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In late 2002 signs of a new flu pandemic emerged in Asia. The first reported case of the often-fatal virus occurred in China, spreading as doctors and other health care workers traveled throughout Asia and beyond. By early 2003 severe acute respiratory syndrome, or SARS, had infected hundreds of people in 37 countries.

At about that time, Peter Nakada received a call for help. Several global reinsurance companies asked Nakada, a risk management expert who specializes in catastrophic events, to create a computer model that would help them evaluate the transmission and lethal potential of the new virus.

Nakada, who heads the life risks and capital markets units of Risk Management Solutions (RMS) at the firm’s Hoboken, New Jersey, office, built and delivered the software to his reinsurance clients, then decided to shop it to the life insurance market. That was when Nakada, sitting across a table from the chief actuary of one of the largest U.K.-based life insurers, learned of a new catastrophe. Though the flu software was very interesting, the actuary said, SARS “isn’t what keeps me awake at night.”

What disturbed the actuary’s slumber was not death but life: catastrophic longevity. The risk that many more people would live a lot longer than anyone had imagined had become the scariest scenario in life insurance.

There is no doubt that over the past century life spans have increased — a trend that has accelerated in recent decades. But when it comes to planning for retirement income security, budgeting economic resources or even creating shareholder value in public companies, expanding life expectancy is wreaking havoc on balance sheets and heightening financial risk for governments and individuals alike. “It’s been recognized that mortality is improving,” says Zorast Wadia, principal and consulting actuary on the pension-risk management team in the New York office of actuarial consulting firm Milliman. “There’s no hiding that fact.”

After his encounter with the actuary, Nakada returned to RMS with a new mission: to build a risk model that would project life expectancy for a given population. After two years of research and engineering, RMS released a program with 10,000 hypothetical paths that could influence longevity. One key finding revealed by the new model: There is a one-in-100 chance that the average pensioner in the U.S., Canada and 13 other developed countries will live five years longer than currently projected by actuarial tables. Though the families of these European, Australian and North American retirees will likely welcome having them around, this unanticipated decline in mortality will cost defined benefit plans a cool $1 trillion.

That’s a crisis that makes SARS look small. And it’s captured in the phrase “longevity risk.”

MANAGEMENT CONSULTANT PETER DRUCKER famously once wrote, “What gets measured gets managed.” Yet despite all the attention paid to various flavors of risk besetting public and private pension funds — credit risk, interest rate risk, market risk, currency risk ­— longevity risk has not been accurately measured, and it has not been managed well, either.

Investment risks have traditionally been the primary concern of pension sponsors who manage large portfolios. More recently, with the Federal Reserve’s quantitative easing program holding rates at historic lows, interest rate risk has become a greater concern. These low rates effectively reduced the present value of future pension liabilities — known as the discount rate — and increased the amount of assets needed to fully fund future pension obligations. Add to that the devastation to these portfolios wrought by the financial crisis, and it’s easy to see how once-ignored longevity risk became a big and growing problem.

The accuracy of the traditional mortality tables used to measure life expectancy has been the subject of controversy, particularly with the impending release of updated tables assembled by the Society of Actuaries (SOA), an educational, research and professional organization based in Schaumburg, Illinois; the tables were last published 14 years ago. “It’s a monumental task projecting future liabilities,” notes Amy Kessler, head of longevity reinsurance for Prudential Retirement, a unit of Newark, New Jersey–based Prudential Financial. When the new SOA tables are officially published, later this year or in early 2015, they will show that the median American is living 2.2 years longer than just a decade ago. That means the average 65-year-old will live 22.7 more years, to 87.7.

In actuarial terms the new SOA data means pension fund sponsors and individuals will need to set aside an additional 5 to 6 percent in assets, before factoring in inflation. “People are just coming to grips with this now,” Kessler says.

In the U.S. alone, using only the current estimates of mortality, actuarial liabilities include $3.6 trillion in the 126 largest public pension funds (closer to $4 trillion when you fold in local and municipal funds), $3 trillion in private defined benefit pension funds and $24.3 trillion in unfunded obligations to current workers and retirees within the Social Security program. Factoring in universal social security systems in 170 other countries, Blackstone Group co-founder Peter Peterson used $30 trillion in total global retirement savings when he wrote Gray Dawn: How the Coming Age Wave Will Transform Americaand the World in 1999. That number has grown a lot since then.

The International Monetary Fund argues that forecasters have consistently underestimated how long people will live, over time and across populations, regardless of the techniques they have used. A 2000 report, Beyond Six Billion: Forecasting the World’s Population, says that estimates have been too low in many countries, including Australia, Canada, Japan, New Zealand and the U.S., by an average of three years.

The British have led the way in acknowledging, quantifying and tackling longevity risk. The U.K. Pensions Regulator has pushed for trustees and sponsors to employ the latest available methods and techniques in setting demographic assumptions. British actuaries use socioeconomic factors that influence life spans, such as county of residence, type of employment, housing, health care, education and diet, to gauge life expectancy. The U.S. has not used these factors in a sophisticated way.

“Longevity risk has been much less visible in the U.S. market,” says Guy Coughlan, Pacific Global Advisors’ chief risk and analytics officer, based in the firm’s London office. “The pension mortality tables have been lagging behind the actual life expectancy.”

Part of the problem in gauging longevity risk has been that insurers, pension funds and others in the financial markets have always depended solely on actuarial data that extrapolates from the past. It has now become clear that actuarial tables do not include the classic fund industry warning label: “Past results do not guarantee future performance.” RMS was the first to build a multifactor longevity risk model, which is now used by life insurers, reinsurers and those developing longevity-risk products in the capital markets. Among the many factors that go into the design of a longevity-risk model are estimates about the pace and duration of improvement in life expectancy. As with climate change, the science encompasses extremes. One side believes the human life span can and will continue to grow. The other concludes there is an end point to human longevity, an age beyond which it will not be possible to survive.

But even if you do not believe longevity will extend indefinitely — no one is suggesting it isn’t improving, at least in the short run — the need to mitigate the future retirement income needs of a global population is critical.

To meet those needs, an increasing number of longevity-­risk solutions and strategies are gaining steam, from human-capital solutions to specialty financial products designed by Wall Street, insurers and other purveyors of risk mitigation tools. In the latest round of creativity, new financial products are being packaged for sale to endowment, foundation and sovereign wealth investors as a way to profit from longevity risk. The question is, Will these efforts improve global retirement income security?

UNTIL THE MID-19TH CENTURY, HUMANS COULD expect to live fewer than 40 years. In about 1900 life expectancy began rising globally, reaching 48 years in 1950, 60 years in 1980 and close to 70 by 2010, according to data from the United Nations and the IMF.

The dramatic surge in life expectancy is mainly a result of the decline in infant mortality, which accounted for more than 70 percent of improved life expectancies in Canada and the U.S. from 1950 to 1970; other health care benefits aimed at people under 65 also contributed. Death from infections was reduced, while mortality as a result of chronic and degenerative diseases at advanced ages increased.

Then, starting in about 1970, a significant improvement in life expectancy for people over 65 began. It continues today, with the largest effect on the oldest, those aged 85 and over. The improvement in later life expectancy is the key factor in the more recent upswing in longevity risk.

Will rapid mortality gains continue indefinitely or taper off? On one side of the debate is Leonard Hayflick, a microbiologist and professor of anatomy at the University of California, San Francisco. He contends that science has not yet discovered the fundamental causes of aging. “The resolution of causes of death tells you zero about the cause of death,” says Hayflick, a founding member of the National Advisory Council of the National Institute on Aging, stressing that wiping out cancer or heart disease will not add many years to life expectancy. Patients cured of cancer in their 50s, 60s or 70s continue to age. “For the past 25 to 30 years, the cause of death in the U.S. and developed countries is essentially unknown for people over 80.” People don’t die from a disease; they die with it. To increase life expectancy, Hayflick concludes, “the only other thing you can do is tamper with the aging process.”

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