Dan DeKeizer, chief executive officer, MetLife Assurance Limited, on ways to effectively reduce longevity

Today, people are living longer than ever before. In 1981, the life expectancy for a man aged 65 was another 14 years, now it is over 20 years(1). Whilst this improvement in life expectancy has been good news for individuals, it has had a significant financial impact on sponsors of defined benefit (DB) schemes. Research by Hewitt(2) in December 2009 showed that as a result of increases in longevity, UK DB pension scheme liabilities are increasing at the rate of £1 million per hour.

The debate as to whether continued improvement in longevity is a persisting or temporary problem continues to rumble on. One train of thought suggests longevity will continue to improve indefinitely as medical advances, better nutrition and improved lifestyle potentially defeat ageing entirely. The opposite view is that pandemics, war and lifestyle issues, such as obesity, mean that longevity improvements cannot continue forever.

Longevity risk can be defined as the risk that a broad and dramatic improvement in longevity occurs and significantly lengthens the lifespans of the pension members, whether deferred, active or in-payment. While the actual increases in pension payments associated with that longevity improvement won't emerge for many years, from a funding and accounting point of view, there will be an immediate increase in the scheme's liabilities. In addition, this type of event is not likely to be concentrated in just one scheme - it will affect the population broadly, creating strains on the basic state pension, on public pensions and on health care resources. All of those suggest increases in taxes and a slowing economy which have their own negative impacts on funding status.

Depending on a pension scheme's view on longevity, pension schemes can choose to retain the risk on their own books, as many have done historically, mitigate the risk through benefit changes, transfer some of the risk through longevity swaps or longevity insurance, or transfer all or some of the risk through a full or partial buy-in or buyout.

Touching briefly on benefit changes; reducing indexation in exchange for higher nominal pensions or ensuring that young spouses or financial dependants get actuarially fair levels of benefits compared to average aged spouses are examples of ways to reduce the scheme's exposure to longevity risk. Of course, pensioners that take their pension as cash (via trivial commutation) or deferred members that leave the scheme (via cash equivalent or enhanced transfer values) take their longevity risk with them so trustees and employers may also wish to explore the use of such liability reduction exercises to decrease their exposure to longevity.

However, let's turn to the options available to transfer longevity risk. A Bulk annuity buyout involves shifting longevity risk along with investment, administration and employer covenant risk to an insurer with the capital and regulatory structure to protect the scheme's members. Whilst full bulk annuity buyout is perhaps the gold standard for pension risk transfer,not many schemes are in a funding position today to use that approach. The question then is how best to reduce risk with the funds available. A scheme considering derisking ahould first examine which liabilities should be addressed first, and what type of risk reduction product will be most effective.

Broadly speaking three types of products are available today in the market:

1) Bulk annuity buy-in. This product, like a bulk annuity buyout, references the benefits of specific members (pensioner, deferred and / or active) in the scheme and provides longevity and investment risk transfer for those specified members. It is normally a partial solution and the price will be similar to an equivalent partial buyout, but since the annuity remains an asset of the scheme, the cash flows from the annuity can be used to fund any benefits that the scheme is obligated to pay.

2) Longevity insurance. Typically at a much lower premium than a traditional buy-in, longevity insurance transfers just the tail risk, usually by identifying a pensioner age at which the insurance benefits will begin, or, sometimes, by reference to a specific future date at which the insurer begins to pay all benefits. By placing a definitive last payment date for each pensioner, the scheme has a clearer investment horizon and is protected from dramatic improvements in longevity, especially among older pensioners. The disadvantage is that the scheme is still exposed to the increased cost associated with greater numbers of people reaching the cut-off age, albeit with much lower volatility and cost impact than before.

3) Longevity swaps. For an even lower upfront premium, but with a commitment to make additional fixed payments in the future, a scheme can contract with an insurer to exchange payments based on the longevity experience of the scheme's members, or tied to a population index. With this product, the scheme pays to the insurer the expected pension payments, and the insurer returns to the scheme the actual pension payments. If scheme members live longer than expected, the insurer takes that risk. If scheme members live shorter than expected, the insurer benefits. Carefully defining "expected" and "actual" mortality and the conditions and price at which the swap can be novated or canceled are important steps in entering this type of arrangement.

Selecting both the product and the risks to be transferred depends on how the pension scheme measures risk and the expectations of the scheme for its future operation. Taking the latter point first, a scheme which is on a path to buyout may not want to enter into either a longevity swap or longevity insurance without either committing to go to buyout with the same provider, or at the very least having a clear understanding of how this risk mitigation product can be surrendered or converted into a useful asset when selecting another.

When examining the risks to be transferred, older pensioners will in one regard have higher volatility as one extra year of their life will be proportionately larger compared to the baseline life expectancy. However, for most other purposes, it's the younger lives that have the most volatility. They have longer exposure to medical advancements, greater exposure to inflation and are likely to include the members with the largest pensions as well. Consideration should be given to this when determining whether to transfer the longevity risk associated with older-age pensioners, early retirees, deferred or active members.

In summary, a partial buy-in or buyout effectively reduces longevity risk, both in terms of controlling funding volatility and for protection against tail risk events, whilst alternative solutions can provide targetted risk mitigation depending on which liabilities are included and the structure of the agreement. Trustees who are undertaking an alternative solution should also have regard to any future de-risking activity the pension scheme may undertake so as to ensure future options are not inadvertently limited. Discussing those objectives with the corporate sponsor and scheme advisers can help trustees prepare as they enter the market for longevity risk reduction.

1. GAD cohort expectation of life, 2006 based projections
2. Hewitt 2009 Global Pension Risk Survey

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