10 Pensions – The Way Ahead www.professionalpensions.com

Longevity

Consultant perspective

Although living longer is generally accepted to be a good thing, it is a cruel twist of fate that longer life expectancy could cause the death of UK defined benefit (DB) pension schemes. With over 10,000 people in the UK now having reached the age of 100, the need to manage longevity risk more effectively is being placed firmly under the spotlight.

So what is the way ahead and how is the market likely to shape up? It seems sensible to answer this in two parts: first, how do we deal with the problems we already know about; secondly, what are the implications for pension savings in the future?

Dealing with the past – to boldly go?Over the last 15 years, assumptions of life expectancy have typically increased by around 10 years, adding around 30% to existing DB scheme liabilities. Even without the recent volatility in asset values, this is a huge strain on scheme finances and is fuelling the continued focus on finding a solu-tion for managing legacy pension problems.

While the level of buy-in activity seems to have slowed (either because schemes can no longer afford the insurance premiums, because pricing is difficult, or simply due to a lack of capital), 2009 looks set to be the year of longevity only solutions. Both insurance and capital markets organisations are lining up to provide longevity swaps to pension schemes to help manage better the risk of continued improvements in life expectancy. This rapid emergence of new solutions is reminiscent of the developments in the buy-in market over the past few years, as well as the expansion of the deriva-tives market illustrated in the diagram below. It is not too much of a leap to envisage longevity swaps becoming just as important as interest rate swaps in the risk toolkit.

Longevity risk transfer is commonplace in the reinsur-ance world and there is no shortage in investors’ appetite to provide the risk capital to do so. The challenge for the UK pensions industry has been to translate this into a format suitable for pension schemes. But with the first UK pension scheme longevity swap about to be executed, we stand on the verge of an exciting new market.

The Way Ahead – It’s life (expectancy) but not as we know it…

In addition, continued innovations in modelling mortality rates (using approaches that use individual health, wealth and lifestyle factors, with address and postcode data being used as a way of accessing information on these individual characteristics) help to provide a better understanding of the factors that affect member life expectancy. Over time this will continue to develop, with actuarial and medical thinking increasingly converging; we are currently seeing the start of more advanced techniques to capture the complex interde-pendencies between causes of death.

In the future, we would expect longevity risk to become routinely priced and traded, removing the need to feel quite so glum each time a scheme member receives a birthday greeting from Her Majesty.

Looking to the future – live long and prosper?While living longer is becoming a more manageable problem for benefits already earned, there are some much tougher challenges for policy makers and sponsors of retirement saving schemes, who may well feel that living to 100 requires a rethink of the rules of the game. Those who hanker after rose-covered cottages and the golf course may recoil in horror at the thought of no longer retiring at age 65 or earlier, but can you really expect to work for only half your life? The increase in life expectancy drives the need to re-assess a few balances.

Although many companies value younger workers for their eagerness to get on, their vigour and compara-tive cheapness, there is a growing appreciation of older workers by some businesses, including a number of high street retailers who have prompted an initial move in the direction of the “grey” employment market. Until recently, retirement for most people has been a single event – albeit a very important event. This will change. A more flexible approach will enable a gentler move from fuller employ-ment to less, and a corresponding need for a more flexible approach to both workforce planning and provision of retirement savings.

The concept of risk sharing mechanisms in defined benefit schemes could help to provide a fairer balance of risk between member and sponsor (for example by linking benefits directly to life expectancy). In defined contribution arrangements, education will be required to ensure that mem-bers adjust (already inadequate?) contributions to maintain current replacement income levels in retirement, or to help plan for a more gradual transition from work to retirement.

Finally, it seems salutary to note the recent Budget announcements. Following the pensions tax simplification measures introduced in 2006, the “complexification” meas-ures now being introduced (penalising high earners and potentially disincentivising the very decision makers pro-viding retirement savings through occupational provision) are already starting to prompt discussions about broader reward policies and the most efficient way to help employees provide for their (much) later years.

Martin Bird from Hewitt Associates’ Longevity Solutions Group discusses the challenges pension schemes face as members continue to live longer and considers the implications for future retirement planning

Martin Bird is a principal at Hewitt and leads the UK Longevity Solutions Group

Hewitt.com/lon-gevity or email: martin.bird@hewitt.com

Source: Bank of international settlements

Amounts outstanding of over the counter (OTC) derivatives £m

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