Advances in medical science have increased the life span of individuals. It is now common for people to live for ten to twenty years longer than their previous generation. This seems like a good development from a humanist point of view. However, from a pension funds point of view, a longer life span has several financial implications. These financial implications are called longevity risk. In this article, we will have a closer look at the impact of longevity risk on pension funds.
- Longevity risk is defined as the risk of actual survival rates of pension beneficiaries being greater than the assumptions which were made while pricing the product. Pension funds sell annuities of uncertain tenure to their beneficiaries. The tenure for which the monthly payment will continue depends upon the longevity of the beneficiary. If more beneficiaries start surviving for a longer period of time, there can be a significant financial impact on the fund.
- Longevity risk has implications for both parties. On the one hand, pension funds are concerned that greater longevity would mean increased cash outflow. This is because they would have to pay the beneficiaries for a longer frame of time. On the other hand, increased longevity also means increased medical expenses for the beneficiaries. Hence, they are concerned about the fact that they may not be able to meet their increased expenses and may have to lower their standard of living during their increased lifespan.
- Pension funds and insurance companies use life tables to determine the average age and the number of expected survivors. These tables are prepared by actuaries based on the data present at the time of the preparation. Changes in the medical field lead to a change in this data every year. However, a lot of the time, pension funds do not account for these changes. Hence, money is invested based on assumptions that are very different as compared to the final outcome.
- In the past, pension funds have made projections related to increased life expectancy. However, these projections have consistently underestimated the actual increase in life expectancy. Hence, pension funds have empirically not been able to accurately predict this variable. This is the reason why there is a lot of uncertainty surrounding the outcome.
- Pension fund investments are made over a long period of time. It is common for pension funds to hold sums of money for more than fifty years. Now, the development of science and technology is taking place at a breakneck speed. Hence, the average life span typically ends up increasing during this period. Hence, pension funds have to work with uncertainty when it comes to the longevity of their beneficiaries. Since longevity cannot be accurately predicted, it becomes challenging to create a financial plan for it.
- Longevity risks affect pension funds regardless of the mean age of their beneficiaries. If the mean age of their beneficiaries is low i.e. if most of the beneficiaries are young, then the pension fund is more likely to face longevity risks and may have to pay out more in cash flow. However, the good news is that these payments have to be made in the distant future.
Hence, the pension funds can start adjusting their financial plans which would allow them to make these payments at a later date. At the same time, if the mean age of the pension fund is high i.e. most of the beneficiaries are old, the pay-out might not be affected so much. However, the fund has very little time to make adjustments in order to provide for this increased cash flow.
- Longevity risks become even more critical for pension funds in a falling interest rate scenario. In the past few years, interest rates across the years have been continuously declining. In such scenarios, pension funds find it hard to generate enough funds that will allow them to pay monthly payments for an increased period of time.
It has been estimated that a two-percentage-point fall in the interest rate leads to a 20% increase in the liabilities of the pension fund. Since lower interest rates have now become the norm across the developed world, pension funds are feeling a greater impact of the longevity risk.
- Pension funds have to be careful while dealing with longevity risks. Some pension funds have tried to mitigate longevity risks by using different life tables for people belonging to different gender and different socio-economic strata. However, they had to stop doing this since it amounts to discrimination. This is because it amounts to penalizing certain groups for having a higher life expectancy as compared to others. This practice may be considered to be illegal in most parts of the world.
Pension funds have created another method that is more useful in managing their financial position. Pension funds have started indexing the value of their pay-outs with the average life expectancy. This solution allows pension funds to manage their finances without using discriminatory policies.
The bottom line is that longevity risk is unique to the pension fund industry. However, it can have a massive impact on the financials of any fund. Also, with medical science advancing by the day, life expectancy is expected to continue to rise in the future. Hence, it is very important for pension funds to recognize longevity risks and also take steps to properly manage the same.