Pension providers should take action now to tackle the risk of a “longevity shock” that could affect their financial stability, the International Monetary Fund (IMF) has declared in its well-respected Global Financial Stability Report.
If not tackled soon, this “longevity risk” — the prospect that the average person will live for considerably longer than currently expected — will make private- and public-sector balance sheets “more vulnerable to other shocks.” It warns, “Most private pension systems in the advanced economies are currently underfunded, and longevity risk alongside low interest rates further threatens their financial health.”
The IMF concludes: “Better recognition and mitigation of longevity risk should be undertaken now. Measures will take years to bear fruit and effectively addressing this issue will become more difficult if remedial action is delayed.”
The IMF’s comments — which are most relevant to defined benefit schemes, since they must achieve sufficient returns to guarantee a certain level of pension payment — carry weight among pension providers and other institutional investors because of its prestigious status as one of the world’s financial policemen. The organization has a long record of issuing well-researched warnings about global financial stability, in addition to its more hands-on role of lending money to governments in crisis.
The IMF’s analysis is in its latest biannual Global Financial Stability Report, whose role is to warn of looming hazards in the global economy. An entire chapter of the report, published on April 18, is devoted to the financial impact of longevity risk.
Its central argument is that forecasts have repeatedly underestimated life expectancy for people on the cusp of retirement age — and that over the past few decades the degree of miscalculation has averaged about three years. The United Nations currently predicts that by 2050, life expectancy at age 60 will be about 26 years in advanced economies — a gradual improvement of about one month per year from now until then. However, if forecasts again underestimate increases in longevity by three years over the coming few decades, the funding ratios of corporate defined benefit schemes — the proportion of future liabilities that are covered by the market value of current assets — would fall drastically.
The IMF projects, for example, that the funding ratio would decline from a current average of 95 percent to 88 percent in the United Kingdom, and from 87 percent to only 77 percent in Switzerland.
A large part of this deterioration will come from the rising value of future obligations, as scheme trustees are compelled to find the money to fund more years of retirement.
However, the IMF also warns that the aging population could hit economic growth, which would further reduce funding ratios by decreasing investment returns. There are several potential reasons for this: a reduction in the proportion of the adult population at work, rather than in retirement, would reduce output per person; moreover, the chapter suggests that workers’ ability to solve problems, learn and work fast, which are all important to productivity and hence to growth, decrease with age.
The chapter also warns of potential distortions to the investment market caused by an aging society. For example, the resulting shortage of labor would force firms to increase the use of capital as a substitute. This would reduce the return on capital for pension funds and other investors, and hence their investment returns. Moreover, older people and their pension funds tend to put their money in safer assets, because of the need for a regular income (in the years after retirement), and for assets that are unlikely to fall sharply in value (in the last few years before retirement). The IMF warns that this “reallocation of saving from riskier to safe assets may lead to potential mispricing of risk” — with safer assets overpriced, and riskier assets such as equities underpriced.
Turning to solutions to the longevity risk problem, the organization says private and public pension providers should consider increasing retirement ages and pension premiums, and reducing the generosity of pension payments.
It warns that in countries where the “flexibility” to take such steps “is lacking” — including the U.K. — “plan sponsors are closing down defined benefit plans and switching to defined contribution schemes”.
The IMF also extols the virtues of financial instruments that allow defined benefit pension providers to pass longevity risk to organizations that will benefit from higher-than-expected life expectancy, such as life insurance companies and suppliers of long-term care. Through a longevity swap, for example, the pension scheme’s sponsor makes a regular payment to the counterparty, which in return makes periodic payments based on the difference between actual and expected payments of benefits to retired scheme members.
However, the IMF acknowledges: “The use of capital market–based longevity risk management solutions has been growing, but their use remains small” — with the “notable exception” of the Netherlands and U.K. In the U.K., the value of deals cut by pension funds to transfer their longevity risk rose to £9 billion in 2011.
