By Mark Barnicutt on July 4, 2010
In a recent article, Degrees of Longitude by Rhea Wessel, in the CFA Institute Magazine (March/April 2010), the issue of longevity risk — ie: life expectancies increasing beyond original forecasts — was reviewed as well as some of the risk management solutions currently being developed for use primarily by pension plans.
A summary of the key points in this article are noted below:
What’s The Current State:
– Advances in technology and medicine have contributed to a significant rise in the life expectancy during the past few decades.
– The implications of this risk for organizations that provide pensions and annuities is profound as small increases in life expectancy can add organizations that effectively underwrite/guarantee these future income streams to retirees/annuitants.
What Are Some Of The Potential Solutions:
1. Switching To Defined Contribution Plans:
– This has been a trend for many years in which very few new Defined Benefit Pension Plans are setup and Defined Contribution Plans have been the trend for the past many years.
– See our recent article, though, about the investment issues associated with DC Pension Plans. Click to here read the article.
– A buyout company (many times, an insurance company) purchases the pension liabilities from the books of corporations — for a price.
– Both assets and liabilities are transferred to the purchaser.
3. Buy-In Deals:
– This too is done with an insurance company in which the company buys sufficient immediate annuities to match the pensions that they have to pay retirees but they retain the liabilities on their own corporate books.
– This means that the insurance company assumes the longevity risk.
3. Longevity Swaps:
– Similar to interest rate swaps which trade floating interest rates for fixed interest rates.
– Companies forecast the mortality rates of their groups and enter into a counterparty agreement with an investment bank.
– If more people survive than predicted, the company will receive payments from the investment bank.
– If more people die than predicted, the company will make payments to the investment bank.
– Like all counterparty arrangements, the investment banks offset the liability to investors on the other side of the agreement.
4. Longevity Bonds:
– Similar to the market that developed when governments issued inflation-linked bonds, there is now early stage discussions to create Longevity Bonds.
– Just as the markets have now been able to price-in inflation forecasts into inflation-linked bonds, the same could happen if governments that have maturing populations were to create Longevity Bonds — the markets would then develop projections for mortality rates for different ages.
To read this article in its entirety, please click here.
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