SINCE THE 1950s, occupational pension schemes have seemed a clever recruitment strategy. Promising generous retirement benefits which would not fall due for decades, and with plenty of time to build up the funds needed with the help of the stock markets, pensions seemed much cheaper than raising wages. However, over the last decade, a combination of tighter regulation, tougher accounting methods and poor stock market performance have stopped defined benefit pensions in their tracks.
By the end of May 2011, on aggregate, UK private sector pension schemes were in deficit by £73 billion on an IAS 19 or FRS17 accounting basis, according to Pension Capital Strategies1. But while most of the problems that have beset occupational schemes can now be calculated, quantified and managed, one of the biggest variables cannot; life expectancy.
Predicting life expectancy has always been a fine art, practised by experienced actuaries at life insurance companies with a high degree of statistical confidence. Unfortunately for occupational pension schemes, the relatively limited information available combined with a dramatic improvement in life span means predictions are highly prone to error.
Around the world, average life expectancy has increased by almost 20 years since the 1960s, and is now 69.2 years. In England it is 78 for men and 82.1 for women, according to the Office for National Statistics (ONS). In the UK a 65-year old male can expect to live 17.6 years and a female 20.2 years; three or four times the length of retirement that many occupational schemes would have assumed when they were first instigated.
It is not difficult to see why funding a pension scheme with open ended liabilities, often linked to inflation, has become so expensive due to the significant increases in longevity. However, for finance directors the question is: how much worse can it get?
Medical breakthroughs, rising standards of living, access to healthcare, higher infant survival rate, better diet and reduction in smoking are among the reasons cited for increased life expectancy. In a study of trends in the last 40 years published in March, Professor David Leon from the London School of Hygiene and Tropical Medicine points to a reduction in deaths from heart disease as the biggest recent contributor in the UK noting that deaths from cardiovascular disease have seen, “some of the largest and most rapid falls of any Western European country, partly due to improvements in treatment as well as reductions in smoking and other risk factors”3.
The UK is now ahead of the US in terms of life expectancy; with Japan one of the few countries boasting marginally better figures. Many experts have suggested the rate of improvement must tail off, but predictions of an upper age limit have been frequently surpassed by reality. Predictions made by Stanford University professor James Fries in 1980 of a limit to average life expectancy of 85 are likely to soon be surpassed in Japan for instance4.
More recently, the US Census Bureau, using stochastic models, has estimated that average life spans will reach 86 by 2075 and 88 by the end of the century. The stochastic forecasting model assumes the current rate of improvement will remain constant5. Instead of being stable, research shows that the rate of mortality improvements have tended to decline over time at younger ages, while rates of improvement have risen at older ages. If this trend continues, then this implies that even these models underestimate the improvement in lifespan for retirees.
There are, of course, potential threats that could disrupt the upward trajectory of life spans. Economic, political and social unrest, war, pandemics and poor lifestyles, can all thwart medial improvements. The biggest threat currently visible in the UK is rising obesity levels, but it seems there is one fact that medical and population academics all agree on – there is no way of knowing how far and fast longevity will continue to improve.
Cambridge University geneticist Aubrey de Grey famously stated: “The first person to live to be 1,000 years old is certainly alive today”6. While that might not be an opinion shared by many, pension schemes are obliged to be conservative about the assumptions they use to predict the member longevity. Typically, UK occupational pension schemes now assume the life expectancy of their members will grow by 1-1.5% each year, with some performing sophisticated analysis, by postcode and income, of their members to estimate current life expectancy.
Such an approach is now expected by the Pensions Regulator and has increased actuarial estimates of pension scheme liabilities substantially. For example, last year it was reported that FTSE 100 company pension schemes have increased their longevity assumptions for pensioners for a fourth year in a row, raising scheme liabilities by about 1.5%.
Compared to 31 December 2008, the report showed that FTSE 100 companies had increased UK longevity assumptions by about five months for current pensioners and by approximately seven months for future retirees7. However, by their very nature, assumptions are prone to error and the financial impact of even a small miscalculation can be substantial; potentially increasing the cost of benefits by 20% for every five years of life underestimated. Many finance directors believe they have already dealt with the pain of expensive defined benefit pensions, injecting one-off additional contribution payments and closing the schemes to new entrants and even existing members. However, these actions do not remove risk or reduce volatility; they simply limit future liability accrual. It is not just the members, of course, but their spouses and children who could be drawing a pension for many decades.
It is no wonder, that finance directors are giving serious consideration to insurance buyouts and partial buy-ins of their members, transferring the financial burden of their members to an insurance company. The costs can be significant for under funded schemes, but it is a cost many companies are willing to bear for the certainty and security that the insurance guarantee offers to both the member and the company regardless of how long they live.
Emma Watkins is director of business development at MetLife
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