Fifty isn’t what it used to be — just look at Madonna who at 52 is still making music, looking great and dating guys half her age. But while people today now enjoy longer, healthier lives than ever before, defined benefit (DB) pension plans now have a big problem on their hands.
Longer lives mean we need more money to keep us in retirement — and that’s a risk that is chipping away at the ability of DB plans to meet the pension promise. According to George Graziani, senior vice-president, Swiss Re, even a one per cent change in mortality improvement can knock down a plan’s value by four percent (watch our video interview here).
No surprise then that pension funds are keen to hedge their longevity risk – and back in September Hendrik Rogge, who manages Deutsche Börse’s Xpect longevity indices suggested ETFs as a possible solution for making longevity risk more tradable (provided the index gets liquid enough).
But could this really happen? And how would it work? To find out, I asked Mark Yamada, President & CEO, PUR Investing Inc., to explain what longevity ETFs are and how they work. His take: they have advantages — if you’re comfortable with taking on a lot of counterparty risk.
CC: How could ETFs be used to manage longevity risk?
MY: A longevity index is simply a more currently updated mortality table. As we understand longevity swaps, an institution swaps a level stream of payments for the actual experience that is assumed by a counter party. The institution trades the certainty of capping its risk on an annual basis in exchange for a premium paid to the counter party. Similar to a credit default swap (CDO) for which the unknown risk is that of a default on a fixed income instrument, the longevity swaps transfers risk to the counter party.
CC: Are we just trading longevity risk for increased counterparty risk?
MY: To the extent that plan sponsors can build certainty into their liability schedules, there is an advantage to a longevity swap but the sponsor assumes the new risk that the counter party can honour the original contracts. This would be particularly useful for smaller plans that lack a diverse population and for whom a series of lumpy payments could stress financial statements.
CC: Are they too risky for plan sponsors?
MY: Swap and other derivative strategies used for ETF construction are increasingly attracting the scrutiny of the authorities that goes beyond the counter party risk assumed by the plan sponsor. There is a moratorium on the creation of new derivative based ETFs in the U.S. and the FSA in the U.K. is considering banning derivative-based ETFs from retail use.