Why do you consider longevity to be a risk?
A risk is something that differs from what we anticipate. Otherwise, we could have an idea of the outcome and then plan some contracts in order to offer some protection. And we observe that people have been living much longer than what was anticipated. Longevity is a slowly-developing trend risk, and the recent improvements of life expectancy have been underestimated, especially in Western countries. On top of this, the casual factors underlying longevity are not always well accounted for. Indeed, it varies with gender, geographic location, social class, income and wealth and the year of birth.
As a consequence, mortality forecasting models, used by insurance companies and pension funds, are not a true reflection of reality. There is a poor accuracy of official projections of life expectancy. Moreover, in some countries, data is limited or incomplete. The insurance sector knows, for instance, that it is the case in the United States. Not only is data wrongly reported, but it is also incomplete and not reflecting the real mortality rate in the country. So, if distribution is incorrectly modelled, insurance companies face a modelling risk, due to a wrong or limited data set.
Two other risks also need to be taken into account. There is a trend risk: major evolutions in our socio-economic environment or our health care could highly improve our longevity. And there is what we call an idiosyncratic risk: mortality rates could still vary from the expected outcome as a result of random chance.
Who is bearing that longevity risk?
A great number of issues come along with an increasing longevity, such as individuals outliving their savings and annuity providers inadequately reserving. And pension plans must provide retirement income security, no matter how long people live. This means that plan sponsors might have to divert some resources away from dividend and investment programs in order to ensure the payment of that income. And sometimes, it is for workers that have not even been working in the company for 20 years. Longevity risk causes a misallocation of companies’ resources.
Of course, governments are also bearing a part of that risk, since they have public pension systems and since they will be the insurer of last resort, if needed. And let’s not forget investors, who face a financial risk when investing in longevity risk products. So, there is a great number of stakeholders bearing longevity risk.
Why are the existing solutions not sufficient to address that risk?
So far, insurance companies have been in charge of handling that risk. They have the skill set to deal with it and have been in the forefront of the buy-in and buy-out market. But this a very complex marketplace and it has a size limit. In the UK, for instance, only legally registered companies can sell annuities, so investment banks are kept out of the market, unless they own an insurance subsidiary. In the UK, Deutsch Bank and Goldman Sachs did. But, after the financial crises, the Dodd-Frank act forced them to pull out of that market.
Another consequence of the crises are the new capital requirements for insurance companies. Even though they can benefit from special conditions, some of those companies face a risk of bankruptcy if they do not handle the longer life expectancy.
So far, pension funds, especially American and Canadian, have been willing to take some longevity risk, but this is coming to an end. Now, there is not enough capacity in the insurance industry to buy out all this risk. For all of those reasons, we need a new class of investors and new assets as well. This is the better way to transfer that growing risk to the market.
What could be that new asset class?
A new global capital market is already emerging. It trades longevity-linked assets and liabilities. It is an interesting market because it is, to a first-order, uncorrelated with traditional financial assets.
I also encourage governments to issue longevity bonds. There are multiple reasons for governments to follow that path. An efficient annuity market is in their interest, and so is the fact of having an efficient capital market for longevity risk transfers.
There will be a rising appetite for bonds on financial markets. Since 2000, there is a structural change in those markets. The main drivers are now demographic, but this is widely ignored. Returns will be lower and one of the explanations is that we have an aging population. And that population is not willing to take some risk. She wants to invest in assets that deliver regular cash flows to pay for their retirements, such as bonds.
Investment companies are soon going to realize that they will need to have more bonds than equities in their capital structure and that they won’t be able to take the risky investments that they used to.
On a global prospective, markets are the right answer to the longevity risk because they are more efficient than the insurance industry in reducing informational asymmetries, and bonds, more precisely, are facilitating price discovery.
Can you estimate the size of that potential longevity risk market?
If we encompass both state and private sector, we can estimate the potential size of global longevity risk market for pension liabilities to be between $60trn to $80trn. The major market would be the US, with $14 460 trn. Then the market size drastically falls, the second market being the UK, with $2 685trn. Australia, Canada, Holland, Japan and Switzerland would follow.
Is the solution only a matter of financial assets?
A successful answer to the longevity risk is also social. The ultimate holders of that risk are the younger generations. There is some work to be done to ensure that they are willing to take it, and some thoughts need to be made on the premiums they should get in exchange. But governments also need to ensure that the risk is co-shared. Governments must enforce intergenerational contracts. Old models of intergenerational support are coming to an end and we could see younger generations refusing to bear that risk, especially in countries where the fiscal burden is already heavy. A good example of that is what happens in the Netherlands right now. About 20 years ago, they realized that their pension model was not sustainable. The government encouraged a wide transformation in the insurance industry. The schemes moved from a salary to a more collective model. It worked out pretty well for decades. But we now see a wide movement within the younger generations, refusing to pay for the eldest and rejecting the collective schemes.
Moreover, if the financial burden is too important for the younger generations, they can easily move to another country. This means that the longevity risk will be on a more and more reduced population. In addressing that risk, we need to take into account demographic and labor market evolutions.↵
This is why governments are the best placed to engage in intergenerational risk sharing, that could be obtained through issuing longevity bonds. But resolving that issue will also require some political measures because, as of now, each generation needs to work longer. In the UK, it is admitted that individuals should spend two thirds of their life working, and one third in retirement. This is not sustainable. When the British Welfare State was implemented in 1948, the retirement age was 65 years old and male life expectancy was 67! But those major changes will require some courage from the governments, who need to step away from their purely political agenda.
