Longevity Hedging Risk: One Area the Market Fails to Deliver

Despite aging populations, the market for longevity risk products is underdeveloped, according to a study.

(January 31, 2012) – Hope is poor strategy for pension fund managers to rely on when faced with any risk, whether tail, interest rate or inflation, but perhaps especially so with longevity. 

An interdisciplinary study by four researchers, including finance and accounting specialists, has compared the two most common longevity-hedging strategies in the context of defined benefit pension plans. The ground-up hedging strategy transfers a portion of all future retirement payments, often in the form of a bond. 

Excess-risk hedging, in contrast, involves offloading longevity risk at a certain level. The most prominent example of the latter occurred in 2008, the insurance company Canada Life orchestrated a “survivor swap” with owners of insurance-linked securities. The researchers used historical data and a model to determine the optimal approach to longevity hedging for DB plans specifically, considering both cost and risk. 

Their conclusions, based on how pension plans have used the strategies and how they could optimize them, called for better options: “First, the market should design appealing longevity securities that can attract pension plans. As our results indicate, the pension plans are inclined to transferring more longevity risk with the excess-risk hedging strategy since it is less capital intensive and more cost effective.” 

Again, unlike most other risks facing pension funds, the authors argued that insurance companies and asset managers are failing to provide sufficient products to defray risk. Those that are available, are simply too expensive to justify. “The current high transaction costs in the capital market discourage the plans from transferring longevity risk,” the authors wrote. “This problem can be mitigated by standardizing longevity transactions. For example, we can promote consistent best market practices and publish tradable longevity indices. Such efforts will provide greater transparency and confidence for this market, and increase transaction activity.” 

Longer life spans are posing an acute problem in Japan particularly, which has both an aging population and widespread pension coverage. 

Read the whole article, “Managing Capital Market and Longevity Risks in a Defined Benefit Pension Plan,” here.