Key statistics:
• Cost of longevity risk increases by 50%
• Low interest rates push liabilities up 50% over past 12 years
• The risk of yields staying low or getting lower for longer has increased following Brexit
• Total Defined Benefit pension liabilities now stand at £2.3 trillion
Commenting on the effect of low interest rates on longevity risk, Andy Green, Chief Investment Officer said:
“Any trustee or plan sponsor will know that the fall in yields weighs heavily on the cost of pension fund provision. The continued erosion of interest rates over the past 12 years has already hit pension schemes hard. Scheme liabilities have increased by 50% over that timeframe to £2.3 trillion. And the situation could get worse over the coming months if the Bank of England chooses to lower rates even further.
“What many don’t realise is that interest rates and longevity risk are highly correlated.
“When interest rates were much higher, if people lived one year longer than expected, this increased the cost of providing their pension by around 3%. However, with real yields on index-linked gilts now below -1%, more money needs to be held today to pay a year’s pension in 25 years’ time than is needed to pay next year’s pension.
“Consequently a one year change in life expectancy is now more likely to add 4.5% to the cost of paying a pension for someone’s lifetime. That’s a 50% increase in longevity risk.
“In combination with the increase in liabilities, there has been a 125% increase in like for like longevity risk in pound terms.”
Commenting on the options for schemes, James Mullins, Head of risk transfer solutions said: “This increase in the cost of longevity risk comes at a time when, due to schemes maturing, they’ve been dialling down their exposure to investment risk. This means that longevity risk now represents a larger risk than ever before for DB pension schemes.
We will therefore inevitably see longevity risk management move higher up the agenda for those running DB schemes.
“This is right. Schemes should be seriously considering reducing their exposure to members living longer. Longevity solutions such as buy-ins and longevity swaps will be more relevant to risk management plans than ever before. The good news is that prices for these types of insurance have not been adversely affected by the market shocks following the Brexit referendum result. So longevity risk has leapt up for DB pension schemes but the cost of insuring against this risk has remained nicely competitive.”
Discussing how longevity hedging solutions are no longer the preserve of large schemes, he added: “While longevity insurance using longevity swaps has played an important role in the de-risking plans of some of the UK’s largest schemes, smaller schemes have found the costs prohibitive. Fortunately the longevity swap market is innovating to make longevity hedges more accessible and affordable to smaller schemes too.”
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