PAYING THE PRICE FOR LIVING LONGER WHAT IS THE RIGHT PRICE FOR REMOVING LONGEVITY RISK?

Life expectancy around the world is rising and there is no sign that this trend is about to stop anytime soon. For companies that sponsor either active or closed Defined Benefit pension plans increased longevity requires careful attention. Longevity swaps are increasingly seen as a solution to reduce longevity risk in pension plans. But what is the right price for removing longevity risk?
Over the past several decades, life expectancy has continued to rise. Recent UK research indicates that more than 2 million people presently aged over 50 in the UK will live to be older than 100 (17% of the present population), and 33% of female babies born today can expect to live 100 years or more.1 Estimates vary, but life expectancy now appears to be increasing at a rate of 1 to 3 months every year. While the impact that this has on pension liabilities varies according to plan demographics and the levels of interest rates, every year of additional life expectancy is generally thought to add about 3-4% to the present value of pension obligations for a typical pension fund.2 Once again, it is not clear whether life expectancy will continue to rise at present rates but the risk is clearly visible. For example, if, as a result of increasing public smoking bans, the number of smokers were to fall, average life expectancy from birth could increase by between one and two years. This in turn would require an increase of between 8 and 10% in pension reserves.3 Figure 1: Longevity swaps to date (source: AEGON Global Pensions)
500 Mln Indemnity swap for Canada Life by JP Morgan 1500 Mln Indemnity swap for Abbey life by Deutsche Bank 1900 Mln for RSA by Goldman Sachs & Rothesay Life 3000 Mln for BMW by Deutsche Bank & Abbey Life

100 Mln Index swap for Lucida by JP Morgan

475 Mln Indemnity swap for Aviva by RBS & PartnerRe

550 Mln Indemnity swap for Babcock by Credit Suisse & Pacific Life Re

750 Mln for Berkshire Pension fund by Swiss Re

70 Mln for PALL Pension fund by J.P. Morgan

July 2008

March 2009

July 2009

Feb 2010

Jan 2008

Feb 2009

May 2009

Dec 2009

Feb 2011

DB plans and longevity risk

The fundamental underlying risk for any Defined Benefit pension plan (and its corporate sponsor) is that the plan should be unable to meet its liabilities. Longevity risk the risk that the pension plan has to provide benefits to its members over a longer period than expected is increasingly being recognised as a major threat to pension plans and the companies that sponsor them.
1 2

http://research.dwp.gov.uk/asd/asd1/adhoc_analysis/2010/Centenarians.pdf Sources: J.P. Morgan and AEGON 3 On this note, Philip Morris announced in 2010 the possible loss of 176 jobs in its Netherlands factories, citing the decrease in demand for cigarettes in the Netherlands. http://nos.nl/artikel/186161-philip-morris-schrapt-banen-innederland.html 1
March 2011

Longevity swaps and the derisking dilemma

Longevity swaps can help pension plans and their corporate sponsors to protect themselves from one of the major risks they face (the other major risk include asset risk, inflation risk and interest rate risk). In addition, longevity swaps provide an excellent diversifying effect on a pension funds portfolio, particularly for low risk portfolios (typical of closed Defined Benefit plans with older members). In calculating how much they should be willing to pay for a longevity swap, some companies may be faced with the challenge of reconciling their present estimates of future costs with the potential worst case scenario against which the longevity swap provides a hedge. As with many derisking solutions, companies are faced with the dilemma of whether to take action now or not. When derisking is affordable, it is often viewed as being less necessary. At times when the appetite for derisking increases (typically when the risk materialises), it is also usually less affordable. In the present environment, there are two elements at play that may be leading some pension funds to hold back the contrast between the pension funds perceived liabilities and their actual liabilities, and the relative newness of the market in longevity swaps. However, as new regulatory regimes (including Solvency II) will increasingly recognise longevity risk, it is likely that more companies will start actively looking to protect their pension funds.

Pricing longevity risk

With a longevity swap, a variable stream of cash flows is exchanged for a fixed stream. When looking to price a longevity swap, both parties to the swap need to agree on the best estimate of future cash flows, which includes the most accurate and up-to-date mortality statistics. At present, many pension funds rely upon a deterministic model, based on official actuarial tables against which to measure their liabilities. While mortality rates have been improving for decades, actuaries have repeatedly assumed that this growth would slow. It is this assumption that is now increasingly being revisited. Although current deterministic models can assist a pension fund to reach a best estimate of their future cash flows, they do not always provide a good picture of the measure of risk around the numbers. For this reason, in pricing a longevity swap, stochastic (or probability-based) models of mortality rates are increasingly being used. A stochastic model enables the best estimate cash flows and the related longevity risk to be calculated, taking into account diversification at all levels, the latest statistical data for the specific country or region involved, and pension-specific mortality experience. When comparing the perceived liabilities of a pension fund using a deterministic model and the actual best estimate liabilities using a stochastic, pension-specific model, the deterministic model is often revealed to underestimate future liabilities. Although this liability gap needs to be bridged, it should not be viewed as part of the cost of the derisking solution itself but rather be seen as a cost adjustment that is required in recognition of the new best estimate of future liabilities.

March 2011

Figure 2: Breakdown of longevity swap pricing (source: AEGON Global Pensions)

Total Pension Plan Cashflows

50.000 45.000

Cash Flow (in Thousands)

40.000 35.000 30.000 25.000 20.000 15.000 10.000 5.000 1 6 11 16 21 26 31 36

Source: AEGON

Current Valuation Expectation Current Cash Flow Projection

Actual Best Estimate Expected Cash Flows Cash Flows Best Estimate Fixed Cash Flows+ Risk Premium

Cash Flow

41 46 51 56 Time (in years)

61

66

71

76

81

86

Once the best estimate cash flows have been quantified, the price of the longevity swap itself has to be determined. When discussing pricing, a comparison is often made between longevity swaps and interest rate swaps. There is, however, a key difference, as interest rate risk is a tradeable risk and the price of the swap is largely determined through supply and demand. In contrast to interest rate risk, however, there is no market-based price-setting mechanism for longevity risk. Market players therefore generate best estimate projections and add a risk premium to compensate for the risk.

Insurers a natural counterparty

The price of a swap also depends on the counterparty involved. Although longevity risk is not a perfect match for mortality risk, the two can offset each other to some degree. As insurance companies are well diversified and also carry mortality risk, they are able to assume longevity risk more efficiently than other parties. Despite the lack of a liquid market, the existence of insurance companies with mortality risk on their books therefore creates something of a natural counterparty for longevity risk. Although it is impossible to provide a general price for a longevity swap, a risk premium above best estimate cash flows typically ranges between 3% and 7% for a pensioner-based portfolio. At this price, the pension fund protects itself for a sum it can afford against a risk it cannot afford to have.

Conclusion
As with all risks, there is a temptation with longevity risk to wait and see how the market and mortality tables develop (it may never happen). However, for companies with Defined Benefit pension plans, in the light of the present demographic trends and regulations, it is a good idea to quantify the potential impact of longevity risk on your company. Once these calculations have been made, it is possible to address the derisking dilemma and to find the right solution at the right price.

March 2011

AEGON and derisking

AEGON Global Pensions offers a broad range derisking capabilities (including buyouts and buyins, liability driven investments and longevity swaps) in the UK, continental Europe and the USA. If you are a multinational company with pension funds in one or more countries, AEGON Global Pensions can help you decide on the most efficient derisking route, taking into account the cultural, legislative and accounting aspects of your local pension schemes. To find out more about our derisking capabilities, please contact AEGON Global Pensions. Tel: +31 (0)70 344 8931 | aegonglobalpensions@aegon.com | www.aegonglobalpensions.com

March 2011