The cost to pension plans of longer life expectancy

Employers must contemplate strategies to tackle the risk of longer life expectancies, says Matthew Craig

If you read nothing else, read this…

  • A one-year difference between actual and expected life expectancy can increase scheme costs by just over 3%.
  • Average life expectancy can vary by five or six years between schemes.
  • Longevity swaps are becoming more affordable for schemes with prudent estimates for life expectancy.
  • Schemes should assess their own longevity experience and develop a risk strategy.

Longevity risk – the possibility that pension scheme members will live longer than expected – is an issue for defined benefit (DB) plans, but good news for the individuals concerned.

Life expectancy among pension scheme members is currently increasing at a rate of one year every 10 years, which means the longevity assumptions that underpin scheme funding can quickly become out of date. Gordon Fletcher, senior associate at Mercer, says: “All DB plans have a buffer built in to allow for improvements in life expectancy.

The question is, is the buffer enough?” Andrew Gaches, a longevity expert at Club Vita, an organisation that collects and distributes pension fund longevity data, adds: “For a £300 million scheme, if actual life expectancy is one year different to expected, the financial impact will be around £10 million. It is a big issue, even for relatively modestly-sized schemes.”

Buyout or buy-in

Given these figures, it is not surprising employers want to find ways to manage longevity risk. Until recently, the only option was to perform a bulk buyout (or a buy-in) of liabilities. With a buyout, a premium is paid to an insurance company, which takes on the responsibility for future pensions. With a buy-in, the trustees pay a premium but hold an insurance policy as an asset.

Around two years ago, there was surge of scheme buyout and buy-in activity, as several new players entered the market and competed over transactions in order to gain a critical mass. But the recession has halted this activity, with adverse market conditions raising scheme deficits and reducing the availability of capital to buyout providers.

As a result, buyout activity dried up as premiums increased sharply in relation to scheme funding.

Longevity swaps

Now longevity swaps are also possible. With a longevity swap, a pension scheme exchanges its uncertain future payments on pensions for a series of certain payments from the swap provider. “Longevity swaps have been around for a while, but pension schemes have not adopted them before,” says Fletcher. “This year has seen the first handful of deals involving pension schemes.”

It seems a new market in longevity swaps is offering some attractive terms, just as the buyout market did a couple of years ago. Martin Bird, principal and leader of Hewitt Associates’ longevity and risk solutions group, says that in some cases, the pricing of longevity swaps is based on the same assumptions employers and trustees are using already. “Schemes almost have to make a decision to keep longevity risk; it flips the decision on its head,” he says. “Speaking to a number of clients, they are happy to be leading edge, but they do not want to be bleeding edge.”

But he says this danger is now past, with plenty of deals in the pipeline which are likely to be announced in 2010.

Accurate data

Managing longevity requires up-to-date and accurate data. “Trustees need a handle on how long their members are living,” says Fletcher. “If they go to the market without that knowledge, they are going out blind.”

One option is to join Club Vita, which pools longevity data from 120 schemes with 1.5 million members. Employers can access this for an annual subscription of £10,000. However, life expectancy can vary hugely between schemes, with a difference of five to six years in average life expectancy being possible, says Gaches. Having an insight into this should help schemes and employers decide how they want to manage longevity risk and help them in any future negotiations.

It is also important for trustees and employers to be on the same page when it comes to managing longevity risk, although both groups share an interest in doing so.

Developing a longevity risk strategy is becoming just as important as an investment strategy. The aim is to help employers make decisions on managing a longevity risk, such as whether or not to offload it.

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