longevity risk | Pension360

OECD Report: Longer Life Expectancy Threatening Pension Sustainability; More Reforms Needed

The Organization for Economic Cooperation and Development released a report Monday morning highlighting the challenges that longer life expectancy poses to pension systems around the world.

From CNBC:

The world’s retirement bill is coming due—and many countries aren’t ready to pay it.

That’s the conclusion of a report Monday from the Organization for Economic Cooperation and Development, a Paris-based group representing the world’s developed countries.

With populations aging and lifespans rising, government-supported pensions are cutting deeper into national budgets, crowding out spending on other programs and services. The added burden comes as the economies of the developed world are growing slowly, putting added pressure on the tax revenues needed to pay rising pension costs.

[…]

“The ongoing rapid demographic shift and the slowdown in the global economy highlight the need for continuing reforms,” OECD Secretary-General Angel Gurría said. “We must communicate better the message that working longer and contributing more is the only way to get a decent income in retirement.”

The report acknowledges numerous pension reforms by countries and states in recent years, but says more needs to be done. The report presented a handful of reform proposals. From the OECD:

Increasing the effective retirement age can help but more efforts are needed to assist older workers find and retain jobs. Public policies to reduce age discrimination, improve working conditions and increase training opportunities for older workers are essential.

Countries have also introduced reforms to strengthen funded private pensions. The report highlights the importance of increasing coverage rates in countries where funded pensions are voluntary. Auto-enrolment programs have been successful in raising coverage in the countries that have implemented them.

The report also calls for strengthening the regulatory framework to help pension funds and annuity providers deal with the uncertainty around improving life expectancy. It argues that regulators should make sure that providers use regularly updated mortality tables, which incorporate future improvements in mortality and life expectancy. Failure to account for such improvements can result in a shortfall of provisions of well over 10% of the pension and annuity liabilities.

Capital markets could offer additional capacity for mitigating longevity risk, but the transparency, standardization and liquidity of instruments to hedge this risk need to be facilitated. The regulatory framework will also need to reflect the reduction of risk exposure these instruments offer by ensuring they are appropriately valued by accounting standards and lowering the level of required capital for entities hedging their longevity risk.

Issuing longevity bonds and publishing a longevity index to serve as a benchmark for the pricing and risk assessment of hedges would support the development of longevity instruments.

Rebuilding trust is also an important challenge that policy makers face, says the OECD. Young people in particular need to trust the long-term stability of the pension system and the pension promise that is made to them. Communication campaigns and individual pension statements to explain the need for reform and facilitate choice by individuals are needed, says the OECD.

The full OECD report can be read here.

Photo by Horia Varlan via Flickr CC License

Can Insurance Companies Save Public Pensions?

Last week, Pension360 covered a question asked by the Washington Post’s Wonkblog:

Does it make sense for local governments to turn over the assets of their employee pension plans to insurance companies, who would in turn make monthly payments to retirees?

This week, Mary Pat Campbell (who runs the STUMP blog) has given an in-depth answer to the above question:

Here is the problem: for all of my posts about alternative assets in public pensions (though those are troubling when they are a huge portion of the portfolio), it’s not the financial risks per se, or even the longevity risk, that has been killing public pensions, though those do contribute.

It’s that governments are great at promising, but not so great at putting money by to pay for those promises.

[…]

Insurers are willing to write group annuities to back pension promises — they did this with GM and Verizon pensions — but you have to give them all the assets they require to back that business. A “fair price” would be less than what is statutorily required, probably, because statutory requirements tend to be very conservative in valuing the liabilities, in order to protect policyholders/annuitants. This is called surplus strain.

But the thing is, even with the “fair price”, governments would have to pay amounts way beyond what they’re paying now, just to meet the pension promises made for past service, forget about any future service accruals.

The main problem is that not enough money has been put by. The risk is not so much that public pensions across the country have been investing too riskily or anything like that (but overly risky investing can make the bad situation worse.)

Now, not all pensions are underfunded as grossly as New Jersey or Illinois. But you don’t get to a 72% overall funded ratio just from those two states.

While insurers might be able to reduce the worry about longevity risk and financial risk for fully-funded plans, they cannot help politicians trying to lowball pension costs.

Her answer, in other words: “No”.

Photo by www.stockmonkeys.com

Wall Street Securitizes Pension Liabilities to Create “Longevity Derivatives”

No one ever said Wall Street wasn’t creative.

Several firms are selling securities backed by longevity risk—the risk that retirees receiving benefits will live longer than expected and thus incur a higher cost on their retirement plan. More from Institutional Investor:

Sovereign wealth funds, educational endowments and ultrahigh-net-worth individuals are the target investors for longevity derivatives, which package the risk that retirees drawing annuities will outlive actuarial expectations.

The roots of this nascent market date back to 2006, when small monoline insurance companies such as U.K.-based Lucida (purchased by Legal & General in June 2013) and Paternoster (bought by Goldman Sachs Group in 2011) began taking longevity risk off European pension funds through bulk annuity buyouts.

These buyouts entail a company selling pension assets earmarked for all or some of its plan participants. The assets are converted to annuities that the sponsor can keep on its books or off-load to the insurer.

[…]

Banks build longevity derivatives products using risk models provided by firms like Newark, California–based Risk Management Solutions (RMS). They’ve closed a dozen such deals, but the customized structure can be tough for investors to grasp. Deutsche Bank is focused on creating a path into the capital markets, according to Paul Puleo, global head of pension and insurance risk markets in New York.

In December 2013, Deutsche created longevity experience options, or LEOs, a more standardized product tailored to capital markets participants. Longevity derivatives resemble the older catastrophe bond, or insurance-linked security (ILS), market, which packages insurance against natural disasters. A key difference between longevity insurance derivatives and cat bonds is that there are now a number of hedge funds dedicated to the ILS market.

Who buys these securities? It’s been mostly life insurers so far. But firms anticipate other interested parties will soon be buying up these instruments, as well. From Institutional Investor:

Although it’s been difficult for capital markets participants to compete with such natural buyers, long-term investors like sovereign wealth funds may find the portfolio diversification attractive. Ultrahigh-net-worth investors might also be interested, says Peter Nakada, Hoboken, New Jersey–based head of the life risks and capital markets units at RMS. These products can be viewed as a social good because they provide insurance for people who may not have enough cash in retirement, Nakada posits: A wealthy individual makes good money now by purchasing them; in the unlikely event that retirees exhaust their annuities, the monetary outlay can provide financial relief to the needy elderly.

The firms selling these instruments seem to realize the market is “immature” and it will take investors a while to warm up to them. But several industry sources told Institutional Investor they see longevity derivatives as a diversification tool and a good fit for portfolios of endowment funds and even high-worth individual investors.