In the first part of our investigation into longevity risk, Sara Benwell explores the impact on defined benefit schemes

Will we all live to a thousand or is longevity no longer rising? On the one hand, renowned scientist Dr Aubrey De Grey has predicted that the first person who will live to 1,000 has already been born, whereas the International Longevity Centre predicts that the age of death for retirees will cluster in the early 90s.

This divergence of views can cause problems. Stephen Baxter, partner at consultancy Hymans Robertson explains: “Differing views create a challenge for trustees trying to manage this risk.”

But while most people aspire to living longer, increasing life expectancies are causing additional financial pressure for defined benefit schemes. 

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Hugh Nolan, chief actuary at JLT Employee Benefits explains: “From the DB perspective, it’s largely about the costs of paying for this.”

Jon Palin, an associate at consultancy Barnett Waddingham, explains that the financial problems that growing longevity causes are exacerbated by the low interest rate environment.

Over the past few decades the assumptions that pension schemes are making for future longevity have gone up”

He says: “Over the past few decades the assumptions that pension schemes are making for future longevity have gone up and up. That’s caused quite an increase in liabilities, and in particular because it’s happened at a time when interest rates have been falling.”

There are a number of options available for trustees to consider:

Buy-ins and buyouts Both buy-ins and buyouts can also be used to remove longevity risk for a scheme. A buyout will completely remove all liability from a sponsor, including the longevity risk, while a buy-in can help manage uncertainty and insure against members living longer than expected. Both options are often expensive and are often regarded as an end goal for pension schemes.

Pension increase exchanges and transfer incentives 

Both of these tools, which are usually used to reduce future inflation risk and manage the costs of running defined benefit scheme, can also be used to manage volatility.

Longevity swaps

These are derivative contracts that offset the risk of scheme members living longer than expected. In recent years big schemes have been cutting out the middle man (usually an insurer or bank) and creating bespoke deals where they deal with the reinsurers directly, sometimes using captive arrangements to achieve this.

The impact of de-risking

Another complication is the de-risking journey taken by most DB pension schemes. Nolan explains: “They’re reducing their exposure to the riskier investments and growth assets and focusing more on assets that are more closely aligned with their liabilities. 

Another complication is the de-risking journey”

“What that does is gear up the sensitivity to longevity because you’ve locked down your investment strategy to be aligned with your expended future payments. If you change those because you suddenly think people are going to live longer, that becomes a major source of uncertainty in your financial planning.”

Small schemes, big problems

For smaller schemes the problem is even greater. Many of the more sophisticated longevity specific hedging tools are unavailable to them because there’s less appetite from the reinsurance market. 

Peter Coyne, a pensions partner at law firm CMS Cameron McKenna, argues that this is because of data. “There are two drivers for that. One is simply that the implementation costs of these transactions is relatively high. There’s a minimum implementation cost and for the smaller schemes it just doesn’t make sense. 

“The second driver is the longevity risk…  the reinsurers aren’t interested in small schemes, simply because there is insufficient data.” 

However, Colette Christiansen, head of de-risking solutions at Punter Southall, says: “Traditionally the people who just hedged longevity in isolation were the very large schemes, but now, that’s filtering down.”

The reinsurers aren’t interested in small schemes, simply because there is insufficient data”

Even if solutions are more accessible, trustees have bigger problems. Small schemes face special challenges when it comes to evaluating longevity risk.

Nolan explains: “Even if you get the underlying assumption right about what the average man does, with only ten people to think about, they’re not going to be average.” 

He continues: “What happens if those people happen to be lucky? You’ve got to go back and keep asking for more money from an employer who thought they’d finished with a scheme years ago.”

There is also a problem of concentrated risk”

There is also a problem of concentrated risk – where a retired chief executive with a large pension lives for a long time. 

A new solution is emerging. Palin says: “If you’re a small scheme with 50 members, if your long-serving chief executive with a big pension happens to live a very long time, that scheme might choose to buy an annuity, held as an asset of the scheme but in the name of that high-pension person, and then if he lives a long time that risk is borne by the insurance company and not the pension scheme itself.”

Finding the right approach

With so many schemes underfunded, longevity is not always their primary concern. Alex Christie, vice president of global solutions and advisory at J.P. Morgan  Asset Management, says: “Many firms want a plan for getting out of their DB schemes altogether, so hedging against longevity risk is something they can consider in that context.”

Of course, argues Christiansen, longevity risk is something that all trustees will have to deal with eventually. “Most of these schemes are on a journey to buyout or even to a low-risk position at some point – so something for trustees to bear in mind is, if not now, when are they going to do it?”

With so many schemes underfunded, longevity is not always their primary concern”

For trustees who are in a position to deal with their longevity risk, Baxter advises first, to understand the risk. “It’s really important to look at the different characteristics of a pension scheme, to understand how longevity varies between different individuals and how the trends that we’re seeing in longevity might vary.”

The second is to do a cost-benefit analysis. “Think about whether or not it’s the right allocation of the money you’ve got to spend on managing risks.”