As DB pension schemes de-risk, longevity risk becomes more and more important says Howard Kearns, Longevity Pricing Director at Insight Investment
How big a challenge is longevity risk to pension schemes?
Until around 2015, longevity projections had only been going in one direction, pushing all pension scheme liabilities up by a material amount. Unfortunately, longevity risk is not like a financial risk, where you can look at historical prices and volatility, so it's a difficult risk for schemes to assess.
Instead, it's affected by things such as medical developments, NHS spending and factors that are not consistent across pension schemes, like socio-economic mix, lifestyle and member age.
Should schemes prioritise longevity risk over other risks?
It depends on the other risks they're facing. If a scheme still has lots of unhedged interest rate and inflation risk, or it has a large equity portfolio, longevity probably isn't the most pressing risk. But as your tolerance for funding-level volatility reduces and your interest rate and inflation hedges increase, you need to take a closer look at longevity risk, which becomes the biggest remaining risk.
Will recent reductions in life expectancy mitigate longevity risk?
Between 2015 and 2018, the Continuous Mortality Investigation (CMI) - the organisation behind UK longevity assumptions - revised life expectancies down by about one year; for a typical pension scheme that might shave 4% off liabilities.
In 2019, however, deaths have so far been relatively light, so we might yet see a reversal of the recent downward trend. In summary, longevity risk creates uncertainty and needs to be managed.
How can pension schemes manage longevity risk?
There are three ways, or four if you count ignoring it completely. First, reserve for it. For example, if your best-estimate liability value is £100 million, you might add an extra £3-5 million as a buffer against the impact of changing longevity expectations.
Second, via an insurance buy-in. This removes longevity risk as well as interest rate risk and inflation risk - a secure but expensive solution which may impact the certainty of achieving your endgame.
The third approach is to use a longevity swap. The advantage of longevity swaps over buy-ins is that you don't pay across any assets to the insurer on day one. All scheme assets remain available for investment, working to generate the returns needed to reach the endgame.
IMPORTANT INFORMATION
RISK DISCLOSURES
Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
ASSOCIATED INVESTMENT RISKS
Where the portfolio holds over 35% of its net asset value in securities of one governmental issuer, the value of the portfolio may be profoundly affected if one or more of these issuers fails to meet its obligations or suffers a ratings downgrade.
A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.
The issuer of a debt security may not pay income or repay capital to the bondholder when due.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise.
Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.
Where high yield instruments are held, their low credit rating indicates a greater risk of default, which would affect the value of the portfolio.
The investment manager may invest in instruments which can be difficult to sell when markets are stressed.
Where leverage is used as part of the management of the portfolio through the use of swaps and other derivative instruments, this can increase the overall volatility. While leverage presents opportunities for increasing total returns, it has the effect of potentially increasing losses as well. Any event that adversely affects the value of an investment would be magnified to the extent that leverage is employed by the portfolio. Any losses would therefore be greater than if leverage were not employed.
This document is a financial promotion and is not investment advice. Unless otherwise attributed the views and opinions expressed are those of Insight Investment at the time of publication and are subject to change. This document may not be used for the purposes of an offer or solicitation to anyone in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it is unlawful to make such offer or solicitation. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment.
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