“In the long run we are all dead.” So wrote John Maynard Keynes in 1923, criticising economists who try to describe far-horizon events rather than grappling with the present.
But just how long is “the long run” in terms of your own lifespan? Because, like it or not, there is almost certainly a pension fund sponsor or annuity provider somewhere who hopes that for you it will be shorter rather than longer.
Try not to take it personally. Life expectancy has been rising across the developed world – in the UK, for example, by about two years a decade. Although this figure is likely to start tailing off, your old age is nevertheless getting a bit costly for the pensions providers.
The more sunrises you see after you’ve cleared your pencils from your desk and picked up your retirement carriage clock, the more the defined benefit pension industry, which has roughly £1tr of liabilities in the UK, will have to pay out. And they’re worried.
“The impact of life expectancy being just one year different from expected is more than £30bn across funded defined benefit pension schemes in the UK,” says Andrew Gaches, a longevity expert at Club Vita, a life expectancy comparison group in London for occupational pension schemes. “The pick-up [in liabilities] for British pension schemes and their sponsors through increased life expectancy has been £6bn a year over the past five years.”
Tired of the risk
Historically, pension funds have borne the risk of rising life expectancy on their own books, Gaches explains, but over the past two or three years they have started to try to offset the risk that their members will live longer and longer. Longevity swaps have appeared to hedge this risk, and there are hopes of a market in longevity-linked bonds.
“Couple [increased longevity] with the uncertainty that many schemes face — for example, we have found five years’ variation in [observed] life expectancy between schemes with the longest and shortest lived members — and it’s easy to see why pension schemes are upping their game when it comes to managing longevity risk,” says Gaches.
The market for trading longevity risk is still in its infancy. In May last year, Credit Suisse underwrote a longevity swap, taking on the risk that pensioners from the British engineering services company Babcock International Group will live longer over the next 20 years.
The deal only concerned liabilities for current pensioners, who account for about £750m of liabilities, just under half of the company’s total.
That transaction was completed in the third quarter, as was an agreement that offloaded risk from Royal & SunAlliance to Goldman Sachs-owned Rothesay Life.
In September, the Royal County of Berkshire Pension Fund agreed a deal with Swiss Re to protect about £1bn of its liabilities from longevity risk. It was the first public sector venture in the area.
And in January this year came the first concerted move to develop standardised longevity derivatives. The Life and Longevity Markets Association was formed in London by Deutsche Bank, JP Morgan and Royal Bank of Scotland, together with Axa, Legal & General, Pension Corp, Prudential and Swiss Re.
Funds are ready for change
A survey last year by Aberdeen Asset Management found that pension funds expect longevity derivatives activity to move apace. More than 40% of the 51 large UK schemes surveyed by Aberdeen said they expected the instruments to play a “strong role” in managing their liabilities in the future, while most of the rest expected it to have a “moderate role”.
As with any derivative product, however, three demands must be fulfilled for a fledgling market to truly take wing.
First is counterparty appetite. For while we might naturally hope that people should live longer, from a financial point of view there is little to gain from an ageing population.
The big exception is life insurance providers, who want people to live as long as possible.
“The fit is not ever perfect,” says John Fitzpatrick (pictured), director at Pension Corporation, a London-based group that seeks to derisk pension funds for their trustees and sponsors. “But [the instruments] are useful to investors who are long the risk of life insurance. There is approximately $50tr of life insurance outstanding in the world and longevity risk is anti-correlated to the risk of people living shorter than the actuaries expect.” 
Legal & General confirmed last year that it was considering entering the longevity swap market in 2010.
An asymmetric market
The problem with this, however, is twofold. Many of the life assurers enjoy some degree of internal hedging, because they also provide annuities.
And as Neil Robjohns, who specialises in mortality and morbidity at Barnett Waddingham, an independent firm of actuaries and consultants, points out: “Some insurers could clearly gain, but when most of the people on life assurers’ books are middle-aged and the liabilities extend only to their retirement, the overlap with retirement payments is not there. So when you look at the size of what is to be gained from reduced longevity, that total is much smaller.”
In other words, much life assurance only covers people up to retirement – a time when hardly anyone dies anyway. Improvements in longevity for this cohort may be poorly correlated with overall longevity gains, and might be a minor factor in the profitability of a life assurance book, compared with investment returns. The amount of their profits from extended longevity that assurers might be willing to sell to the pensions industry is therefore probably small, relative to the annuity providers’ needs.
There may be other natural hedgers — nursing homes may stand to gain from longer life expectancy, their charges surviving longer and hence paying more. But to these one would have to add an awful lot of hot water bottle-makers, producers of antiques TV shows, bingo hall conglomerates and the like to balance the supply-demand equation.
A further structural problem is that, barring a horrendous epidemic or disaster, longevity is not expected to fall, ever. So although, like commodity markets, there are enterprises that want the variable to move both ways, the ones that like longevity have no real risk to shed – unlike commodity users and producers.
So cue the hedge funds. “The other side of the deal have been insurance-linked securities investors and hedge funds seeking to invest in an uncorrelated asset class,” says David Blake, professor of pension economics at Cass Business School, part of City University, London. Uncontaminated by market risk (and hence with the much-sought-after low beta), the argument goes, longevity derivatives will appeal to hedge funds’ diversification strategies.
In theory. Watson Wyatt, the consulting firm, estimated in November that there were longevity deals covering about £20bn of assets in the offing, but that the current market capacity was only between £10bn and £20bn.
Help me, nanny
For this to change markedly, the two other preconditions for an active derivatives market — liquidity and transparency — must be established. And this is an area where a loudening chorus of participants is calling for government involvement.
Just as inflation-linked Gilts were first issued for pension funds in 1981, creating a market in inflation risk, so, proponents argue, the government could kickstart a longevity market by issuing longevity-linked bonds.
“Longevity risk has an idiosyncratic component, arising from the randomness of individual lifetimes, and an aggregate component, arising from trend improvements in longevity over time,” says Blake. “While the idiosyncratic component can be dealt with by pooling large numbers of lives, as insurance companies do in their annuity books, the aggregate longevity risk cannot be hedged without an instrument that hedges this risk.
“No existing instruments can do this. That is why we need the government to issue longevity bonds. Only governments are in a position to hedge aggregate risks. The same is true for inflation: only governments — and similar entities like utilities — can issue index-linked bonds.”
Such bonds would help the government meet its £175bn borrowing requirement, tapping into a new pool of appetite and perhaps enabling it to borrow more cheaply.
However, there are plenty of reasons why governments in general might be reluctant to do this.
The state would have to issue bonds in which its liability grew as longevity did. Yet the state is another pension provider – and not only that, it supplies free healthcare to the aged. Longevity is a menace to the government’s finances. Why should taxpayers absorb more of this risk from those who have private pension schemes?
“At least the government has options,” observes Robjohns at Barnett Waddingham, arguing that the government has the flexibility to change the age from which pensions are paid, as well as the size of pensions. “We’re beginning to get some debate on that,” he says.
However, this would mean the state shifting risk it had taken from private sector pension funds to recipients of the state pension – a highly regressive policy.
Fitzpatrick at Pension Corporation appeals to the analogy with inflation. He argues that even though issuing inflation-linked debt increased the government’s exposure to inflation risk, this was worthwhile.
“[Inflation-linked Gilts] led to the development of an inflation swap market that helped all counterparties to better hedge their exposure to inflation risk,” he says. “The same should happen with longevity risk.”
On the other hand, inflation has been low for years, so the cost to the state of its inflation-linked debt exposure has not really been tested; and the state can also partly benefit from higher inflation, as it reduces the real value of its ordinary debt, and sometimes coincides with higher taxes and a thriving economy. The same is not true of longevity, unless people were made to work much longer.
But still, the proponents argue that, compared to the government’s already huge exposure to longevity, issuing a fairly small quantity of longevity-linked bonds would not make that much difference to the state – yet it might provide a benchmark around which private longevity trading could crystallise.
Quantifying the unknowable
Whether the UK government will, any time soon, do what market participants are asking and introduce longevity-linked bonds is uncertain, although some market participants, off the record, say there is an even chance of this happening.
Blake says the chance of government action is “in the short term, very small”, but he notes increasing pressure. “A whole range of organisations such as the Pensions Commission, the IMF, the World Bank and the World Economic Forum now support the government issuance of longevity bonds, so we can live in hope.”
State involvement would be a huge fillip to the mortality market, although there are already other indices on which to hedge.
In 2008 Deutsche Börse set up Xpect, an index that makes a monthly evaluation of German and Dutch mortality by digging through undertakers’ figures.
JP Morgan has LifeMetrics, which collects data on life expectancy in England and Wales. And both Credit Suisse and Goldman Sachs have indices measuring life expectancy in the US.
Research from the Pensions Institute suggests that the current best estimate is that 25% of 65-year-old males in the UK will live to be 90, but that the actual figure could be anywhere between 16% and 33%.
That is an enormous window, made opaque by uncertainties such as advances in medicine (or the lack of them), the direction of social inequalities and the impact of health education.
One forecast is that 5%-10% of private pension longevity risk might be offloaded into the capital markets soon, making for some £10bn a year. But the prospects are greater still.
“The main problems are getting sufficient investor interest and persuading trustees that capital market solutions provide very good, even if not perfect, hedges,” says Blake.
“The buyout market reached £8bn in the year before the banking crisis. There is no reason to believe a longevity derivatives market of a similar size could not be achieved, even without government-issued longevity bonds.”
Longevity is a baby market – but one that looks likely to have a long life.