Towers Watson's stochastic mortality model reveals an urgent need for action by pension funds and policy-makers
Record low interest rates and a gloomy outlook in the capital markets have been placing a strain on pension funds for some time. Following the crises of the last 15 years, it is now suddenly becoming clear what, thanks to good returns, no one had noticed before: the life expectancy of Swiss people has been significantly underestimated up to now. As a consequence, pension funds do not have enough reserves to be able to meet all of their future pension obligations right up until death. As pensions which have already come into payment cannot be shortened, increasing redistribution from active members to pensioners is also occurring in the second pillar. There is an urgent need for action by pension funds as well as within the political arena.
Some forward-looking pension funds are already working with newly available generational tables, in order to be able to calculate future pension liabilities based on the effective life expectancy. Statistics from the last 40 years show that life expectancy is much longer than assumed and is increasing in a linear fashion. Life expectancy in Switzerland is increasing not by 1.1 months per year, but by 1.7 months per year. "The average life expectancy of a 65-year-old woman in 2030 can be up to 32.2 years rather than 25.3 years. However, pension funds do not have enough reserves to make up the difference, in this example, of almost seven years. This issue has not really drawn much attention before now, due to the favorable capital markets having an offsetting effect on the deficit. However now there is an urgent need for action", urges Peter Zanella, Head of Retirement Solutions at Towers Watson in Zurich.
His team has developed a stochastic mortality model for Switzerland which uses statistical methods to correctly model the potential distribution of life expectancy. When looking further afield, similar models are already being used in other countries. "If action is not taken now, active members will have to cross-finance pensions on an even greater scale. This is neither fair from a generational perspective, nor is it sustainable over the long term", warns Ljudmila Bertschi, pension fund expert at Towers Watson.
Pension Funds and Polictians Must Act
Highly qualified men, who tend to draw higher pensions, typically have a 20% lower mortality rate than the average person. As a result, pension funds must pay these high pensions for longer than lower ones, meaning that it is only possible to balance risk to a limited extent. "Pension funds must adjust life expectancy in line with the personal situation of their members because an industrial worker has a different life expectancy from an academic or a manager", explains Ljudmila Bertschi.
A reduction in the conversion rate and the introduction of variable pensions will soften the impact of increasing life expectancy. But both methods come at the expense of active members alone. Only through an overhaul of asset management, which is able to absorb the volatility inherent in every investment strategy, will there be a real solution. "Systematic monitoring of risk trends as well as appropriate and dynamic risk budgeting (one which also takes longevity risk into consideration) will help create an investment strategy that accounts for the specific situation facing pension funds. There needs to be more dynamic thinking in this area than has been the case up to now", explains Ljudmila Bertschi. Employer and employee contributions will also have to increase, so that institutions can continue to fund ever-longer pension payments. Both pension funds and policy-makers must seek new solutions in this field and put the second pillar back on a firm footing.
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