Traditional risk management tools
Plan sponsors are most familiar with annuity purchases as a longevity risk management tool. Annuities can be purchased for an entire pension plan or for a certain subset of the plan, such as the pensions already in payment. When a plan sponsor purchases annuities for its plan members, it not only removes the investment risk for those liabilities but also eliminates the longevity risk, both systematic and specific, associated with those members.
However, transferring these risks comes at a cost. In today’s market, purchasing a single-premium immediate annuity for a retiree who is 60 years old will cost the plan 115% or more of the liabilities held for that retiree (based on a non-indexed pension plan that is valued using a 6% discount rate and the UP94 mortality table projected to 2020). Given the funded status of most defined benefit plans these days, that extra 15% is hard to find.
Another way to reduce a pension plan’s systematic longevity risk is to select a mortality table that is appropriate for the plan’s demographics. As noted earlier, large pension plans can undertake mortality studies to produce a plan-specific mortality table. Small plans can use standard tables and adjust them for known past mortality experience. By strengthening the mortality table, a plan can pre-fund the longevity risk. However, note that this risk is not eliminated.
Plan design can also reduce the specific longevity risk. One option is to reduce the number of beneficiaries that a plan is covering or subsidizing. For example, many Canadian plans subsidize joint and survivor pensions, which increases the longevity risk. Plan sponsors can remove the subsidy, but they can’t remove the requirement that a member must provide his or her spouse or partner with a survivor pension. However, the plan can reduce the longevity risk associated with the spouse, requiring that the member pay for the added cost of the joint and survivor benefit through a reduced pension. The plan can also choose an appropriate mortality assumption to use when calculating the actuarially equivalent joint and survivor pension.
In addition, plan sponsors can rely on long-term investment gains to fund any shortfalls resulting from members living longer than expected. However, most sponsors view this as an ineffective way to manage longevity risk because of the embedded risks. Relying on investment gains is usually viewed as an option of last resort.
Longevity Risk for DC Plans Longevity risk also applies to defined contribution (DC) pension plans. As DC plan members live longer, there is an increased likelihood that members will outlive their retirement assets. And as more members move from the accumulation phase to the de-accumulation phase, this risk will become even more important to address. While new products, such as guaranteed minimum withdrawal benefits, are now available to help DC plan members manage this risk, other innovative products will likely come to market over the coming years. |
Emerging strategies
Since plan sponsors may be reluctant to make annuity purchases today, given low interest rates, new tools are being developed to allow them to insure longevity risk separately from investment risk, which eases the dependence on the level of interest rate risk that is a significant part of annuity pricing. While they offer some promise, they also raise additional considerations such as complexity, costs, credit risk and lack of product choice, all of which should be carefully evaluated. Many of these tools are not yet broadly available in Canada, but they have been introduced to manage longevity risk in other jurisdictions.
Longevity insurance provides compensation if the mortality for a plan is better than expected. Deferred annuities purchased at retirement that start payment at a later date (for example, at age 85) are one example of longevity insurance.
Longevity bonds have coupons that are based on the longevity of a defined group (such as the general population or, for larger plans, the actual plan experience).
Longevity swaps provide a hedge against plan members living longer than expected. With this type of swap, a bank or insurer agrees to take on a series of payments that relate only to changes in longevity. This strategy has gained momentum in the U.K. over the past few years, with six longevity deals completed in 2009 covering liabilities of approximately £4.1 billion.
Risk-sharing allows plan sponsors to share the financial impact of changes in mortality. In some jurisdictions, plan sponsors have reached an agreement with their members around this.
While investment risk has been the focus of many pension plans over the last couple of years, it’s clear that a comprehensive risk management program must include longevity risk. Plan sponsors must monitor this risk diligently and ensure that they manage it effectively. And as new tools are introduced into the Canadian marketplace, plan sponsors may have even better ways to manage longevity risk in the future. BC
Jasenka Brcic is a principal and Chris Brisebois is a senior consultant with Eckler Ltd.
jbrcic@eckler.ca
cbrisebois@eckler.ca
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© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the April 2010 edition of BENEFITS CANADA magazine.