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Work to live: Increasing longevity and the strain on investment schemes

By now we are all getting rather familiar with the risks that the increase in
longevity of life poses to final salary (defined benefit) pension funds. But
being familiar with the risks is one thing; solving the problems is another,
requiring a total overhaul of pension practice.

As Hymans Robertson partner Douglas Anderson observes, “The rate of increase
in longevity has been so great that it is now effectively dragging back
investment performance by half a percent a year, which is a terrifying figure
for fund managers,” he says.

The average lifespan is increasing at the equivalent of 12 minutes every
hour, which is wonderful for individuals. But if you ponder Anderson’s point
about the impact on investment returns, it effectively means that in 10 years, a
steady, continuous year-on-year investment return of 5% after inflation (which
is not a bad rate) would be the equivalent of a zero real return by the tenth
year ­ and every subsequent year the fund would actually lose value by 0.5% a
year cumulatively, plus the rate of inflation.

Moreover, this disastrous scenario assumes that there is no sudden upward
leap in longevity caused by some new medical breakthrough such as a cure for
cancer. Recently, a life sciences company started clinical trials of a genetic
treatment that is expected to cause cancer cells to “commit suicide”. Good news
for mankind if the trials work; rotten news for annuity providers.

War generation
To date, the generation that has been most favoured in the mortality statistics
is the generation born between 1930 and 1945. “This generation saw a real step
change in life expectancy, but about 40% of that change is thought to be due to
the fact that it was the first generation to profit from the discovery of the
link between smoking and lung cancer,” says Anderson. The second factor is
probably the dietary improvement brought about by rationing during the war
years, which forced people to cut back on sugars and fats and to eat more
balanced meals.

Danny Vassiliades, a principal at Punter Southall, makes the point that there
is a built-in bias in developed societies for longevity to increase. “The plain
fact is that mortality creep is going to be an enduring phenomenon for the
pensions industry to deal with,” he says. “You have a biosciences industry and a
pharmaceutical industry hugely active in the area of keeping people alive. You
have governments trying to attack behaviours that kill off people, such as
obesity, dangerous driving and excessive alcohol consumption. And as the aged
population expands you have a massive voting bloc very interested in seeing that
public funds are spent promoting longevity. We are already seeing annuity
providers adding hundreds of millions to their reserves to offset business they
have written which under-estimated growing longevity.”

Vassiliades argues that people’s expectations about their standard of living
at retirement will have to be managed downwards, or the retirement age will have
to be pushed out substantially (BT is a very large and recent example of a
company that has just raised its retirement age from 60 to 65). “Pension schemes
will not be able to deliver a retirement income that gives you the freedom to do
everything you want to do in retirement if everyone lives to 85 and beyond. So
there is a macro-economic question of whether the nation’s wealth should be used
for retirement or whether we should keep the same proportion of that wealth
allocated to retirement (without increasing it), and just keep walking the
retirement age upwards,” he says.

Shifting the risk
For companies, the simplest way out of the dilemma has long been to shift from
defined benefit to defined contribution, since this effectively shifts the
longevity risk to the individual employee.

Chris Tavener, a partner with
Lane
Clark & Peacock
, says that actuaries and trustees need to keep
a near-continuous eye on the interaction between any deficit in the scheme, the
amount a company can afford and the strength of the company’s covenant. “You can
no longer afford to wait for the three-yearly scheme valuation report. These
matters should be on the agenda for every trustee meeting,” he says.

A sound response to increasing longevity is to deploy sophisticated liability
matching techniques. “On a high level, this is along the lines of using interest
rate and inflation swaps to ensure the benefit payments from the scheme are
matched by receipts from the assets,” he says. The better you can match these
two streams, the more resilient the financial base of the scheme will be to
changes in financial conditions.

Paul Kidson, a senior consultant with
Watson
Wyatt
, says that the figures for increasing longevity make gloomy
reading from the standpoint of annuity providers. But he adds that the current
round of reserve adjustments being made by providers to deal with potential
losses on this front could be being overdone.

Mortality frisk
Until, and unless, something extraordinary happens, however, the main aim of the
game is for trustees to get a lot closer to the mortality risks inside their own
particular schemes. Kidson points out that Watson Wyatt has been helping
trustees to analyse their schemes using a variety of tools. Postcode analysis is
one of the more frequently used options.

The point here, Kidson says, is that trustees of smaller schemes are
disadvantaged by comparison with trustees whose schemes have, say, 10,000 or
more members. With that size of membership the law of large numbers comes into
play and trustees can be reasonably confident that national mortality statistics
for the population as a whole will apply to their scheme. However, in smaller
schemes the figures can be skewed in all kinds of ways. Breaking down members of
a smaller scheme to post codes and then using the population-wide post code
mortality statistics provides a very good way of bringing the law of large
numbers to bear on smaller schemes.

“There is nothing magical about post codes, nor is there any direct causal
link. But post codes are a very good proxy for the kinds of things that impact
on longevity,” Kidson explains. The analysis, then, is all about answering
questions like: how many of the 60-year-olds in the scheme are likely to die
through the course of the next year? How many 61-year-olds, 62-year-olds, and
so on? What emerges from this is a better understanding of the liability
structure of the scheme. “The better that trustees understand their scheme, the
more likely they are to make appropriate assumptions about longevity,” he says.

Another answer to longevity risk is to insure against it. There are an
increasing number of products being introduced to the market which let trustees
hand over their mortality risks to insurers. Andy Briscoe, chief executive of
Life
Trust
, outlines the idea behind his scheme. “We work on a mutual
concept, by creating a pool where smaller schemes can group all those scheme
members who are high-benefit members and who might live for a long time. Life
Trust dubs these people the scheme’s ‘idiosyncratic risk’. This risk, then, is
taken by the mutual pool,” he explains.

Consider a small scheme with several highly-paid members. The risk of those
members living well beyond the average assumptions of the scheme, on which it
bases its liability calculations, can skew the risks for the whole scheme. By
“dumping” those members into the pool the “risk” is capped off at the cost of
the premium paid to Life Trust.

Briscoe says that Life Trust is receiving a substantial number of enquiries
from employee benefit consultants and advisers. The real appeal of the scheme,
he says, is that unlike a scheme buyout or going to an insurance company for an
annuity-based solution, there is no immediate large transfer of scheme assets to
the insurance company.

“The assets continue to sit where they are and it is only when the life
cover for the individual ends that the assets are transferred to our pool,” he
says. In the present market conditions, where no scheme trustee wants to
crystalise a loss on the equity markets for example, the idea of not having to
hand over assets immediately is very appealing. Under the arrangement with Life
Trust, when an individual in the scheme reaches, say, the age of 75, the insurer
starts paying income into the pension scheme. The amount paid in rises each year
that the individual remains alive. “This effectively caps the risk and makes
predicting the assets and cash flow needed into the future far easier,” Briscoe
says.

Watson Wyatt’s Kidson says that insurance-based solutions to the longevity
issue are starting to attract real attention. However, Dave Robertson, a partner
in
Mercer’s
financial strategy group, argues that, in many instances, simply purchasing an
annuity for these “idiosyncratic” scheme members will be a more attractive
option for some schemes. “The problem with all the insurance-based longevity
offerings out there at the moment is that they all need to get some momentum up
. There is no shortage of ideas and capital starting to address the pensions
market and we can expect some of these to succeed and some to fall away,” he
concludes.”

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