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Longevity and Pensions: Protecting Company Pensions Against Longevity Risk


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Longevity and pensions: protecting company pensions against longevity risk

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Longevity and Pensions: Protecting Company Pensions Against Longevity Risk

  1. 1. Longevity and PensionsProtecting companypensions againstincreasing longevityChris MadsenMartijn Tans
  2. 2. Table of ContentsIntroduction 11 Risks to the pension system 2 Estimating future mortality – how long can we expect to live? 2 Old age dependency in public plans 3 Changing face of pensions – pension reform 42 Longevity and private company pensions 6 The sources of pension plan risk 6 Addressing uncertainty in longevity 7 Longevity risk and other risks 8 Defined Contribution plans and longevity risk 10 Longevity – a challenge and an opportunity 103 Longevity solutions for pensions 11 Pension plans and longevity swaps 11 Pricing – and measuring – longevity risk 12 Index swaps versus indemnity swaps 13 Controlling pension risk 164 Hedging your longevity risk: one step at a time 175 Conclusion 18Additional bibliography 19
  3. 3. IntroductionOver the past century and a half, retirement has changed from being a luxury into a perceived right.Over the same period of time, life expectancy has steadily increased. However, as people havecome to enjoy longer lives, our pension systems have not been adjusted accordingly. In particular,retirement ages and funding assumptions for pensions do not yet fully reflect the impact of longer-lived populations. As a result, the three pillars of pensions – state-run social plans, company-sponsoredplans and private retirement savings – are facing unprecedented challenges.In the first pillar, state pensions are based on the ‘pay-as-you-go’ system, which makes them particularlyvulnerable. State pensions use tax income from younger working generations in order to pay oldergenerations. In the second pillar, company-sponsored retirement plans have fortunately not beenallowed to be unfunded, but the actuarial assumptions that underlie the funding requirements forDefined Benefit (DB) plans have historically trailed actual mortality levels, which means that fundingrequirements have been too low. Although Defined Contribution (DC) plans are, by definition, notsubject to funding requirements, pensioners still require them to be properly funded in order to beable to pay for their retirement. As longevity increases, more must be saved.Pension systems are presently facing several trends. First, longevity has continued to rise, whichis desirable from a personal point of view but puts severe strain on our pension systems. Secondly,the number of children being born per family is steadily decreasing. This puts additional pressure onpublic pay-as-you-go systems. Today, with more people living longer lives and relatively fewer beingborn, societies are faced with the challenge of looking after more people for longer with smallerworking age populations to help support them.The pressure on state pension systems is already evident and it is clear that we will see continuingmajor reforms in most countries over the coming years. At the same time, companies are also facingsimilar pressures. In this paper, we focus on the impact of increasing longevity on companies andcompany-sponsored DB plans, and discuss possible solutions.When considering longevity risk to a plan, some of the most commonly asked questions are:• How can a pension fund assess the longevity risk it is exposed to?• How can a pension fund protect itself from longevity risk?• What is a fair price for protection?In addressing these questions, section 1 looks at longevity risks in the wider pension system; section2 focuses on longevity risk and company pensions; section 3 takes a closer look at the availablesolutions; and, in section 4, we provide seven guidelines on hedging longevity risk. 1
  4. 4. 1 Risks to the pension system Estimating future mortality – how long can we expect to live? One of the difficulties with preparing for an older population is that it is impossible to predict future events. Yet pensions by their nature attempt to provide an element of financial security for the future. In order to be able to make appropriate preparations, we need to have some idea of how long we can expect people to live. For this purpose, funds have historically relied upon actuarial mortality tables. These tables have typically been viewed as fixed – a snapshot of reality as it will be. For years, the tables contained no assumptions for future improvements, which meant that the assumptions became increasingly inaccurate with every year of additional improvement. As a result, when determining the funding ratio of a pension plan, plans were implicitly looking more to the past than the future. Over the past decades, life expectancy has continued to rise. Estimates vary, but life expectancy broadly appears to be increasing at a rate ranging (at the moment) from 1 to 5 months every year, depending on age group and geographical location (see figure 1). While the impact that this has on pension liabilities varies according to interest rate levels and the specific demographics of each individual pension plan, every year of additional life expectancy is generally thought to add about 4% to the present value of pension obligations for a typical pension fund. It can be argued that it is not clear whether this steady advance will continue, but the risk is clearly visible and the trend has been in place for over a century. To bet against this trend is to wager that the future will be very different. Yet, in the face of this steady trend, people have continuously predicted that the long-term trend would taper off. Instead, the trend has stubbornly persisted (and even accelerated recently for the older age groups). Although the rate of improvement is uncertain, it is highly likely that improvements will continue – even if temporarily side-tracked by shocks to the system such as natural catastrophes, pandemics or wars. In other words, although recent adjustments in Figure 1: Learning from our mistakes? UK historical projections for life expectancy at birth 84 Actual 82 1971-based 80 1977-based Life expectancy at birth (years) 1981-based 78 1985-based 76 1989-based 74 1991-based 1992-based 72 1998-based 70 2002-based 68 2004-based 2006-based 66 1966 1976 1986 1996 2006 2016 2026 years Source: UK Office for National Statistics2
  5. 5. official actuarial assumptions may have made longevity risk seem unpredictable and unquantifiable,it is perhaps rather the case that assumptions have historically ignored the evidence rather than thatthe risk is unquantifiable.In addition to the long-term trend, there are also short-term effects that can alter the trends for certainage groups for a decade or two. For example, in The Netherlands, if smoking were to be banned orwere to be so discouraged as to cause a significant drop in smoking levels, average life expectancyfrom birth could be expected to increase by between one and two years, which alone would requirean increase of between 4% and 8% in pension reserves. This would show up as an acceleration inlong-term trends and is perhaps part of the increase that the Netherlands has experienced in the pastfew years. 1 Smoking rates in the Netherlands remain at relatively elevated levels compared with othercountries, but are decreasing. Figure 2: Male and female life expectancy at birth, more developed and less developed regions 1950-2300 110 100 90 Life expectancy at birth (years) 80 70 60 More developed regions Female Male Less developed regions 50 Female Male 40 1950 2000 2050 2100 2150 2200 2250 2300 years Source: UN publication World Population to 2300 ST/ESA/SER.A/236Old age dependency in public plansAs the strikes in France in 2010 demonstrated, pension reform is seldom easy. Nevertheless, giventhe demographic changes, it is clear that reform is unavoidable. Global birth rates have dropped andpeople continue to live longer. As fewer workers are left to support an increasing number of retirees,pressures on the state pensions system (and the welfare state in general) will increase.1 n this note, the cigarette manufacturer Philip Morris announced in 2010 the possible loss of 176 jobs in its Dutch factories, O citing the decrease in demand for cigarettes in the Netherlands. in-nederland.html 3
  6. 6. Figure 3: World total fertility and life expectancy at birth 1995-2050 2.9 76 2.8 2.7 74 2.6 72 Total fertility Life expectancy at birth 2.5 70 2.4 2002 Total Fertility Rate 2.3 2002 Life Expectancy at birth 68 2.2 66 2.1 2.0 64 1995 2005 2015 2025 2035 2045 years Source: UN publication World Population to 2300 ST/ESA/SER.A/236 Despite recent reforms aimed at opening up the pensions market, Europeans still derive most of their income in retirement from the government – more than 80% in France and Belgium, and almost three-quarters in Germany. 2 Only in the United Kingdom and the Netherlands is the figure below 50%. Compare that with 36% in the United States, where most people rely on income from private retirement savings and there is less pressure on the state. In Japan, people on average work to the age of 69, six years past the official retirement age. As fewer workers are left to support an increasing number of retirees, pressures on the state pensions system (and the welfare state in general) will increase. The most immediate impact of increased longevity and falling birth rates will be upon states that rely heavily upon ‘pay as you go’ pension systems, such as France, Poland, Hungary and others. France provides a good example of a country with an urgent need to reform its pension system. The Melbourne Mercer Global Pension index, compiled annually by Mercer and the Australian centre for Financial Studies, ranks the French pension system in its present form eleventh out of thirteen countries in terms of its sustainability. Changes will have to be made – and such changes are seldom popular. Changing face of pensions – pension reform The large demographic shifts of the coming years and increasing longevity will have far-reaching consequences across societies. Governments and businesses are already responding by re-examining long-standing systems and practices, looking to redesign them to meet the challenges of the future. Signs of change are already visible, with many governments and companies actively starting to look at how they can empower and encourage an older workforce to continue to work productively. Considering the stresses to all pillars in the pension system, it is clear that more reform is on the way. Already several countries have raised their retirement age and more will follow. For example, in the 2 See the OECD Income-Distribution Database
  7. 7. Figure 4: Old age dependency – number of people in EU receiving pensions in relation to the number of people of working age in 2010 and as projected for 2060 2010 2060 Ratio 30% Ratio 30% - 39% Ratio 40% - 49% Ratio 50% Sources: AEGON Global Pensions/EurostatUK, the state pension age has been raised to 66 from April 2020 (six years earlier than the previousgovernment had planned), rising to 68 in 2046. In addition, in order to encourage people to worklonger, the Default Retirement Age in the UK is being removed in 2011, which means that employeeswill have the right to continue to work as long as they wish. Germany, which possesses one of the mostrapidly ageing populations in the developed world (see Figure 3), took a somewhat different approachwith the introduction of the ‘sustainability factor’ for state pensions in 2005. The sustainability factorautomatically changes the level of state pension depending on a number of factors, including longevityand the number of contributors in the system. Similarly, both Finland and Portugal have introducedexplicit links between the level of state pension and increases in life expectancy. The OECD recentlyestimated that pension reforms in OECD countries since the early 1990s have already reduced futurebenefits on average by 20%. 3These are just a few examples of recent pension reforms, but it is clear that states around the worldare looking to find ways to make their pension systems sustainable and it is clear that companies andtheir employees will be affected by these changes. As state pensions continue to be reduced, peoplewill turn to company and private pensions to fill the gap. In an ageing world, pensions are becomingincreasingly important – and companies, like states, need to take steps to ensure that their pensionsare sustainable.3 OECD, Pensions at a Glance 2011. 5
  8. 8. 2 Longevity and private company pensions The sources of pension plan risk The fundamental underlying risk for any pension plan and its corporate sponsor is that the plan should be unable to meet its liabilities. In the past, the main potential causes for such a failure have been considered to be a failure of investment strategy (equity risk for example) or an unexpected change in interest rates and credit spreads that was not sufficiently matched by a valuation change in liabilities. Increasingly, however, longevity risk – the risk that the pension plan has to provide benefits to its members over a longer period than expected – is being recognised as a major threat to pension plans and the companies that sponsor them. As a rule of thumb, 10% mortality improvement adds one year to life expectancy, and one year of life expectancy adds 4% to the required value of a pension fund’s reserves. Thus, a pension fund with a funded ratio of 100% will see its funding ratio drop to 96% if it factors in one additional year of life expectancy. According to the UK Office for National Statistics, male life expectancy at birth in the UK has increased from 70.0 in 1976 to 77.9 in 2009.4 This amounts to approximately an additional 32% of assets that pension plans need to have available in order to cover their liabilities as a result of the increase in life expectancy. If this trend persists, it clearly represents a significant challenge for pension funds and their sponsors. A pension fund is exposed to three sources of longevity-related risk: • he first source of risk comes from the expected decline in future mortality rates. For more than T a century, mortality rates have decreased for all ages, both male and female. The rate of decline over any one decade, however, has not been stable. It is therefore difficult to estimate what the decline in mortality rates over the next decades will be. Developments in medical science, changing habits (like consumption of alcohol or smoking), obesity, new diseases, climate change, disasters or warfare may all affect mortality improvement, positively or negatively. This is called ‘trend risk.’ • he second source of risk is related to the difference in mortality rates between the overall T population and the pension fund-specific population. The risk here is that the fund comprises certain groups of the population that experience higher or lower mortality (blue or white collar workers, for example). This is also called ‘experience assessment error’ or ‘level risk’. • he final source of risk comes from random fluctuations. Even if the mortality rate of a certain T individual is accurately estimated according to the model, this person may outlive their predicted mortality range – purely due to chance. This risk is inversely related to the number of participants, but can still be material even for plans with thousands of participants – especially if benefits are weighted toward a few high earners. Although the impact of this final source of risk can be surprisingly large, it is often completely disregarded in plan risk assessments. 4 For this and further information, see
  9. 9. Figure 5: Three sources of longevity risk for pension plans Longevity risk for the pension plan = Risk of decreasing mortality rates Equal for all plans beyond expected levels + Risk of experience assessment error More relevant if the plan has a membership from specific groups + Risk of random fluctuation in plan More relevant if the plan lacks diversification (small numbers or experience pronounced benefit distribution) Source: AEGONAddressing uncertainty in longevityAs a result of the steady increase in life expectancy, a significant amount of research has been carriedout in the past few years on the impact of increasing life expectancy on pension fund finances andhow best to model changing mortality rates. There is no single right answer. Some choose to modela single permanent ‘shock’ to rates and then ensure that their pension plan is able to withstand sucha shock. A suitable shock for the purpose of modelling future changes may be in the order of a 20to 40% instant change in mortality rates depending on plan size. Others may look to developmentin other countries to gauge what longevity could realistically become in the foreseeable future. Stillothers may choose to focus more on specific events such as a cure for cancer or the elimination ofsmoking. All have merits in their own right.In order to refine the different methods listed above, a stochastic (or probability-weighted) modelgenerates thousands of possible scenarios. This enables the pension plan to view its profile across auniverse of possible outcomes, weighing each, and determining what the more major risks to the fundmight be. The advantage of such a probability-based approach is that the fund itself is specificallyand uniquely modelled, and all sources of risk are properly addressed. The disadvantage of such anapproach is that it can be difficult to use in management communication due to its inherent complexities.Despite this complexity, the stochastic model provides the best solution for modelling future risk dueto its ability to address exactly the nature of any change that a plan might be exploring.While the reasons for mortality improvement vary and short-term mortality rate volatility canfluctuate, the rate of improvement over the longer term has been remarkably stable (see figure 6) ashas the relative volatility around that trend. In fact, mortality has improved for decades. 7
  10. 10. Figure 6: Dutch mortality experience – mortality rates have been largely log-linear for the past century Spanish flu World War II Recent accelerated mortality improvement 10.00% 1.00% q(80+) q(65-80) Smoking q(45-65) 0.10% 1900 1920 1940 1960 1980 2000 Years Sources: CBS, AEGON Looking at the chart above, you may reasonably ask ‘why the sudden fuss now?’ It hardly seems a surprise that mortality rates continue to improve. The fundamental reasons for improvements may have changed over time, but, viewed over the long-term, mortality has improved over the past century at least in a fairly predictable fashion. This log-linear trend is what most mortality rate models are based on. As can also be seen in figure 7, the older age groups have recently dipped below the trend line. This is a concern not just because of the accelerating trend, but also because it has a much greater impact now than in the past. Fifty years ago, an obligation to pay a pension at age 65 was less sensitive to improvements (half the participants would not live that long). Obligations were much smaller as a result. Now, an obligation to pay an annuity beginning at age 65 is a significant commitment. While mortality rates have steadily decreased for over a century, mortality improvements have not been constant over time. This can be explained by demographic factors such as a decrease in smoking rates and better and quicker treatment for cardiovascular diseases (probably assisted by the development of the mobile phone) .5 Pandemics and extreme temperatures can also have temporary effects that persist for up to a decade or two. If these effects are combined in a stochastic model (as in figure 6), different future scenarios with different probabilities can be investigated. Each of these different scenarios may be worth considering for any given plan. Longevity risk and other risks While most pension funds recognise the relevance of longevity risk, positioning longevity risk within a pension fund risk management framework is not straightforward. When viewed over the life of a pension plan, our analysis shows that longevity risk is of a similar magnitude for a typical plan as interest rate risk and equity risk. 5 his is one of many examples of how technology has additional, unplanned benefits. The mobile phone has helped in T bringing paramedics quickly to the scene of a cardiac arrest. When someone is having a heart attack, the quicker they can be assisted, the more likely they are to survive. Minutes – or seconds – make a difference.8
  11. 11. Figure 7: Past and future projected mortality rates for 75-year olds (male and female) 75 Years 7% Male 6% 5% Scenarios 4% Female 3% 2% 1% 0% 1990 1995 2000 2005 2010 2015 2020 Years Observed mortality Source: AEGONMany pension funds measure risk on the basis of 1-year Value at Risk (VaR): in an extreme one-yearevent, how much will the funding ratio change? While this is a useful measure to demonstrate short-term sensitivities, it is insufficient for long-term pension plan planning.The following table looks at plan sensitivity to interest rates versus mortality rates in the short- andlong-term. Short-term Long-term Financial market risk High Low Longevity risk Low HighOn a short-term basis, the impact of longevity on a pension fund is never going to be extremely high.In one year, our assessment of future mortality is not likely to change dramatically. Even if very fewplan members have died in a single year and the actual mortality is much lower than projected, mostplans will not automatically assume that future mortality rates will drop at the same rate. Longevityrisk emerges over time.Over the longer term, however, the comparison is different. Interest rate movements from one yearto the next tend to have a relatively low correlation. Even if interest rates increase or decline rapidlyin one year, over a number of years, interest rate changes are more likely to even out. In fact, interestrates are generally considered to be mean reverting.6Longevity risk, however, is essentially different from interest-rate risk and equity risk. Thirty yearsago, mortality rates were very different from today and 30 years from now they may likewise be verydifferent again. Even the correlations over time (serial correlation) around the trend tend to be quitehigh. In practice, what this means is that a one-year change in mortality rates is more likely to signalfuture changes than is the case for interest rates. In this respect, mortality risk is a different creatureand should be treated accordingly.6 ean reversion describes the inability of interest rates to continue to rise or fall indefinitely. As a result, they tend to M revert to a long-term mean value. 9
  12. 12. Defined Contribution plans and longevity risk DC pension plans place the burden of risk entirely on the plan participant. For companies, DC plans looked like a good solution for reducing the corporate sponsor’s pension risk (including longevity risk). While there is some truth to this view, it ignores potential spill-over effects from inadequacies in the alternative solutions. The pension gap in the UK was recently estimated to be approximately €370 billion or a shortfall of €12,000 per person per year.7 DC contributions have remained significantly and consistently lower than DB contributions. Over the past couple of decades, western civilization has not been very adept at saving. While many of today’s workers may have been planning to retire between the ages of 60 and 65, the trend to provide DC plans in place of DB plans will probably mean that workers will have to work for longer (and save more). This in itself is an indirect way of increasing the retirement age, leaving workers to decide for themselves when they will retire. The longer you work, the more comfortable your retirement will be. Companies will need to be prepared for this shift in employee behaviour and expectations. Longevity – a challenge and an opportunity Increasing longevity will not only affect pensions. Although it is only possible here to highlight the most general developments, it is clear that considerable effort will also have to be put into enabling older workers to continue to develop and be productive. In the light of the shrinking number of younger workers, the continued availability of older, experienced workers may be seen as a positive development. However, it is clear that both employer and employee attitudes and expectations will need to change. Performance management, career paths, redundancy terms and remuneration models will all need to be reviewed. If we look at a national level, Finland provides a good example of how to approach an ageing population. Finland carried out some groundbreaking work in the late 1990s in order to increase the productivity and participation rate of older workers. The Finnish National Programme on Ageing Workers (FINPAW) set out to address the very same issues facing companies today. FINPAW paid particular attention to improving the ability of ageing workers to perform their work and attempted to promote more favourable attitudes to older workers. The programme prepared the way for the Finnish 2005 pension reform that delayed the age of retirement and adjusted the pension system to increasing longevity rates. As with Finland, companies need to look for new ways to make the most of an ageing workforce – stimulating and enabling more people to stay in productive employment for longer. Already organisations, such as the UK Employers’ Forum on Age (EFA) are working to help employers find new ways to engage and employ their older employees for longer. Such programmes can help prepare companies and employees for the challenges and opportunities ahead.8 7 Aviva, The Pensions Gap across Europe 2010. 8 he recent creation of the ‘Global Coalition on Aging’ ( is another example of businesses T voluntarily coming together in order to highlight and realise many of the opportunities that ageing populations will bring. The Coalition’s aim is to approach ageing societies not as a problem but as an opportunity for all of us to live longer, healthier and more productive lives.10
  13. 13. 3 Longevity solutions for pensionsPension plans and longevity swapsOver the past few years, longevity swaps have been developed as a tool to help pension plans – andtheir corporate sponsors – to protect themselves against longevity risk, one of the major risks theyface. In addition, longevity swaps provide an excellent diversifying effect on a pension fund’s portfolio– particularly for medium to low risk portfolios. By viewing longevity swaps as an investment, planscan now ‘duration’ match assets and liabilities – not just from an interest rate perspective, but alsoincreasingly from a longevity risk perspective.In looking at the benefits of longevity swaps, a key question that is raised sooner or later relates to thecost of the protection provided. In calculating how much a plan should be willing to pay for a longevityswap, some companies may be faced with the challenge of reconciling their present estimates of futurecosts with the potential ‘worst case’ scenario against which the longevity swap provides a hedge. Aswith many de-risking solutions, companies are faced with the decision of whether to take action nowor not. The dilemma faced by companies is that when de-risking is affordable, it is often viewed asbeing less necessary. Conversely, at times when the appetite for de-risking increases (typically whenthe risk materializes), it is also less affordable.In the present environment, there are two elements at play that may be leading some pension fundsto hold back from de-risking – the relative newness of the market in longevity swaps and the contrastbetween the pension funds’ present best estimates of their liabilities and revised best estimateliabilities based on new insights into longevity trends.As with all risks, there is a temptation to wait and see how the market – and mortality tables – develop(‘it may never happen’). However, for companies with DB pension plans, in the light of the presentdemographic trends and regulations, it is a good idea to quantify the potential impact of longevityrisk now. This involves re-examining how a pension plan’s liabilities are presently evaluated. Oncethese calculations have been made, it is possible to address the de-risking dilemma and to find theright solution.As new regulatory regimes (including Solvency II for insurers) will increasingly recognize longevityrisk, it is likely that more companies will start actively looking to protect their pension funds. At thesame time, insurance companies with mortality risk on their books, create something of a ‘naturalcounterparty’ for longevity risk. Many hedge funds are also interested in assuming insurance risk,such as longevity risk, as part of a diversified portfolio.Although it is impossible to provide a general ‘one size fits all’ price for a longevity swap, a risk premiumabove the revised best estimate cash flows (which are often different from the present best estimateplan valuations) typically ranges between 4% and 7% for a pensioner-based portfolio. For most plans,this can be seen as a fixed cost increase in order provide complete protection against a worst caselongevity loss of between 10% and 30% of the plan value. Not only do the plans protect themselvesagainst this worst-case (and potentially unaffordable) risk, but, by implementing a longevity swap,they can also create an improved asset-liability matched portfolio. This improved portfolio can enablethem to re-allocate the risk into other asset classes, potentially allowing them to recapture more thanthe risk premium paid. 11
  14. 14. Ultimately, the decision to de-risk will depend on both the plan’s and sponsor’s risk appetite. The choice is not between the two extremes of no hedge versus a full hedge. Rather, the choice is where the company wants to be (or can afford to be) on the risk spectrum. Most plans have actively addressed the issue of equity and interest rate risk. Those plans should now include longevity risk in their deliberations. Pricing – and measuring – longevity risk With a longevity swap, a variable stream of cash flows is exchanged for a fixed stream of cash flows. When pricing a longevity swap, both parties need to agree on the fixed set of cash flows. This represents the price and includes a risk premium (figure 8). At present, most pension funds generate mortality assumptions upon which they base their best estimate projection of future cash flows. However, these projections often trail improvements in actual mortality rates, which results in them underestimating future liabilities. Although this ‘liability gap’ needs to be bridged, it should not be viewed as part of the cost of the de-risking solution itself Figure 8: Typical plan view of pricing: current best estimate versus revised best estimate and the fixed cash flow level. Note that the fixed cash flow level may be more front-loaded in some structures 100,000 90,000 80,000 Best Estimate + Risk Premium 70,000 Cash Flow (in Thousands) Best Estimate Cash Flows 60,000 Current Cash Flow Projection 50,000 40,000 30,000 20,000 10,000 0 1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 Time (in years) Source: AEGON but rather as a necessary cost adjustment in recognition of the new best estimate of future liabilities. To the extent that such a gap is observed, it simply represents the expected adjustments that the next actuarial updates will reflect. Although deterministic models can assist a pension fund to reach a best estimate of their future cash flows, they do not provide a 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 may be used. A stochastic model enables the best estimate cash flows and the related longevity risk to be calculated, taking into account all sources of risk as well as considering the latest statistical data for the specific country or region involved, and including plan-specific mortality experience without being specifically constrained to a given mortality table.12
  15. 15. Index swaps versus indemnity swapsThere are two main types of longevity swaps: index-based and indemnity-based swaps.9 In principle,index-based swaps tie the swap payment to a specific country or segment mortality index, while anindemnity swap covers the actual plan experience. The two types can be compared according toeffectiveness and cost. The effectiveness of an index swap depends on the pension plan’s performancerelative to the chosen index. An index swap introduces an element of basis risk, as the basis of theplan necessarily differs from that of the index. The closer the two are, the better the index hedge.Indemnity swaps introduce no basis risk as they indemnify the plan for actual experience.While an index swap may seem like a simple solution, it requires a complex strategy to create anadequate hedge for the fund (and even then it will not provide a complete hedge). In the UK market,where several transactions have taken place, there have been only a few examples of a pension planindex hedge.10 The market appears to have recognized that the current risk/reward trade-off of anindemnity-based swap is superior for most plans.Indemnity-based swaps are cash-flow based, providing full indemnity for the plan. For example, usingan indemnity-based swap, the pension plan would pay the provider fixed cash flows and the providerwould pay the plan floating cash flows. The fixed cash flows are based on accrued benefits only.No future accruals and indexations are included, although they could be covered by future swapsarrangements. The provider projects the cash flows based on the current participants and adds arisk premium. In comparison with an index-based swap, such an arrangement is more complicatedto implement and administer, but provides greater value for a pension plan than simpler index-basedswaps.The pricing of indemnity-based transactions and index-based transactions in the market presentlyappear to be similar. The reason for this is that for a fully diversified pool of lives (such as an insurer’sportfolio) it doesn’t make a significant difference how the risk is assumed. If you look at the marginalvolatility that an insurer experiences from the transaction, it is more similar to population volatility.However, from the pension plan’s perspective, an indemnity swap is more valuable as it matchesexisting volatility better. So, in general, it is more beneficial for a pension fund to carry out an indemnityswap because it covers all risks, including basis risk, for a similar price to an index-based swap.9 n this paper, our discussion focuses on q-forward index swaps, where the index used is a mortality rate for a specific I age group at a specific time in the future.10 In 2010, Pall UK’s pension fund entered into a 10-year index swap. 13
  16. 16. Table 1: Comparison between indemnity and index swaps Indemnity Swaps Index Swaps Pricing More complex Straightforward Involves fund-specific Only involves assessing risk of mortality rates as well as chosen index mortality rates conversion to cash flows Hedging strategy Straightforward More complex A single swap hedges all Finding the right combination of relevant risk index swaps is not trivial and will never be perfect Effectiveness Complete Partial Covers all levels of mortality Covers nationwide risk only and risk ignores fund-specific risk Source: AEGON Table 1 demonstrates the relative ineffectiveness of an index swap. The scatter represents the outcomes of scenario simulation, where the x-axis value is the present value of cash flows without the swap and the y-axis the present value of cash flows of the portfolio with the swap. The scatter shows how the distribution along the y-axis is not as wide as along the x-axis – the index swap has had a dampening effect. Figure 9: Scatter diagram of scenarios showing the sum of cash flows with and without an index hedge in place. Even though using the hedge narrows the distribution of total cash flow, reflecting the risk-reducing effect of the hedge, there is still significant residual risk. In addition, as the hedge comes at a certain cost, there is no single scenario where the outcome with the hedge is more favourable than the outcome without a hedge, as demonstrated by the fact that all the points are above the diagonal. Even if priced more attractively (which would cause a shift downward in the scatter ‘cloud’), the slope of the scatter makes it difficult for the q-forward to come out ahead in all but a few scenarios. With Without Source: AEGON14
  17. 17. Figure 10: Scatter diagram of scenarios showing the total sum of cash flows with and without an indemnity hedge. With the indemnity hedge in place there is complete certainty over the total sum of cash flows that the fund is going to have to pay, reflected in the straight line. The hedge comes at a cost, but for the extremely negative scenarios, where the sum of cash flows is high, using the hedge results in a more favourable result for the fund. The fund has effectively locked in a sum of cash flows and bought protection against adverse scenarios.With Without Source: AEGONHowever, it is also clear that significant residual basis risk remains.11 The swap also comes at a price,reflected in the fact that the scatter is higher than the diagonal. In the case of the index swap, thetwo factors together do not create a good outcome for the fund: for no single scenario does theswap actually create a better result. The scatter is always higher than the diagonal. Even if pricedmore attractively (which would cause a shift downward in the scatter ‘cloud’), the slope of the scattermakes it difficult for the q-forward to come out ahead in all but a few scenarios. This is an example ofbasis risk. In the end, although the basis risk may be manageable, it is vital that the plan understandsthat it has assumed basis risk by entering into the trade.The indemnity swap, in contrast, performs significantly better (figure 10). There is no residual risk andthe scatters are all on a straight line. And in the case of extreme events, the indemnity swap providesthe protection it was designed to provide. It is also clear that any downward change in price (verticalshift of the line) directly moves further into a winning outcome for the plan.Finally, the price for the two different types of swaps is presently similar. While index swaps may bethought to have the potential to become more liquid, if a secondary market were to develop, andarguably should trade at a lower price, this is a theoretical phenomenon only. It is clear that indexswaps have a better chance of developing into a liquid secondary market, but currently, the market forlongevity swaps does not exist and index swaps are generally priced at the same level as indemnityswaps. In addition, liquidity can be seen quite simply as the ability to exit the transaction – and thispossibility can easily be structured into an indemnity swap.11 ndex swaps also contain one more risk: re-investment risk. The index swap covers the fact that the index has changed over I a certain period, but does not cover the risk of having to buy a new index swap, which may be more expensive due to the changed index. 15
  18. 18. Controlling pension risk Longevity risk is one of several risks faced by company pensions and, as such, should not be addressed in isolation. The first step to controlling pension risk is to identify which pension risks are present. And – as different companies will have different tolerance for risk – it is important to address all the risks and identify which need to be removed or controlled. Some companies may wish to remove all risk in order to be able to concentrate on their core business. Others may wish to take some risk but to remove inflation, interest or longevity risks. In managing pension risk, companies can choose from a range of de-risking tools including: • iability-Driven Investment (LDI) – LDI allows a pension fund to manage unwanted interest, inflation L and other asset risks by better matching liabilities with assets. • ongevity swaps – As discussed above, longevity swaps enable pension funds to protect themselves L against the risk that their employees will live longer than previously estimated. Longevity swaps allow companies to reduce the volatility of their pension plans. • ension buy-ins – Buy-ins are insurance policies that are regarded as a separate asset class on P the pension fund balance sheet. They can be implemented by companies with pension funds that are not fully funded and enable companies to use their available resources in the most effective fashion. They differ from longevity swaps mainly in the fact that a form of asset risk is part of the transaction. • ension buy-outs – Pension buy-outs remove all pension risks by enabling a company to completely P transfer the accrued pension liabilities of a defined benefit plan to another provider in return for a premium. A number of solutions have been developed, including phased buy-outs (where liabilities are transferred in agreed stages). By using a combination of the different solutions available, companies can de-risk their pensions in stages, by country or by plan, reducing risk over time. Although a relatively recent addition to the ­ de-risking toolkit, longevity swaps perform an important function in reducing volatility and protecting against extreme events. Figure 11: The spectrum of de-risking solutions Derisking solutions Protect balance Longevity Swap sheet Buyout Buy-in Remove longevity risk Inflation overlay Open DB Plan Interest overlay Remove investment risk Source: AEGON16
  19. 19. 4 Hedging your longevity risk: one step at a timeThe decision process involved in hedging the longevity risk of your pension fund can be lengthy, andinvolves many different parties and stakeholders. It is helpful therefore to know in advance how toapproach the decision-making process and what the implementation of longevity swaps may entail.The following guidelines are designed to support the sponsoring company in implementing a suitabledecision-making process.GUIDELINE 1: START PREPAREDAlthough longevity risk is not new, only recently has the importance of this risk become fullyunderstood. Before the process of de-risking is started, the main team involved in driving the de-risking process will need to understand the mechanics of longevity risk and the impact it has onthe pension plan.GUIDELINE 2: DETERMINE YOUR OBJECTIVEHedging longevity risk can be part of a wider derisking strategy, or a first step to a full buyout, orboth. The longevity swap contract needs to be flexible enough to support any future plans. Your long-term strategy, and the part that the longevity hedge will play in it, should therefore be clear beforeyou start discussing hedging options.GUIDELINE 3: REVIEW DATAExperience shows that longevity swaps are very sensitive to data accuracy. Implementing a swaprequires up-to-date and accurate data on your pension plan and its participants. Reviewing your plandata may be of benefit to your plan in any case.GUIDELINE 4: ESTABLISH INTERNAL SUPPORT FOR A LONGEVITY SWAPIn order to be able to progress with a longevity swap, it is essential to have the support andunderstanding of the key stakeholders.GUIDELINE 5: LOOK AGAIN AT THE VALUATIONBefore you request a quote for a longevity swap, it is advisable to review the mortality assumptionsunderlying your current valuation of liabilities in the fund. A key element in implementing longevityswaps is reaching agreement on the best estimate of future cash flows, which involves comparingrespective views.GUIDELINE 6: THE LOWEST QUOTE IS NOT ALWAYS THE BESTPrice is one of the main points of negotiation when agreeing on a longevity swap. However, as a contractcan last for 50 years or more, it is very important to have a trustworthy, professional counterpartythat can allow for the flexibility in the contract that is necessary to meet your future goals. So, inaddition to comparing prices, comparing providers and underlying structures is an important part ofthe selection process.GUIDELINE 7: SPECIFY YOUR NEEDSOnce the price is established and you have a found a flexible, trustworthy counterparty, you will needto create a contract that suits your needs, now and for the future. Depending on your strategic goals,flexibility may be required so as to be able to unwind the longevity swap or transfer it into a buyoutcontract at a later date. Exit clauses, valuations and collateral agreements will all need to be agreedupon before a contract can be signed. 17
  20. 20. 5 Conclusion Pension systems are under stress. Each pillar of these systems – public, company and private – has its own characteristics and challenges, but the current pressures are one-directional. The inability of any one pillar to address the challenges it faces will have an impact on the other pillars. For companies, therefore, it is important to consider public and social trends even as they address their own pension risks. Longevity looks set to continue to improve in the same way that it has for decades.12 For this reason, pension plans and their company sponsors need to look at protecting themselves against longevity risk. Although longevity risk may be viewed as a relatively new phenomenon, there are now a number of de-risking solutions available, and both the market and technology have evolved sufficiently for companies and pension plans to be able to address the longevity risk on their balance sheets. In addressing longevity risk, companies will first need to revisit the best estimates of their future pension liabilities and the risk around those estimates. This can be done through studying plan mortality development relative to underlying actuarial assumptions and using a stochastic plan- specific model. This exercise alone may help the sponsor to identify a potential liability gap that needs to be filled. Only once a company or pension plan has a good picture of its future pension liabilities, is it possible to address the costs and benefits of protecting the plan from further longevity risk through a longevity swap. Although the trend for longer life is still heading resolutely upwards, there is nevertheless uncertainty around the trend, and the pension plan and the company sponsor have to judge whether they are willing to pay a risk premium of between approximately 4% and 7% to protect against a possible cost of between 10% and 30% of the plan value. In order to protect themselves against longevity risk, companies may prefer to look at indemnity hedges rather than index hedges, as index hedges offer only partial protection and introduce basis risk. In addition, the pricing of the two types of hedges are currently similar. Indemnity swaps provide better protection and, although they are not tradable, they are reversible. Increasing longevity is not only an issue for company pensions. In the end, all stakeholders (government, companies and individuals) need to address the challenge of people living for longer. Preparations are already being made to help keep more people active and working for longer, and we can expect to see many more developments on this front over the coming years. The repercussions of this dramatic success story will have an enormous effect on our societies. But the benefits of longer life also pose a risk, and this is where companies need to start taking action now. The time has come to look again at longevity risk and to investigate how best to protect against it. 12 ome people are even suggesting that science will enable us to extend our lifespan radically further. The Cambridge-based S SENS (Strategies for Engineered Negligible Senescence) Foundation under the leadership of its Chief Scientific Officer, Aubrey de Grey aims to achieve ‘healthy lifespan without limit.’18
  21. 21. Additional bibliographyFurther AEGON articles on longevity and longevity swaps‘A Dutch Perspective on longevity swaps’:‘Why longevity swaps should also be viewed as an investment’:‘A Practical View on Longevity Swaps’:‘Longevity Modeling and Longevity Protection’:‘PP Show 2010 – Longevity swaps hedges risk while retaining asset flexibility’:‘Longevity Risk – Source and Mitigation’:‘Fresh approaches to longevity risks’: Madsen.pdfAcknowledgementsThe authors would like to thank the following people for their valued input and insight: Jeroen Bogers;Sylvain de Crom; Ugo Hofman; Frans van der Horst; Thurstan Robinson; and Andrew Wood. 19
  22. 22. Contact details AEGON Global Pensions P.O. Box 85 2501 CB, The Hague The Netherlands Telephone: +31 (0)70 344 89 31 E-mail: Website: Disclaimer This white paper contains general information only and does not constitute a solicitation or offer. No rights can be derived from this white paper. AEGON Global Pensions, its partners and any of their affiliates or employees do not guarantee, warrant or represent the accuracy or completeness of the information contained in this white paper. AEGON, April 201120