Longevity and PensionsProtecting company pensions against increasing longevity

Chris MadsenMartijn Tans

Table of ContentsIntroduction 1

1 Risks to the pension system 2

Estimatingfuturemortality–howlongcanweexpecttolive? 2

Oldagedependencyinpublicplans 3

Changingfaceofpensions–pensionreform 4

2 Longevity and private company pensions 6

Thesourcesofpensionplanrisk 6

Addressinguncertaintyinlongevity 7

Longevityriskandotherrisks 8

DefinedContributionplansandlongevityrisk 10

Longevity–achallengeandanopportunity 10

3 Longevity solutions for pensions 11

Pensionplansandlongevityswaps 11

Pricing–andmeasuring–longevityrisk 12

Indexswapsversusindemnityswaps 13

Controllingpensionrisk 16

4 Hedging your longevity risk: one step at a time 17

5 Conclusion 18

Additionalbibliography 19

1

IntroductionOverthepastcenturyandahalf,retirementhaschangedfrombeingaluxuryintoaperceivedright.

Over the same period of time, life expectancy has steadily increased. However, as people have

cometoenjoylongerlives,ourpensionsystemshavenotbeenadjustedaccordingly. Inparticular,

retirementagesandfundingassumptionsforpensionsdonotyetfullyreflecttheimpactoflonger-

livedpopulations.Asaresult,thethreepillarsofpensions–state-runsocialplans,company-sponsored

plansandprivateretirementsavings–arefacingunprecedentedchallenges.

Inthefirstpillar,statepensionsarebasedonthe‘pay-as-you-go’system,whichmakesthemparticularly

vulnerable.Statepensionsusetaxincomefromyoungerworkinggenerationsinordertopayolder

generations. In the second pillar, company-sponsored retirement plans have fortunately not been

allowedtobeunfunded,buttheactuarialassumptionsthatunderliethefundingrequirementsfor

DefinedBenefit(DB)planshavehistoricallytrailedactualmortalitylevels,whichmeansthatfunding

requirements have been too low. Although Defined Contribution (DC)plansare, by definition, not

subjecttofundingrequirements,pensionersstillrequirethemtobeproperlyfundedinordertobe

abletopayfortheirretirement.Aslongevityincreases,moremustbesaved.

Pension systems are presently facing several trends. First, longevity has continued to rise, which

isdesirablefromapersonalpointofviewbutputsseverestrainonourpensionsystems.Secondly,

thenumberofchildrenbeingbornperfamilyissteadilydecreasing.Thisputsadditionalpressureon

publicpay-as-you-gosystems.Today,withmorepeoplelivinglongerlivesandrelativelyfewerbeing

born, societies are faced with the challenge of looking after more people for longer with smaller

workingagepopulationstohelpsupportthem.

Thepressureonstatepensionsystemsisalreadyevidentanditisclearthatwewillseecontinuing

majorreformsinmostcountriesoverthecomingyears.Atthesametime,companiesarealsofacing

similarpressures. Inthispaper,wefocusonthe impactof increasing longevityoncompaniesand

company-sponsoredDBplans,anddiscusspossiblesolutions.

Whenconsideringlongevityrisktoaplan,someofthemostcommonlyaskedquestionsare:

• Howcanapensionfundassessthelongevityriskitisexposedto?

• Howcanapensionfundprotectitselffromlongevityrisk?

• Whatisafairpriceforprotection?

Inaddressingthesequestions,section1looksatlongevityrisksinthewiderpensionsystem;section

2 focuses on longevity risk and company pensions; section 3 takes a closer look at the available

solutions;and,insection4,weprovidesevenguidelinesonhedginglongevityrisk.

2

1 Risks to the pension system

Estimating future mortality – how long can we expect to live?Oneofthedifficultieswithpreparingforanolderpopulationisthatitisimpossibletopredictfuture

events.Yetpensionsbytheirnatureattempttoprovideanelementoffinancialsecurityforthefuture.

Inordertobeabletomakeappropriatepreparations,weneedtohavesomeideaofhowlongwecan

expectpeopletolive.Forthispurpose,fundshavehistoricallyrelieduponactuarialmortalitytables.

Thesetableshavetypicallybeenviewedasfixed–asnapshotofrealityasitwillbe.Foryears,the

tablescontainednoassumptionsforfutureimprovements,whichmeantthattheassumptionsbecame

increasinglyinaccuratewitheveryyearofadditionalimprovement.Asaresult,whendeterminingthe

fundingratioofapensionplan,planswereimplicitlylookingmoretothepastthanthefuture.

Over the past decades, life expectancy has continued to rise. Estimates vary, but life expectancy

broadlyappearstobeincreasingatarateranging(atthemoment)from1to5monthseveryyear,

dependingonagegroupandgeographicallocation(seefigure1).Whiletheimpactthatthishason

pension liabilities varies according to interest rate levels and the specific demographics of each

individualpensionplan,everyyearofadditionallifeexpectancyisgenerallythoughttoaddabout4%

tothepresentvalueofpensionobligationsforatypicalpensionfund.

Itcanbearguedthatitisnotclearwhetherthissteadyadvancewillcontinue,buttheriskisclearly

visibleandthetrendhasbeeninplaceforoveracentury.Tobetagainstthistrendistowagerthatthe

futurewillbeverydifferent.Yet,inthefaceofthissteadytrend,peoplehavecontinuouslypredicted

that the long-term trend would taper off. Instead, the trend has stubbornly persisted (and even

acceleratedrecentlyfortheolderagegroups).Althoughtherateofimprovementisuncertain,itis

highlylikelythatimprovementswillcontinue–eveniftemporarilyside-trackedbyshockstothesystem

suchasnatural catastrophes,pandemicsorwars. Inotherwords,althoughrecentadjustments in

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1966 1976 1986 1996 2006 2016 2026 years

Figure 1: Learning from our mistakes? UK historical projections for life expectancy at birth

Source:UKOfficeforNationalStatistics

3

officialactuarialassumptionsmayhavemadelongevityriskseemunpredictableandunquantifiable,

itisperhapsratherthecasethatassumptionshavehistoricallyignoredtheevidenceratherthanthat

theriskisunquantifiable.

Inadditiontothelong-termtrend,therearealsoshort-termeffectsthatcanalterthetrendsforcertain

agegroupsforadecadeortwo.Forexample,inTheNetherlands,ifsmokingweretobebannedor

weretobesodiscouragedastocauseasignificantdropinsmokinglevels,averagelifeexpectancy

frombirthcouldbeexpectedtoincreasebybetweenoneandtwoyears,whichalonewouldrequire

anincreaseofbetween4%and8%inpensionreserves.Thiswouldshowupasanaccelerationin

long-termtrendsandisperhapspartoftheincreasethattheNetherlandshasexperiencedinthepast

fewyears.1SmokingratesintheNetherlandsremainatrelativelyelevatedlevelscomparedwithother

countries,butaredecreasing.

Source:UNpublicationWorldPopulationto2300ST/ESA/SER.A/236

Figure 2: Male and female life expectancy at birth, more developed and less developed regions

1950-2300

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1950 2000 2050 2100 2150 2200 2250 2300

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Old age dependency in public plansAsthestrikesinFrancein2010demonstrated,pensionreformisseldomeasy.Nevertheless,given

thedemographicchanges,itisclearthatreformisunavoidable.Globalbirthrateshavedroppedand

peoplecontinuetolivelonger.Asfewerworkersarelefttosupportanincreasingnumberofretirees,

pressuresonthestatepensionssystem(andthewelfarestateingeneral)willincrease.

1Onthisnote,thecigarettemanufacturerPhilipMorrisannouncedin2010thepossiblelossof176jobsinitsDutchfactories,citingthedecreaseindemandforcigarettesintheNetherlands.http://nos.nl/artikel/186161-philip-morris-schrapt-banen-in-nederland.html

4

Despite recent reforms aimed at opening up the pensions market, Europeans still derive most of

theirincomeinretirementfromthegovernment–morethan80%inFranceandBelgium,andalmost

three-quarters in Germany.2 Only in the United Kingdom and the Netherlands is the figure below

50%.Comparethatwith36%intheUnitedStates,wheremostpeoplerelyonincomefromprivate

retirementsavingsandthereislesspressureonthestate.InJapan,peopleonaverageworktothe

ageof69,sixyearspasttheofficialretirementage.Asfewerworkersarelefttosupportanincreasing

numberofretirees,pressuresonthestatepensionssystem(andthewelfarestate ingeneral)will

increase.

Themost immediate impactof increased longevityand fallingbirthrateswillbeuponstates 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.

TheMelbourneMercerGlobalPensionindex,compiledannuallybyMercerandtheAustraliancentre

forFinancialStudies,rankstheFrenchpensionsysteminitspresentformeleventhoutofthirteen

countriesintermsofitssustainability.Changeswillhavetobemade–andsuchchangesareseldom

popular.

Changing face of pensions – pension reformThe largedemographic shiftsof thecomingyearsand increasing longevitywill have far-reaching

consequencesacrosssocieties.Governmentsandbusinessesarealreadyrespondingbyre-examining

long-standingsystemsandpractices,lookingtoredesignthemtomeetthechallengesofthefuture.

Signsofchangearealreadyvisible,withmanygovernmentsandcompaniesactivelystartingtolook

athowtheycanempowerandencourageanolderworkforcetocontinuetoworkproductively.

Consideringthestressestoallpillarsinthepensionsystem,itisclearthatmorereformisontheway.

Alreadyseveralcountrieshaveraisedtheirretirementageandmorewillfollow.Forexample,inthe

2SeetheOECDIncome-DistributionDatabasehttp://dx.doi.org/10.1787/888932371025

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Figure 3: World total fertility and life expectancy at birth 1995-2050

Source:UNpublicationWorldPopulationto2300ST/ESA/SER.A/236

5

UK,thestatepensionagehasbeenraisedto66fromApril2020(sixyearsearlierthantheprevious

governmenthadplanned),risingto68in2046. Inaddition, inordertoencouragepeopletowork

longer,theDefaultRetirementAgeintheUKisbeingremovedin2011,whichmeansthatemployees

willhavetherighttocontinuetoworkaslongastheywish.Germany,whichpossessesoneofthemost

rapidlyageingpopulationsinthedevelopedworld(seeFigure3),tookasomewhatdifferentapproach

withtheintroductionofthe‘sustainabilityfactor’forstatepensionsin2005.Thesustainabilityfactor

automaticallychangesthelevelofstatepensiondependingonanumberoffactors,includinglongevity

andthenumberofcontributorsinthesystem.Similarly,bothFinlandandPortugalhaveintroduced

explicitlinksbetweenthelevelofstatepensionandincreasesinlifeexpectancy.TheOECDrecently

estimatedthatpensionreformsinOECDcountriessincetheearly1990shavealreadyreducedfuture

benefitsonaverageby20%.3

Thesearejustafewexamplesofrecentpensionreforms,butitisclearthatstatesaroundtheworld

arelookingtofindwaystomaketheirpensionsystemssustainableanditisclearthatcompaniesand

theiremployeeswillbeaffectedbythesechanges.Asstatepensionscontinuetobereduced,people

willturntocompanyandprivatepensionstofillthegap.Inanageingworld,pensionsarebecoming

increasinglyimportant–andcompanies,likestates,needtotakestepstoensurethattheirpensions

aresustainable.

3OECD,PensionsataGlance2011.

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

Ratio<30% Ratio30%-39% Ratio40%-49% Ratio>50%

Sources:AEGONGlobalPensions/Eurostat

2010 2060

6

2 Longevity and private company pensions

The sources of pension plan riskThe fundamental underlying risk for any pension plan and its corporate sponsor is that the plan

shouldbeunabletomeetitsliabilities.Inthepast,themainpotentialcausesforsuchafailurehave

beenconsideredtobeafailureof investmentstrategy(equityriskforexample)oranunexpected

changeininterestratesandcreditspreadsthatwasnotsufficientlymatchedbyavaluationchangein

liabilities.Increasingly,however,longevityrisk–theriskthatthepensionplanhastoprovidebenefits

toitsmembersoveralongerperiodthanexpected–isbeingrecognisedasamajorthreattopension

plansandthecompaniesthatsponsorthem.

Asaruleofthumb,10%mortalityimprovementaddsoneyeartolifeexpectancy,andoneyearoflife

expectancyadds4%totherequiredvalueofapensionfund’sreserves.Thus,apensionfundwitha

fundedratioof100%willseeitsfundingratiodropto96%ifitfactorsinoneadditionalyearoflife

expectancy.

AccordingtotheUKOfficeforNationalStatistics,malelifeexpectancyatbirthintheUKhasincreased

from70.0in1976to77.9in2009.4Thisamountstoapproximatelyanadditional32%ofassetsthat

pensionplansneedtohaveavailableinordertocovertheirliabilitiesasaresultoftheincreaseinlife

expectancy.Ifthistrendpersists,itclearlyrepresentsasignificantchallengeforpensionfundsand

theirsponsors.

Apensionfundisexposedtothreesourcesoflongevity-relatedrisk:

• Thefirstsourceofriskcomesfromtheexpecteddeclineinfuturemortalityrates.Formorethan

acentury,mortalityrateshavedecreasedforallages,bothmaleandfemale.Therateofdecline

overanyonedecade,however,hasnotbeenstable.Itisthereforedifficulttoestimatewhatthe

declineinmortalityratesoverthenextdecadeswillbe.Developmentsinmedicalscience,changing

habits(likeconsumptionofalcoholorsmoking),obesity,newdiseases,climatechange,disastersor

warfaremayallaffectmortalityimprovement,positivelyornegatively.Thisiscalled‘trendrisk.’

• The second source of risk is related to the difference in mortality rates between the overall

population and the pension fund-specific population. The risk here is that the fund comprises

certaingroupsofthepopulationthatexperiencehigheror lowermortality(blueorwhitecollar

workers,forexample).Thisisalsocalled‘experienceassessmenterror’or‘levelrisk’.

• Thefinalsourceofriskcomesfromrandomfluctuations.Even if themortalityrateofacertain

individualisaccuratelyestimatedaccordingtothemodel,thispersonmayoutlivetheirpredicted

mortalityrange–purelyduetochance.Thisriskisinverselyrelatedtothenumberofparticipants,

but can still be material even for plans with thousands of participants – especially if benefits

areweightedtowardafewhighearners.Althoughthe impactofthisfinalsourceofriskcanbe

surprisinglylarge,itisoftencompletelydisregardedinplanriskassessments.

4Forthisandfurtherinformation,seehttp://www.statistics.gov.uk/STATBASE/Product.asp?vlnk=333.

7

Addressing uncertainty in longevityAsaresultofthesteadyincreaseinlifeexpectancy,asignificantamountofresearchhasbeencarried

outinthepastfewyearsontheimpactofincreasinglifeexpectancyonpensionfundfinancesand

howbesttomodelchangingmortalityrates.Thereisnosinglerightanswer.Somechoosetomodel

asinglepermanent‘shock’toratesandthenensurethattheirpensionplanisabletowithstandsuch

ashock.Asuitableshockforthepurposeofmodellingfuturechangesmaybeintheorderofa20

to40%instantchangeinmortalityratesdependingonplansize.Othersmaylooktodevelopment

inothercountriestogaugewhatlongevitycouldrealisticallybecomeintheforeseeablefuture.Still

othersmaychoosetofocusmoreonspecificeventssuchasacureforcancerortheeliminationof

smoking.Allhavemeritsintheirownright.

Inorder torefinethedifferentmethods listedabove,astochastic (orprobability-weighted)model

generatesthousandsofpossiblescenarios.Thisenablesthepensionplantoviewitsprofileacrossa

universeofpossibleoutcomes,weighingeach,anddeterminingwhatthemoremajorriskstothefund

mightbe.Theadvantageofsuchaprobability-basedapproachisthatthefunditselfisspecifically

anduniquelymodelled,andallsourcesofriskareproperlyaddressed.Thedisadvantageofsuchan

approachisthatitcanbedifficulttouseinmanagementcommunicationduetoitsinherentcomplexities.

Despitethiscomplexity,thestochasticmodelprovidesthebestsolutionformodellingfutureriskdue

toitsabilitytoaddressexactlythenatureofanychangethataplanmightbeexploring.

While the reasons for mortality improvement vary and short-term mortality rate volatility can

fluctuate,therateofimprovementoverthelongertermhasbeenremarkablystable(seefigure6)as

hastherelativevolatilityaroundthattrend.Infact,mortalityhasimprovedfordecades.

Figure 5: Three sources of longevity risk for pension plans

Source:AEGON

Longevity risk for the pension plan

Riskofdecreasingmortalityrates

beyondexpectedlevelsEqualforallplans

Riskofexperienceassessmenterror Morerelevantiftheplanhasamembershipfromspecificgroups

Riskofrandomfluctuationinplan

experience

Morerelevantiftheplanlacksdiversification(smallnumbersorpronouncedbenefitdistribution)

=

+

+

8

Lookingatthechartabove,youmayreasonablyask‘whythesuddenfussnow?’Ithardlyseemsa

surprisethatmortalityratescontinuetoimprove.Thefundamentalreasonsforimprovementsmay

havechangedovertime,but,viewedoverthelong-term,mortalityhasimprovedoverthepastcentury

atleastinafairlypredictablefashion.Thislog-lineartrendiswhatmostmortalityratemodelsare

basedon.

Ascanalsobeseeninfigure7,theolderagegroupshaverecentlydippedbelowthetrendline.Thisis

aconcernnotjustbecauseoftheacceleratingtrend,butalsobecauseithasamuchgreaterimpact

nowthaninthepast.Fiftyyearsago,anobligationtopayapensionatage65waslesssensitiveto

improvements(half theparticipantswouldnot livethat long).Obligationsweremuchsmallerasa

result.Now,anobligationtopayanannuitybeginningatage65isasignificantcommitment.

While mortality rates have steadily decreased for over a century, mortality improvements have

notbeenconstantovertime.Thiscanbeexplainedbydemographicfactorssuchasadecrease in

smokingratesandbetterandquickertreatmentforcardiovasculardiseases(probablyassistedbythe

developmentofthemobilephone) .5Pandemicsandextremetemperaturescanalsohavetemporary

effectsthatpersistforuptoadecadeortwo.Iftheseeffectsarecombinedinastochasticmodel(as

infigure6),differentfuturescenarioswithdifferentprobabilitiescanbeinvestigated.Eachofthese

differentscenariosmaybeworthconsideringforanygivenplan.

Longevity risk and other risksWhilemostpensionfundsrecognisetherelevanceoflongevityrisk,positioninglongevityriskwithin

apensionfundriskmanagementframeworkisnotstraightforward.Whenviewedoverthelifeofa

pensionplan,ouranalysisshowsthat longevityrisk isofasimilarmagnitudeforatypicalplanas

interestrateriskandequityrisk.

Figure 6: Dutch mortality experience – mortality rates have been largely log-linear for the past

century

Sources:CBS,AEGON

0.10%

10.00%

1.00%

Spanish flu World War II Recent accelerated mortality improvement

Smoking

1900 1920 1940 1960 1980 2000 Years

q(45-65)

q(65-80)

q(80+)

5This is one of many examples of how technology has additional, unplanned benefits. The mobile phone has helped inbringingparamedicsquicklytothesceneofacardiacarrest.Whensomeoneishavingaheartattack,thequickertheycanbeassisted,themorelikelytheyaretosurvive.Minutes–orseconds–makeadifference.

9

Manypensionfundsmeasureriskonthebasisof1-yearValueatRisk(VaR):inanextremeone-year

event,howmuchwillthefundingratiochange?Whilethisisausefulmeasuretodemonstrateshort-

termsensitivities,itisinsufficientforlong-termpensionplanplanning.

Thefollowingtablelooksatplansensitivitytointerestratesversusmortalityratesintheshort-and

long-term.

Short-term Long-term

Financialmarketrisk High Low

Longevityrisk Low High

Onashort-termbasis,theimpactoflongevityonapensionfundisnevergoingtobeextremelyhigh.

Inoneyear,ourassessmentoffuturemortalityisnotlikelytochangedramatically.Evenifveryfew

planmembershavediedinasingleyearandtheactualmortalityismuchlowerthanprojected,most

planswillnotautomaticallyassumethatfuturemortalityrateswilldropatthesamerate.Longevity

riskemergesovertime.

Overthelongerterm,however,thecomparisonisdifferent.Interestratemovementsfromoneyear

tothenexttendtohavearelativelylowcorrelation.Evenifinterestratesincreaseordeclinerapidly

inoneyear,overanumberofyears,interestratechangesaremorelikelytoevenout.Infact,interest

ratesaregenerallyconsideredtobemeanreverting.6

Longevityrisk,however,isessentiallydifferentfrominterest-rateriskandequityrisk.Thirtyyears

ago,mortalityrateswereverydifferentfromtodayand30yearsfromnowtheymaylikewisebevery

differentagain.Eventhecorrelationsovertime(serialcorrelation)aroundthetrendtendtobequite

high.Inpractice,whatthismeansisthataone-yearchangeinmortalityratesismorelikelytosignal

futurechangesthanisthecaseforinterestrates.Inthisrespect,mortalityriskisadifferentcreature

andshouldbetreatedaccordingly.

Source:AEGON

Figure 7: Past and future projected mortality rates for 75-year olds (male and female)

0%

1%

2%

3%

4%

5%

6%

7%

1990 1995

Observed mortality

2000 2005

75 Years

2010 2015 2020 Years

Female

Scenarios

Male

6Meanreversiondescribestheinabilityofinterestratestocontinuetoriseorfallindefinitely.Asaresult,theytendtoreverttoalong-termmeanvalue.

10

Defined Contribution plans and longevity risk DCpensionplansplacetheburdenofriskentirelyontheplanparticipant.Forcompanies,DCplans

looked likeagoodsolution for reducing thecorporatesponsor’spension risk (including longevity

risk).Whilethereissometruthtothisview,itignorespotentialspill-overeffectsfrominadequaciesin

thealternativesolutions.ThepensiongapintheUKwasrecentlyestimatedtobeapproximately€370

billionorashortfallof€12,000perpersonperyear.7DCcontributionshaveremainedsignificantly

andconsistentlylowerthanDBcontributions.Overthepastcoupleofdecades,westerncivilization

hasnotbeenveryadeptatsaving.

Whilemanyoftoday’sworkersmayhavebeenplanningtoretirebetweentheagesof60and65,

thetrendtoprovideDCplansinplaceofDBplanswillprobablymeanthatworkerswillhavetowork

forlonger(andsavemore).Thisinitselfisanindirectwayofincreasingtheretirementage,leaving

workerstodecideforthemselveswhentheywillretire.Thelongeryouwork,themorecomfortable

yourretirementwillbe.Companieswillneedtobepreparedforthisshiftinemployeebehaviourand

expectations.

Longevity – a challenge and an opportunity Increasinglongevitywillnotonlyaffectpensions.Althoughitisonlypossibleheretohighlightthe

mostgeneraldevelopments,itisclearthatconsiderableeffortwillalsohavetobeputintoenabling

older workers to continue to develop and be productive. In the light of the shrinking number of

youngerworkers,thecontinuedavailabilityofolder,experiencedworkersmaybeseenasapositive

development.However,itisclearthatbothemployerandemployeeattitudesandexpectationswill

need to change. Performance management, career paths, redundancy terms and remuneration

modelswillallneedtobereviewed.

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

theproductivityandparticipationrateofolderworkers.TheFinnishNationalProgrammeonAgeing

Workers (FINPAW)setout toaddress theverysame issues facingcompanies today.FINPAWpaid

particularattentiontoimprovingtheabilityofageingworkerstoperformtheirworkandattempted

topromotemorefavourableattitudestoolderworkers.Theprogrammepreparedthewayforthe

Finnish2005pensionreformthatdelayedtheageofretirementandadjustedthepensionsystemto

increasinglongevityrates.

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,suchastheUKEmployers’ForumonAge(EFA)areworkingtohelpemployersfindnew

waystoengageandemploytheirolderemployeesfor longer.Suchprogrammescanhelpprepare

companiesandemployeesforthechallengesandopportunitiesahead.8

7Aviva,ThePensionsGapacrossEurope2010.8Therecentcreationofthe‘GlobalCoalitiononAging’(www.globalcoalitiononaging.com)isanotherexampleofbusinesses

voluntarilycomingtogetherinordertohighlightandrealisemanyoftheopportunitiesthatageingpopulationswillbring.TheCoalition’saim is toapproachageingsocietiesnotasaproblembutasanopportunity forallofus to live longer,healthierandmoreproductivelives.

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3 Longevity solutions for pensions

Pension plans and longevity swapsOverthepastfewyears,longevityswapshavebeendevelopedasatooltohelppensionplans–and

theircorporatesponsors–toprotectthemselvesagainstlongevityrisk,oneofthemajorrisksthey

face.Inaddition,longevityswapsprovideanexcellentdiversifyingeffectonapensionfund’sportfolio

–particularlyformediumtolowriskportfolios.Byviewinglongevityswapsasaninvestment,plans

cannow‘duration’matchassetsandliabilities–notjustfromaninterestrateperspective,butalso

increasinglyfromalongevityriskperspective.

Inlookingatthebenefitsoflongevityswaps,akeyquestionthatisraisedsoonerorlaterrelatestothe

costoftheprotectionprovided.Incalculatinghowmuchaplanshouldbewillingtopayforalongevity

swap,somecompaniesmaybefacedwiththechallengeofreconcilingtheirpresentestimatesoffuture

costswiththepotential‘worstcase’scenarioagainstwhichthelongevityswapprovidesahedge.As

withmanyde-riskingsolutions,companiesarefacedwiththedecisionofwhethertotakeactionnow

ornot.Thedilemmafacedbycompaniesisthatwhende-riskingisaffordable,itisoftenviewedas

beinglessnecessary.Conversely,attimeswhentheappetiteforde-riskingincreases(typicallywhen

theriskmaterializes),itisalsolessaffordable.

Inthepresentenvironment,therearetwoelementsatplaythatmaybeleadingsomepensionfunds

toholdbackfromde-risking–therelativenewnessofthemarketinlongevityswapsandthecontrast

between the pension funds’ present best estimates of their liabilities and revised best estimate

liabilitiesbasedonnewinsightsintolongevitytrends.

Aswithallrisks,thereisatemptationtowaitandseehowthemarket–andmortalitytables–develop

(‘itmayneverhappen’).However,forcompanieswithDBpensionplans, inthelightofthepresent

demographictrendsandregulations,itisagoodideatoquantifythepotentialimpactoflongevity

risknow.This involves re-examininghowapensionplan’s liabilitiesarepresentlyevaluated.Once

thesecalculationshavebeenmade,itispossibletoaddressthede-riskingdilemmaandtofindthe

rightsolution.

Asnewregulatoryregimes(includingSolvencyIIforinsurers)will increasinglyrecognizelongevity

risk,itislikelythatmorecompanieswillstartactivelylookingtoprotecttheirpensionfunds.Atthe

sametime, insurancecompanieswithmortalityriskontheirbooks,createsomethingofa‘natural

counterparty’for longevityrisk.Manyhedgefundsarealso interested inassuming insurancerisk,

suchaslongevityrisk,aspartofadiversifiedportfolio.

Althoughitisimpossibletoprovideageneral‘onesizefitsall’priceforalongevityswap,ariskpremium

abovetherevisedbestestimatecashflows(whichareoftendifferentfromthepresentbestestimate

planvaluations)typicallyrangesbetween4%and7%forapensioner-basedportfolio.Formostplans,

thiscanbeseenasafixedcostincreaseinorderprovidecompleteprotectionagainstaworstcase

longevitylossofbetween10%and30%oftheplanvalue.Notonlydotheplansprotectthemselves

against thisworst-case(andpotentiallyunaffordable)risk,but,by implementinga longevityswap,

theycanalsocreateanimprovedasset-liabilitymatchedportfolio.Thisimprovedportfoliocanenable

themtore-allocatetheriskintootherassetclasses,potentiallyallowingthemtorecapturemorethan

theriskpremiumpaid.

12

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

wherethecompanywantstobe(orcanaffordtobe)ontheriskspectrum.Mostplanshaveactively

addressedtheissueofequityandinterestraterisk.Thoseplansshouldnowincludelongevityriskin

theirdeliberations.

Pricing – and measuring – longevity riskWith a longevity swap, a variable stream of cash flows is exchanged for a fixed stream of cash

flows.Whenpricingalongevityswap,bothpartiesneedtoagreeonthefixedsetofcashflows.This

representsthepriceandincludesariskpremium(figure8).

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

actualmortalityrates,whichresultsinthemunderestimatingfutureliabilities.Althoughthis‘liability

gap’needstobebridged,itshouldnotbeviewedaspartofthecostofthede-riskingsolutionitself

butratherasanecessarycostadjustmentinrecognitionofthenewbestestimateoffutureliabilities.

Totheextentthatsuchagapisobserved,itsimplyrepresentstheexpectedadjustmentsthatthenext

actuarialupdateswillreflect.

Althoughdeterministicmodelscanassistapensionfundtoreachabestestimateoftheirfuturecash

flows,theydonotprovideapictureofthemeasureofriskaroundthenumbers.Forthisreason,in

pricingalongevityswap,stochastic(orprobability-based)modelsofmortalityratesmaybeused.A

stochasticmodelenablesthebestestimatecashflowsandtherelatedlongevityrisktobecalculated,

takingintoaccountallsourcesofriskaswellasconsideringthelateststatisticaldataforthespecific

countryorregioninvolved,andincludingplan-specificmortalityexperiencewithoutbeingspecifically

constrainedtoagivenmortalitytable.

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

Source:AEGON

0

10,000

20,000

30,000

40,000

Ca

sh F

low

(in

Th

ou

san

ds)

Time (in years)

50,000

60,000

70,000

80,000

90,000

100,000

1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91

Current Cash Flow Projection

Best Estimate Cash Flows

Best Estimate + Risk Premium

13

Index swaps versus indemnity swapsTherearetwomaintypesoflongevityswaps:index-basedandindemnity-basedswaps.9Inprinciple,

index-basedswapstietheswappaymenttoaspecificcountryorsegmentmortalityindex,whilean

indemnity swap covers the actual plan experience. The two types can be compared according to

effectivenessandcost.Theeffectivenessofanindexswapdependsonthepensionplan’sperformance

relativetothechosenindex.Anindexswapintroducesanelementofbasisrisk,asthebasisofthe

plannecessarilydiffersfromthatoftheindex.Thecloserthetwoare,thebettertheindexhedge.

Indemnityswapsintroducenobasisriskastheyindemnifytheplanforactualexperience.

Whilean indexswapmayseem likeasimplesolution, it requiresacomplexstrategy tocreatean

adequatehedgeforthefund(andeventhenitwillnotprovideacompletehedge).IntheUKmarket,

whereseveraltransactionshavetakenplace,therehavebeenonlyafewexamplesofapensionplan

indexhedge.10Themarketappearstohaverecognizedthatthecurrentrisk/rewardtrade-offofan

indemnity-basedswapissuperiorformostplans.

Indemnity-basedswapsarecash-flowbased,providingfullindemnityfortheplan.Forexample,using

anindemnity-basedswap,thepensionplanwouldpaytheproviderfixedcashflowsandtheprovider

would pay the plan floating cash flows. The fixed cash flows are based on accrued benefits only.

No futureaccrualsand indexationsare included,although theycouldbecoveredby futureswaps

arrangements.Theproviderprojectsthecashflowsbasedonthecurrentparticipantsandaddsa

riskpremium. Incomparisonwithanindex-basedswap,suchanarrangement ismorecomplicated

toimplementandadminister,butprovidesgreatervalueforapensionplanthansimplerindex-based

swaps.

Thepricingof indemnity-basedtransactionsand index-basedtransactions inthemarketpresently

appeartobesimilar.Thereasonforthisisthatforafullydiversifiedpooloflives(suchasaninsurer’s

portfolio)itdoesn’tmakeasignificantdifferencehowtheriskisassumed.Ifyoulookatthemarginal

volatilitythataninsurerexperiencesfromthetransaction,itismoresimilartopopulationvolatility.

However, from the pension plan’s perspective, an indemnity swap is more valuable as it matches

existingvolatilitybetter.So,ingeneral,itismorebeneficialforapensionfundtocarryoutanindemnity

swapbecauseitcoversallrisks,includingbasisrisk,forasimilarpricetoanindex-basedswap.

9 Inthispaper,ourdiscussionfocusesonq-forwardindexswaps,wheretheindexusedisamortalityrateforaspecificagegroupataspecifictimeinthefuture.

10In2010,PallUK’spensionfundenteredintoa10-yearindexswap.

14

IndemnitySwaps IndexSwaps

Pricing Morecomplex

Involvesfund-specific

mortalityratesaswellas

conversiontocashflows

Straightforward

Onlyinvolvesassessingriskof

chosenindexmortalityrates

Hedgingstrategy Straightforward

Asingleswaphedgesall

relevantrisk

Morecomplex

Findingtherightcombinationof

indexswapsisnottrivialandwill

neverbeperfect

Effectiveness Complete

Coversalllevelsofmortality

risk

Partial

Coversnationwideriskonlyand

ignoresfund-specificrisk

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.

Source:AEGON

Without

With

Table 1: Comparison between indemnity and index swaps

Source:AEGON

Table 1 demonstrates the relative ineffectiveness of an index swap. The scatter represents the

outcomesofscenariosimulation,wherethex-axisvalueisthepresentvalueofcashflowswithout

theswapandthey-axisthepresentvalueofcashflowsoftheportfoliowiththeswap.Thescatter

showshowthedistributionalongthey-axisisnotaswideasalongthex-axis–theindexswaphashad

adampeningeffect.

15

However,itisalsoclearthatsignificantresidualbasisriskremains.11Theswapalsocomesataprice,

reflectedinthefactthatthescatterishigherthanthediagonal.Inthecaseoftheindexswap,the

two factors togetherdonotcreateagoodoutcome for the fund: forno single scenariodoes the

swapactuallycreateabetterresult.Thescatter isalwayshigherthanthediagonal.Evenifpriced

moreattractively(whichwouldcauseashiftdownwardinthescatter‘cloud’),theslopeofthescatter

makesitdifficultfortheq-forwardtocomeoutaheadinallbutafewscenarios.Thisisanexampleof

basisrisk.Intheend,althoughthebasisriskmaybemanageable,itisvitalthattheplanunderstands

thatithasassumedbasisriskbyenteringintothetrade.

Theindemnityswap,incontrast,performssignificantlybetter(figure10).Thereisnoresidualriskand

thescattersareallonastraightline.Andinthecaseofextremeevents,theindemnityswapprovides

theprotectionitwasdesignedtoprovide.Itisalsoclearthatanydownwardchangeinprice(vertical

shiftoftheline)directlymovesfurtherintoawinningoutcomefortheplan.

Finally,thepriceforthetwodifferenttypesofswapsispresentlysimilar.Whileindexswapsmaybe

thought tohave thepotential tobecomemore liquid, ifasecondarymarketwere todevelop,and

arguablyshouldtradeatalowerprice,thisisatheoreticalphenomenononly.Itisclearthatindex

swapshaveabetterchanceofdevelopingintoaliquidsecondarymarket,butcurrently,themarketfor

longevityswapsdoesnotexistandindexswapsaregenerallypricedatthesamelevelasindemnity

swaps.Inaddition,liquiditycanbeseenquitesimplyastheabilitytoexitthetransaction–andthis

possibilitycaneasilybestructuredintoanindemnityswap.

11Indexswapsalsocontainonemorerisk:re-investmentrisk.Theindexswapcoversthefactthattheindexhaschangedoveracertainperiod,butdoesnotcovertheriskofhavingtobuyanewindexswap,whichmaybemoreexpensiveduetothechangedindex.

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.

Without

With

Source:AEGON

16

Remove investment risk

Rem

ove

lon

gev

ity

risk

Longevity Swap

Protectbalancesheet

Derisking solutions

Inflation overlayInterest overlayOpen DB Plan

Buyout

Buy-in

Controlling pension riskLongevityriskisoneofseveralrisksfacedbycompanypensionsand,assuch,shouldnotbeaddressed

inisolation.Thefirststeptocontrollingpensionriskistoidentifywhichpensionrisksarepresent.

And–asdifferentcompanieswillhavedifferenttoleranceforrisk–itisimportanttoaddressallthe

risksandidentifywhichneedtoberemovedorcontrolled.Somecompaniesmaywishtoremoveall

riskinordertobeabletoconcentrateontheircorebusiness.Othersmaywishtotakesomeriskbut

toremoveinflation,interestorlongevityrisks.Inmanagingpensionrisk,companiescanchoosefrom

arangeofde-riskingtoolsincluding:

• Liability-DrivenInvestment(LDI)–LDIallowsapensionfundtomanageunwantedinterest,inflation

andotherassetrisksbybettermatchingliabilitieswithassets.

• Longevityswaps–Asdiscussedabove,longevityswapsenablepensionfundstoprotectthemselves

againsttheriskthattheiremployeeswilllivelongerthanpreviouslyestimated.Longevityswaps

allowcompaniestoreducethevolatilityoftheirpensionplans.

• Pensionbuy-ins–Buy-insare insurancepolicies thatareregardedasaseparateassetclasson

thepensionfundbalancesheet.Theycanbeimplementedbycompanieswithpensionfundsthat

arenotfullyfundedandenablecompaniestousetheiravailableresourcesinthemosteffective

fashion.Theydifferfromlongevityswapsmainlyinthefactthataformofassetriskispartofthe

transaction.

• Pensionbuy-outs–Pensionbuy-outsremoveallpensionrisksbyenablingacompanytocompletely

transfertheaccruedpensionliabilitiesofadefinedbenefitplantoanotherproviderinreturnfora

premium.Anumberofsolutionshavebeendeveloped,includingphasedbuy-outs(whereliabilities

aretransferredinagreedstages).

Byusingacombinationofthedifferentsolutionsavailable,companiescande-risktheirpensionsin

stages,bycountryorbyplan,reducingriskovertime.Althougharelativelyrecentadditiontothe

de-riskingtoolkit,longevityswapsperformanimportantfunctioninreducingvolatilityandprotecting

againstextremeevents.

Figure 11: The spectrum of de-risking solutions

Source:AEGON

17

4 Hedging your longevity risk: one step at a timeThedecisionprocessinvolvedinhedgingthelongevityriskofyourpensionfundcanbelengthy,and

involvesmanydifferentpartiesandstakeholders.Itishelpfulthereforetoknowinadvancehowto

approachthedecision-makingprocessandwhattheimplementationoflongevityswapsmayentail.

Thefollowingguidelinesaredesignedtosupportthesponsoringcompanyinimplementingasuitable

decision-makingprocess.

GUIDELINE 1: START PREPAREDAlthough longevity risk is not new, only recently has the importance of this risk become fully

understood. Before the process of de-risking is started, the main team involved in driving the

de-riskingprocesswillneedtounderstandthemechanicsoflongevityriskandtheimpactithason

thepensionplan.

GUIDELINE 2: DETERMINE YOUR OBJECTIVEHedginglongevityriskcanbepartofawiderderiskingstrategy,orafirststeptoafullbuyout,or

both.Thelongevityswapcontractneedstobeflexibleenoughtosupportanyfutureplans.Yourlong-

termstrategy,andthepartthatthelongevityhedgewillplayinit,shouldthereforebeclearbefore

youstartdiscussinghedgingoptions.

GUIDELINE 3: REVIEW DATAExperienceshows that longevity swapsarevery sensitive todataaccuracy. Implementinga swap

requiresup-to-dateandaccuratedataonyourpensionplananditsparticipants.Reviewingyourplan

datamaybeofbenefittoyourplaninanycase.

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 and

understandingofthekeystakeholders.

GUIDELINE 5: LOOK AGAIN AT THE VALUATION Beforeyourequestaquoteforalongevityswap,itisadvisabletoreviewthemortalityassumptions

underlyingyourcurrentvaluationofliabilitiesinthefund.Akeyelementinimplementinglongevity

swaps isreachingagreementonthebestestimateoffuturecashflows,which involvescomparing

respectiveviews.

GUIDELINE 6: THE LOWEST QUOTE IS NOT ALWAYS THE BESTPriceisoneofthemainpointsofnegotiationwhenagreeingonalongevityswap.However,asacontract

canlastfor50yearsormore,itisveryimportanttohaveatrustworthy,professionalcounterparty

thatcanallowfortheflexibility inthecontractthat isnecessarytomeetyourfuturegoals.So, in

additiontocomparingprices,comparingprovidersandunderlyingstructuresisanimportantpartof

theselectionprocess.

GUIDELINE 7: SPECIFY YOUR NEEDSOncethepriceisestablishedandyouhaveafoundaflexible,trustworthycounterparty,youwillneed

tocreateacontractthatsuitsyourneeds,nowandforthefuture.Dependingonyourstrategicgoals,

flexibilitymayberequiredsoastobeabletounwindthelongevityswaportransferitintoabuyout

contractatalaterdate.Exitclauses,valuationsandcollateralagreementswillallneedtobeagreed

uponbeforeacontractcanbesigned.

18

5 ConclusionPensionsystemsareunderstress.Eachpillarofthesesystems–public,companyandprivate–hasits

owncharacteristicsandchallenges,butthecurrentpressuresareone-directional.Theinabilityofany

onepillartoaddressthechallengesitfaceswillhaveanimpactontheotherpillars.Forcompanies,

therefore,itisimportanttoconsiderpublicandsocialtrendsevenastheyaddresstheirownpension

risks.

Longevitylookssettocontinuetoimproveinthesamewaythatithasfordecades.12Forthisreason,

pensionplansandtheircompanysponsorsneedtolookatprotectingthemselvesagainstlongevity

risk.Althoughlongevityriskmaybeviewedasarelativelynewphenomenon,therearenowanumber

ofde-riskingsolutionsavailable,andboththemarketandtechnologyhaveevolvedsufficientlyfor

companiesandpensionplanstobeabletoaddressthelongevityriskontheirbalancesheets.

Inaddressing longevity risk,companieswillfirstneed to revisit thebestestimatesof 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-

specificmodel.Thisexercisealonemayhelpthesponsortoidentifyapotentialliabilitygapthatneeds

tobefilled.Onlyonceacompanyorpensionplanhasagoodpictureofitsfuturepensionliabilities,

is it possible to address the costs and benefits of protecting the plan from further longevity risk

throughalongevityswap.Althoughthetrendforlongerlifeisstillheadingresolutelyupwards,there

isneverthelessuncertaintyaroundthetrend,andthepensionplanandthecompanysponsorhaveto

judgewhethertheyarewillingtopayariskpremiumofbetweenapproximately4%and7%toprotect

againstapossiblecostofbetween10%and30%oftheplanvalue.

Inorder toprotect themselves against longevity risk, companiesmayprefer to look at indemnity

hedgesratherthanindexhedges,asindexhedgesofferonlypartialprotectionandintroducebasis

risk.Inaddition,thepricingofthetwotypesofhedgesarecurrentlysimilar.Indemnityswapsprovide

betterprotectionand,althoughtheyarenottradable,theyarereversible.

Increasinglongevityisnotonlyanissueforcompanypensions.Intheend,allstakeholders(government,

companiesandindividuals)needtoaddressthechallengeofpeoplelivingforlonger.Preparationsare

alreadybeingmadetohelpkeepmorepeopleactiveandworkingforlonger,andwecanexpectto

seemanymoredevelopmentsonthisfrontoverthecomingyears.Therepercussionsofthisdramatic

successstorywillhaveanenormouseffectonoursocieties.Butthebenefitsoflongerlifealsopose

arisk,andthisiswherecompaniesneedtostarttakingactionnow.Thetimehascometolookagain

atlongevityriskandtoinvestigatehowbesttoprotectagainstit.

12Somepeopleareevensuggestingthatsciencewillenableustoextendourlifespanradicallyfurther.TheCambridge-basedSENS(StrategiesforEngineeredNegligibleSenescence)Foundationundertheleadershipof itsChiefScientificOfficer,AubreydeGreyaimstoachieve‘healthylifespanwithoutlimit.’

19

Additional bibliography

Further AEGON articles on longevity and longevity swaps

‘A Dutch Perspective on longevity swaps’:http://www.aegonglobalpensions.com/Documents/aegon-

global-pensions-com/Publications/Events/2010/2010-A-Dutch-Perspective-on-longevity-swaps-The-

indemnity-based-swap-and-other-solutions.pdf

‘Why longevity swaps should also be viewed as an investment’:http://www.aegonglobalpensions.

com/Documents/aegon-global-pensions-com/Publications/Newsletter-archive/2010-Q1/2010-Why-

longevity-swaps-should-also-be-viewed-as-an-investment.pdf

‘A Practical View on Longevity Swaps’: http://www.aegonglobalpensions.com/Documents/aegon-

global-pensions-com/Publications/Events/2009/A%20Practical%20View%20on%20Longevity%20

Swaps%20-%20Netspar%20Dec%202nd%202009.pdf

‘Longevity Modeling and Longevity Protection’: http://www.actuariaatcongres.nl/presentaties/

Sylvain%20de%20Crom.pdf

‘PP Show 2010 – Longevity swaps hedges risk while retaining asset flexibility’: http://www.

professionalpensions.com/professional-pensions/news/1898635/longevity-swaps-hedges-risk-

retaining-asset-flexibility

‘Longevity Risk – Source and Mitigation’:http://www.actuariaatcongres.nl/pdf/Artikel%20Chris%20

Madsen.pdf

‘Fresh approaches to longevity risks’: http://www.aegonglobalpensions.com/Documents/aegon-

global-pensions-com/Publications/Events/2010/2010-Presentation-Andrew-Ward-and-Chris-

Madsen.pdf

Acknowledgements

Theauthorswouldliketothankthefollowingpeoplefortheirvaluedinputandinsight:JeroenBogers;

SylvaindeCrom;UgoHofman;FransvanderHorst;ThurstanRobinson;andAndrewWood.

20

Contact details

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DisclaimerThiswhitepapercontainsgeneralinformationonlyanddoesnotconstituteasolicitationoroffer.No

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informationcontainedinthiswhitepaper.

AEGON,April2011