What is the right price for removing longevity risk? (From 2011)

1. PAYING THE PRICE FOR LIVING LONGER – WHAT IS THE RIGHT
PRICE FOR REMOVING LONGEVITY RISK?
Life expectancy around the world is rising and there is no sign that this trend is about to
stop anytime soon. For companies that sponsor either active or closed Defined Benefit
pension plans increased longevity requires careful attention. Longevity swaps are
increasingly seen as a solution to reduce longevity risk in pension plans. But what is the
right price for removing longevity risk?
Over the past several decades, life expectancy has continued to rise. Recent UK research indicates
that more than 2 million people presently aged over 50 in the UK will live to be older than 100 (17%
of the present population), and 33% of female babies born today can expect to live 100 years or
more.1 Estimates vary, but life expectancy now appears to be increasing at a rate of 1 to 3 months
every year. While the impact that this has on pension liabilities varies according to plan
demographics and the levels of interest rates, every year of additional life expectancy is generally
thought to add about 3-4% to the present value of pension obligations for a typical pension fund.2
Once again, it is not clear whether life expectancy will continue to rise at present rates but the risk is
clearly visible. For example, if, as a result of increasing public smoking bans, the number of smokers
were to fall, average life expectancy from birth could increase by between one and two years. This in
turn would require an increase of between 8 and 10% in pension reserves.3
Figure 1: Longevity swaps to date (source: AEGON Global Pensions)
£ 500 Mln £ 1500 Mln £ 1900 Mln £ 3000 Mln
Indemnity swap Indemnity swap for RSA by for BMW by
for Canada Life for Abbey life by Goldman Sachs & Deutsche Bank &
by JP Morgan Deutsche Bank Rothesay Life Abbey Life
£ 550 Mln £ 70 Mln
£ 475 Mln Indemnity swap £ 750 Mln
£ 100 Mln Index for PALL Pension
Indemnity swap for Babcock by for Berkshire
swap for Lucida by fund by J.P.
for Aviva by RBS Credit Suisse & Pension fund by
JP Morgan Morgan
& PartnerRe Pacific Life Re Swiss Re
July 2008 March 2009 July 2009 Feb 2010
Jan 2008 Feb 2009 May 2009 Dec 2009 Feb 2011
DB plans and longevity risk
The fundamental underlying risk for any Defined Benefit pension plan (and its corporate sponsor) is
that the plan should be unable to meet its liabilities. Longevity risk – the risk that the pension plan
has to provide benefits to its members over a longer period than expected – is increasingly being
recognised as a major threat to pension plans and the companies that sponsor them.
1
http://research.dwp.gov.uk/asd/asd1/adhoc_analysis/2010/Centenarians.pdf
2
Sources: J.P. Morgan and AEGON
3
On this note, Philip Morris announced in 2010 the possible loss of 176 jobs in its Netherlands factories, citing the
decrease in demand for cigarettes in the Netherlands. http://nos.nl/artikel/186161-philip-morris-schrapt-banen-in-
nederland.html
1 March 2011

2. Longevity swaps and the derisking dilemma
Longevity swaps can help pension plans – and their corporate sponsors – to protect themselves
from one of the major risks they face (the other major risk include asset risk, inflation risk and
interest rate risk). In addition, longevity swaps provide an excellent diversifying effect on a pension
fund’s portfolio, particularly for low risk portfolios (typical of closed Defined Benefit plans with older
members).
In calculating how much they should be willing to pay for a longevity swap, some companies may be
faced with the challenge of reconciling their present estimates of future costs with the potential ‘worst
case’ scenario against which the longevity swap provides a hedge. As with many derisking solutions,
companies are faced with the dilemma of whether to take action now or not. When derisking is
affordable, it is often viewed as being less necessary. At times when the appetite for derisking
increases (typically when the risk materialises), it is also usually less affordable.
In the present environment, there are two elements at play that may be leading some pension funds
to hold back – the contrast between the pension funds’ perceived liabilities and their actual liabilities,
and the relative newness of the market in longevity swaps. However, as new regulatory regimes
(including Solvency II) will increasingly recognise longevity risk, it is likely that more companies will
start actively looking to protect their pension funds.
Pricing longevity risk
With a longevity swap, a variable stream of cash flows is exchanged for a fixed stream. When
looking to price a longevity swap, both parties to the swap need to agree on the best estimate of
future cash flows, which includes the most accurate and up-to-date mortality statistics. At present,
many pension funds rely upon a deterministic model, based on official actuarial tables against which
to measure their liabilities. While mortality rates have been improving for decades, actuaries have
repeatedly assumed that this growth would slow. It is this assumption that is now increasingly being
revisited.
Although current deterministic models can assist a pension fund to reach a best estimate of their
future cash flows, they do not always provide a good picture of the measure of risk around the
numbers. For this reason, in pricing a longevity swap, stochastic (or probability-based) models of
mortality rates are increasingly being used. A stochastic model enables the best estimate cash flows
and the related longevity risk to be calculated, taking into account diversification at all levels, the
latest statistical data for the specific country or region involved, and pension-specific mortality
experience.
When comparing the perceived liabilities of a pension fund using a deterministic model and the
actual ‘best estimate’ liabilities using a stochastic, pension-specific model, the deterministic model is
often revealed to underestimate future liabilities. Although this ‘liability gap’ needs to be bridged, it
should not be viewed as part of the cost of the derisking solution itself but rather be seen as a cost
adjustment that is required in recognition of the new best estimate of future liabilities.
2 March 2011

3. Figure 2: Breakdown of longevity swap pricing (source: AEGON Global Pensions)
Total Pension Plan Cashflows
50.000
45.000
Current Valuation Expectation
Current Cash Flow Projection
40.000
Cash Flow (in Thousands)
35.000 Expected Cash Flows Cash Flows
Actual Best Estimate
Cash Flow
30.000 Fixed Cash Flows+ Risk Premium
Best Estimate
25.000
20.000
15.000
10.000
5.000
-
1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86
Source: AEGON Time (in years)
Once the best estimate cash flows have been quantified, the price of the longevity swap itself has to
be determined. When discussing pricing, a comparison is often made between longevity swaps and
interest rate swaps. There is, however, a key difference, as interest rate risk is a ‘tradeable’ risk and
the price of the swap is largely determined through supply and demand. In contrast to interest rate
risk, however, there is no market-based price-setting mechanism for longevity risk. Market players
therefore generate best estimate projections and add a risk premium to compensate for the risk.
Insurers – a ‘natural counterparty’
The price of a swap also depends on the counterparty involved. Although longevity risk is not a
perfect match for mortality risk, the two can offset each other to some degree. As insurance
companies are well diversified and also carry mortality risk, they are able to assume longevity risk
more efficiently than other parties. Despite the lack of a liquid market, the existence of insurance
companies with mortality risk on their books therefore creates something of a ‘natural counterparty’
for longevity risk.
Although it is impossible to provide a general price for a longevity swap, a risk premium above best
estimate cash flows typically ranges between 3% and 7% for a pensioner-based portfolio. At this
price, the pension fund protects itself for a sum it can afford against a risk it cannot afford to have.
Conclusion
As with all risks, there is a temptation with longevity risk to wait and see how the market – and
mortality tables – develop (‘it may never happen’). However, for companies with Defined Benefit
pension plans, in the light of the present demographic trends and regulations, it is a good idea to
quantify the potential impact of longevity risk on your company. Once these calculations have been
made, it is possible to address the derisking dilemma and to find the right solution at the right price.
3 March 2011

4. AEGON and derisking
AEGON Global Pensions offers a broad range derisking capabilities (including buyouts and buy-
ins, liability driven investments and longevity swaps) in the UK, continental Europe and the USA. If
you are a multinational company with pension funds in one or more countries, AEGON Global
Pensions can help you decide on the most efficient derisking route, taking into account the cultural,
legislative and accounting aspects of your local pension schemes.
To find out more about our derisking capabilities, please contact AEGON Global Pensions.
Tel: +31 (0)70 344 8931 | aegonglobalpensions@aegon.com | www.aegonglobalpensions.com
4 March 2011