Longevity as transferable ‘risk’: the new financial dynamics of ageing
Transfers between defined benefit pension schemes and (re)insurance companies are expanding the landscape of retirement risk shifts
We are witnessing an unprecedented global demographic achievement: the world population’s life expectancy for people at the age of 60 has increased from 18.7 years in 2000 to 20.4 years in 2015, according to the World Health Organization. Between 2015 and 2030, the number of people in the world aged 60 years or over is projected to grow by 56 per cent, from 901 million to 1.4 billion.
In the UK, the average life expectancy of children born in 2013 is over 90 years old, and the number of people aged over 65 already outnumbers those under 16.
Despite such amazing demographic achievements, celebration is hardly underway. It is often emphasized that longevity trends engender unprecedented economic and financial challenges at both national and global levels. As reported in the World Economic Forum’s 2017 Global Risk Report, these trends add ‘pressure to pension and healthcare systems, spurring countries to increase retirement ages and encourage older workers to remain economically active for longer’.
Some economists have attempted to estimate the macroeconomic effects of changes in population age structures in a context marked by increasing automation – another unprecedented development transforming labour markets. Findings can diverge significantly, ranging from the grim conclusion that aging will lead to economic strain and deceleration (‘secular stagnation’) to the understanding that, in fact, countries experiencing more rapid aging have grown more in recent decades thanks to automation technologies.
Not only are governments (slowly) contending with the fiscal impact of longevity on social security arrangements, but workers and their private pension providers are growing increasingly aware that living longer comes with a high price tag, often difficult to estimate. It is in this sense that longevity has been labelled in the financial services and insurance industries as ‘risk’.
Simply put ‘longevity risk’ is the possibility that a saver (or the average of savers) will outlive her accumulated wealth (idiosyncratic risk), or that people in the aggregate will outlive their incomes (systematic risk) also adding funding pressure onto employers, pension funds and insurance companies.
The question as to who holds longevity risk differs depending on the nature of an individual’s private pension arrangement – whether that is based on a defined benefit (DB) or a defined contribution (DC) scheme. In a defined contribution (DC) scheme, income during retirement is determined by market returns on private investments. That is, the worker’s accumulated savings and investments in the years prior to retirement determine her income stream thereafter. The worker, not her employer, takes on the longevity risk. In contrast, in DB schemes, income in retirement is based on a portion of the worker’s ‘final salary’ and years worked for the employer who is expected to provide her retirement income (based on her earnings, years of contribution, and age) until her death. In this case, employers take on the longevity risk.
Insofar as many DB schemes have accumulated deficits given historically low interest rates, reduced investment returns, and growing costs, a ‘longevity shock’ can impair their competitiveness. There is hence an incentive for companies that still offer DB pensions to move longevity risk off their books, particularly in Europe given Solvency II’s requirement that firms hold a risk margin relative to reinsured liabilities.
Since 2006, insurers, banks and investment experts have designed what they call ‘de-risking’ deals, allowing employers to shed some or all of their pension liabilities for a price. As of 2016, £280 billion in DB pensions risk have been transferred in the UK, US and Canada. The UK is unquestionably the pioneer in this market and concerns have emerged that the capacity of insurers and reinsurers may be reaching capacity relative to demand from pension schemes.
One de-risking strategy is a buy-in or longevity swap through which the employer buys ‘insurance’ against employees living longer than expected. Although the employer is still responsible for paying pensions, longevity risk falls in the hands of an insurer or bank on the other side of the transaction. A more elaborate deal that can be cut between a DB pension provider and insurance companies is known as a buy-out. Through it, the employer farms out all its pension obligations (both assets and liabilities) to the insurer who becomes responsible for pension payments. Individual benefits paid to retired workers remain the same in either buy-outs or buy-ins. The goal is to improve the stability of the pension scheme and consequently of the company that sponsors it.
Longevity risk transfers between DB pension schemes and insurance companies are a novel empirical element in the increasingly layered private pensions landscape. They expand the range and nature of retirement risk shifts, and consequently demand a better understanding of their distributive impact.
Analyses of risk production and transfer have long been part and parcel of analyses of global finance. Financial ‘risk’ and the ‘complexity’ to which it is associated are often products of agency and deliberate design. They are endogenous to the ever-expanding industry of ‘risk management’ that attempts to conquer volatility, complexity, indeterminacy through more refined techniques for calculation and computation.
Yet, as the 2007-08 financial crisis made all too clear, risk diversification and new hedging instruments (like credit default swaps) were not only ineffective in averting simultaneous losses from (what were perceived to be) ‘uncorrelated’ financial bets when the housing bubble started to burst, but these very diversification efforts and hedging moves intensified the meltdown.
Longevity risk, however, is different and refers to an exogenous (demographic) element in financial production. And risk transfers in this case, although certainly motivated by the ambition to increase profits (or reduce losses), are not the result of securitization processes made for their own sake.
There is a clear social element in these deals, regulated and incentivized by supervising authorities given the aim to help employers manage risks and hence safeguard pension security.
Yet, akin to the concerns raised by the financial crisis, ‘de-risking’ strategies are misnomers. Shifting risk may make individual companies safer at a microprudential level, but a series of transactions involving a limited number of longevity risk ‘buyers’ (insurance and reinsurance companies) may produce more risk concentration at one of the links in the financial system chain, raising macroprudential concerns.
We are indeed only starting to question how existing institutions and strategies can be ‘re-tuned’ to tackle new retirement investment needs, and the extent to which a radical new way of thinking about work, intergenerational exchanges, and solidarity will be called for and made viable. Among many indeterminacies, it is certain that condemning one of humanity’s greatest feats (increasing longevity) as a burden rather than benefit would mark a monumental wasted opportunity.Print page
Articles and comments posted on this blog reflect the views of the author(s) and not the position of SPERI or the University of Sheffield.