LONDON — Pension fund executives face a grave danger: their plan participants might live too long.
Several financial firms are working on new ideas that would help pension executives to hedge against the risk of incurring unexpectedly large liabilities from geriatric retirees. All have significant potential stumbling blocks, but if overcome, this market could be the next frontier for financial derivatives, said David Cule, principal at actuarial consultant Punter Southall & Co. Ltd., London.
Longevity risk is linked to the probability that individuals will live longer than the actuarial assumption. For corporate defined benefit pension plans, longevity is often considered one of the most volatile in terms of significantly increasing pension liabilities.
“As interest rates and inflation have stabilized, more attention is turning toward longevity (risk),” Mr. Cule said.
One of the latest attempts is by New York-based JPMorgan Chase & Co., which in March introduced a longevity index in the United States, England and Wales. The index is part of a platform, dubbed LifeMetrics, that has three components — the longevity index, different forecasting models that can be used to adapt to the population of a particular pension fund and hedging tools including derivatives and structured products. JPMorgan plans to expand it to other European countries and Canada.
Aimed at corporate pension funds, the platform allows plan executives to measure and manage mortality risks within their plans, said Guy Coughlan, managing director and global head of pension asset liability management at JPMorgan.
Also, “in terms of hedging, longevity hedging could be part of a (liability-driven investing) solution,” said Mr. Coughlan, who led the team that developed LifeMetrics. “In the same way that pension funds now hedge inflation risks, so too can they hedge longevity risks.”
In the over-the-counter market, investment banks are acting as intermediaries to structure tailor-made longevity hedging strategies for sellers, which include pension funds and insurance companies, said Mark Azzopardi, head of insurance and pensions at BNP Paribas, based in London.
“We think this is potentially where the money will be made,” Mr. Azzopardi said, referring to the OTC market. He was part of a team that worked on an unsuccessful attempt by BNP Paribas to launch a longevity bond in 2005.
Hedge funds among buyers
Buyers of longevity risks include reinsurance companies and hedge funds, many of which already trade in other insurance-based securities such as mortality bonds. Mortality bonds are short-term coupons linked to occurrences such as natural disasters or disease outbreaks that cause people to die earlier than actuarially predicted.
However, the time horizon for longevity derivatives might be in decades — too long for the short attention span of the average hedge fund, said Gavin Orpin, head of trustee investment consulting at consultant Lane Clark & Peacock LLP in London.
“Improvements (in lifespans) have been more significant than actuaries thought possible,” Mr. Orpin said. “It’s very difficult to extrapolate the trends. It’s not like an investment risk, where you can see the impact immediately.”
In the past several years, longevity risks have been pushed to the fore by corporate defined benefit funds in Europe, largely because of regulatory changes requiring more accurate accounting for pension liabilities on their balance sheets. The demand for corporate executives to better hedge longevity risks could eventually spread to the U.S. as similar mark-to-market rules are planned, said Samuel Cox, the Thomas P. Bowles Jr. chair of actuarial science at Georgia State University, Atlanta.
“If I were a DB plan sponsor, I’d certainly be concerned about longevity risks,” Mr. Cox said. “In the recent 20 years or so, we haven’t projected as rapid improvements (in lifespans) as what was actually happening. That is having huge repercussions on the actual cost of providing pensions.”
There are no known statistics showing the extent to which U.S. pension funds are underestimating the cost of providing pensions due to longevity risks. But according to analysis by Paternoster U.K. Ltd., London,, U.K. defined benefit funds may come up short by £75 billion ($147 billion) to £175 billion because longevity risks have not been fully factored into the total pension liability, which stands about £1 trillion nationwide.
Launched in 2006, Paternoster has agreed to acquire about 15 closed pension funds with £300 million in assets, said Richard Willets, the firm’s longevity director. Paternoster has a team of six actuaries and statisticians dedicated to analyzing longevity risks.
“For us, the two big risk factors are mortality improvements and investment,” Mr. Willets added.
Paternoster is looking to dissect longevity risks from the rest of a pension fund’s asset pool, eventually allowing corporate sponsors to specifically transfer that portion of their long-term pension liabilities. Investment risks, he added, can be controlled more efficiently than longevity risks.
There are hurdles
Skeptics, however, doubt that any of the strategies now being considered will attract many investors because of several hurdles:
•There isn’t enough data to “truly” weigh longevity risks, said Antony Osborn-Barker, head of pensions at BNP Paribas in London. Population statistics are often out of date and inaccurate for the purpose of financial pricing. For example, in the U.K., the latest set of mortality figures — from 2004 — may have included immigrants to the U.K. and omitted U.K. residents retiring in other countries. “The people who are born here and the people who die here are not one and the same,” Mr. Osborn-Barker said.
•The cost is too high. There is a case for buying longevity risk as an uncorrelated, low-beta type of investment, said Julia Coronado, senior U.S. economist at Barclays Capital, New York. However the cost to sellers would be too high for many pension funds to consider, she added. “There’s a strong trend that medical advancements will continue at a very good pace, leading to increased longevity,” Ms. Coronado said. “The result is that people will only take on that risk at a very high price.”
•There aren’t enough buyers. “You need to have people on both sides,” said Mr. Orpin of Lane, Clark & Peacock. “Right now, the problem is there are no obvious takers on the other side of mortality risks.” Liquidity may also pose a problem, he said.
But inflation risk once had similar problems, and that market since has blossomed; the same could occur with longevity risks, according to Mr. Orpin and others.
“We’ve learned from the weaknesses of past attempts,” said David Blake, director of the Pensions Institute at Cass Business School in London who helped JPMorgan develop LifeMetrics. “We want this market to get started.”
Mr. Blake has been lobbying the U.K. government to issue longevity bonds to seed a capital market in longevity derivatives. The idea is similar to inflation-linked bonds, but following a longevity index. Payments would therefore rise as longevity increases, Mr. Blake said.
“Government-issued longevity bonds would help to set the risk-free term structure for longevity risks,” he said. “The government already does this in the inflation risk market as well as the fixed-income market.”
