While the prospect of living longer is great news for individuals, it presents a significant challenge for pension plan funding. Because if pensions need to be paid out longer than expected then extra cash has to be found somewhere.
Over the last 50 years, DB pension schemes have struggled to keep up with the pace of life expectancy improvements. Looking ahead to potential further medical advances, it’s safe to say that predicting life expectancies will remain a tricky business.
What is longevity risk?
As morbid as it sounds, people living longer is a liability to pension schemes. The risk of underestimating the impact of this liability on pension plan funding is known as longevity risk.
It has the potential to seriously weaken a scheme's funding position. To put it simply, for the average scheme, every additional year of life expectancy will cause liabilities to rise by roughly 3-4%.
How can we manage this risk to pension plan funding?
When we think of managing longevity risk, our first thought is often buy-ins or buy-outs. This involves passing assets to an insurer to cover the liabilities of a specified portion of members. With a buy-out, the policy covers all of the member. Whereas with a buy-in, the protection is limited to a section of the membership.
These transactions result in the transfer of longevity risk from the pension scheme to an insurer. If the members live longer than expected the insurance company will take the hit, rather than the pension fund.
Sounds great, right? Yet buy-in and buy-out policies are not as capital efficient as you think. Pension schemes need to pay for protection up-front. This means they are really only suitable for schemes with stable pension funding.
For pension plan funding that’s already stretched thin, going down the buy-in route would exacerbate the problem. This is because you’re left with a proportionately smaller asset pool to meet the remaining liabilities, which is not an ideal situation.
The longevity swap approach
Another option for schemes looking to mitigate longevity risks is to use longevity swaps. Longevity swaps are not a new idea. Until recently they were only a feasible option for very large schemes.
Recently we have seen the market adapting to make this a feasible pension plan funding solution for a broader range of schemes. Insurers have introduced solutions that basically strip out the inflation and interest rate elements of "buy-out" contracts.
Longevity swaps are policies which make or receive cash payments depending on whether scheme-specific longevity is higher or lower than expected. This means more pension schemes can gain longevity protection on a proportion of the liabilities (usually the pensioners and older deferred members). Best of all, with this approach little or no assets need to be handed over at the outset.
The risk management toolkit
Compared to some other risk factors, like inflation or interest rates, longevity hedging may not be so high on the agenda. But it’s definitely not something that is going away.
Capital efficient solutions like longevity swaps are great tool to add to the trustee toolkit to help in managing the risks of running a pension fund. We think the broadening of the market is a really welcome move.
Find out more about pension plan funding from Cardano
To find out more on effective pension plan funding strategies, get in touch with us. Whether you need guidance on pension risk management or achieving a stable funding ratio, we’re happy to lend a hand.
Take a look at our services to find out how we can help you.