My money or your life
New financial instruments may help to make pension schemes safer
OVER the past 50 years, every forecast of how long people will live has fallen short. Despite fears that obesity and global warming would reverse the trend, life expectancy in rich countries has grown steadily, by about 2.5 years a decade, or 15 minutes every hour. That is good news for health-care providers, cruise companies and humanity. It is most unwelcome for those paying the bills to finance this extended lease on life.
Longevity risk, the chance that people will live longer than expected, is potentially very expensive. Never mind the dramatic impact of a cure for cancer: adding an extra year to the average lifespan increases the world's pension bill by 4%, or around 1 trillion, according to the IMF.
Firms that have sold annuities are the most obvious victims of living longer, as they keep on writing cheques to oldies they expected would have passed on by now. But the most severe risk lies with defined-benefit pension schemes, in which participants are promised an annual payment throughout their retirement, however long it may last. Globally private defined-benefit schemes already have 23 trillion of liabilities—the amount they owe current and future pensioners. Many are grossly underfunded as it is.
Such statistics are enough to send a pension trustee to an early grave. Yet there is an apparent cure, in the form of “longevity swaps”, which pension schemes can use to insure against the risk that their members will live longer than expected. In July, the pension scheme of BT, Britain's former telecoms monopoly, which is wrestling with a deficit of 7 billion, offloaded the longevity risk on over a quarter of its liabilities to Prudential Financial, an American insurer. BT will pay Prudential a monthly fee and it in turn will pay the extra pension costs if the shuffleboarders in question live longer than forecast.
Such arrangements have become increasingly common, with 2014 already setting a record for liabilities offloaded in Britain, the centre of the market. BT's deal, which covered pension debt worth 16 billion, was the biggest yet. Most of the 20-odd deals so far have been between big pension schemes and insurers such as Prudential and Swiss Re. The deals should help them hedge a risk they already have through their other businesses, which pay out if clients die unexpectedly early.
But the potential liabilities that need to be neutralised far exceed what insurers might want to take on. So new investors are being sought to take on risks associated with ever-older clients through “longevity” bonds, whereby outsiders take on the unwanted risks. Bondholders get paid a coupon, but start to lose money if life expectancy pushes beyond a pre-agreed rate.
In 2012 Aegon, a Dutch insurer, passed the longevity risk associated with 12 billion of pension liabilities to investors looking for an asset that does not move in tandem with wider financial markets. Chris Madsen, a managing director there, hopes they will follow the trajectory of “catastrophe bonds”, which pay out if there are no hurricanes or earthquakes in a defined period. These have recently become popular with large investors looking to diversify away from stocks and bonds.
But whereas protection against natural catastrophes tends to be offered for a year or two, longevity bonds are only useful over longer periods—enough time needs to pass for past projections to have been proved wrong. This does not suit the average investor, particularly in the absence of a liquid secondary market. So far, only a tiny fraction of the 23 trillion in liabilities in private defined-benefit plans have been protected. Whoever hits on the right formula will do a brisk trade.
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