Longevity risk and its implications for endgame portfolios.

This paper examines how uncertainty regarding future mortality rates and life expectancy, i.e. longevity risk, affects defined benefit pension schemes.

In general, longevity risk is defined as any potential risk resulting from members of a population living longer than expected. Improvements in longevity are bringing many challenges. One of the most obvious and well-publicised impacts is the increased cost of pension provision.

In this piece we focus on the impact of longevity risk on defined benefit (DB) pension schemes. We explore how longevity risk can become a greater concern as a scheme derisks and adopts a more cashflow matched strategy, how schemes can monitor and measure this risk and the potential impact on investment strategy.

The risk management of DB pension schemes is a high priority for trustees and corporate sponsors. Those managing the assets and liabilities of pension schemes require appropriate models and hedging strategies to deal with the uncertainty around future financial, economic and demographic conditions.

Strategies to mitigate equity, interest rate and inflation risk are widely used. In contrast, longevity risk has not yet been addressed in any meaningful way by many schemes. Longevity risk is typically addressed by entering into a buyin, buy-out or longevity insurance policy.

It is common, when performing asset-liability analysis, to simply ignore longevity risk (and other demographic risks) and assume that benefit cashflows vary only in line with changes in inflation experience and expectations.

The temptation is to manage only the risks that are most familiar and readily modelled, without considering the influence of less familiar risks. This does not typically lead to poor decision making when the scheme has a reasonably high proportion of risky assets, since longevity risk is usually dominated by investment risks such as equity risk.