 The impact of longevity is relatively more significant the lower the return target of the investment strategy. As most schemes are on a journey of de-risking, over time longevity risk will inevitably become progressively more material to overall risk.

  

 The toolkit

 There are a range of approaches that can be used to control and moderate the longevity risk a scheme is exposed to including:

 • Pension increase exchange: removes longevity risk on future pension increases
 • Flexible retirement options: members retiring early are offered flexible pensions which can often be front end loaded
 • Transfer value exercise: longevity risk is completely removed for members who transfer
 • Partial buy-in: longevity risk is removed for insured benefits
 • Longevity swap: longevity risk is removed for benefits covered by swap
 • Consolidator: longevity risk is completely removed

  

 Furthermore you can reduce the base and trend risks through using the latest approaches, such as member profiling, to better estimate your membership’s characteristics.

  

 The more we understand about a scheme’s membership, the better we can reflect how long members are living and how this may change in the future. Taken in the context of the wider strategy, then this could unlock the means to better control future funding of your scheme.