The purpose of a pension plan is to hedge longevity risk, but many funds have not adequately offset this simple fact of demography. AMANDA WHITE reports.

Many pension plans have underestimated their longevity risk, and this is causing severe problems, professor David Blake, director of the Pensions Institute at the Cass Business School in London, points out. “Everyone is focusing on the accumulation of the pension fund, no-one’s thinking seriously about de-cumulation. There are two questions that need to be considered: what age do you stop accumulating; and then how long do you live after retiring. It’s no longer about investing, it’s about optimal de-cumulation.”

As director of the Pensions Institute, his focus is on providing the intellectual leadership behind the creation of a new global capital market, namely the life market. Within that context his argument is for the UK government to issue longevity bonds to help overcome the problem that there is insufficient capital in the insurance and reinsurance industry to hedge the longevity risk in all the pension funds in the country. “The way an individual hedges their longevity risk is to buy an annuity, and in the UK you are obliged to do this.

The annuity provider then has to deal with the longevity risk, but there are two components to longevity risk: a systematic or aggregate component, and an individual or idiosyncratic component. The insurance industry is very good at dealing with idiosyncratic risks, it simply pools these risks and this helps to reduce total risk by the law of large numbers. But it is the systematic trend risk that every annuitant lives longer than anticipated that is the real problem,” he says. “The insurance industry is unable to hedge this trend risk efficiently without an aggregate hedging instrument and that’s where government-issued longevity bonds come in.

Only the government can hedge aggregate risks such as inflation risk and longevity risk.” He argues that the UK government has done this in other areas of the capital market, for example by issuing inflation-linked bonds. “Inflation is an aggregate risk, just like longevity risk,” he says. Within the de-cumulation phase of pension funds, Blake says there are three big risks: interest rates, inflation and longevity. “Longevity is the only risk that can’t currently be hedged, unless you buy overpriced annuities,” he says. The government is the obvious candidate for issuing longevity bonds, and is also best placed to engage in intergenerational risk sharing, which is what it would in effect be doing if it issued these bonds, he argues.

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