A recent mini-survey by Watson Wyatt Worldwide of 40 major defined benefit(DB)pension plan sponsors in the United Kingdom revealed that the risk of mortality improvements is a far greater concern to them than the risk of a fall in equity prices or a fall in bond yields. North American plan sponsors may find this survey result surprising. Until recently, there has been relatively little talk on this continent about longevity risk in the funding and expensing of DB plans. While Canadian plan sponsors devote a great deal of effort to managing their investment risks and reviewing their asset-liability mismatch, longevity risk largely remains a sleeper lurking in the background.

What is happening in the U.K. to cause such a focus on longevity? Perhaps the focus is driven by the prevalence of closed DB plans wherein an aging plan membership necessitates greater focus on potential mortality losses. It is probably also because the common U.K. practice of inflation protection significantly boosts the actuarial value of pension payments in the latter part of a member’s life and increases the importance of predicting how long the member will live. Another likely rationale is the U.K. phenomenon known as the “cohort effect.” Simply put, those born between about 1928 and 1945 have experienced a particularly rapid improvement in mortality rates. One explanation for this phenomenon, especially for those born in the earlier part of this period, is that they are likely to have smoked when young, quit before too much damage had accumulated, and subsequently lived longer.

What about longevity risk in Canada? While automatic indexing of retirement benefits is far less common in the private sector in Canada, and there has yet to be any research that reveals a Canadian cohort effect, the current low interest rates and potentially maturing pension plans make future mortality improvements an important factor in DB plan valuations.

Canadian actuaries have not been unresponsive to signals of improving mortality, moving to new standard tables as they become available and as experience dictates the need. Many actuaries are now using the UP94 table with projection to 2015. Projection refers to the future improvements in mortality rates that are assumed, often expressed as a projection to a particular year such as 2015. Improvements differ between males and females—the common improvement for a male aged 55, for example, is to reduce the mortality rate in a particular year by about 2% to obtain the following year’s mortality rate for a 55-year-old, and so on.

Full recognition of potential future mortality improvements would require use of a “generational table.” A generational table does not select some future year(like 2015)as representing the mortality rates that will be in effect in all future years—instead, for each age, it features rates that gradually reduce year after year into the future. A generational table can add considerably to the actuarial liabilities, especially for a less mature plan. For example, in the year 2017, a male aged 55 in that year would have an expected age of 84.5 at death, based on the UP94 table with full generational improvements, as compared to only 80.9 using the UP94 table projected to 2007. Those extra years of pension payments would have to be allowed for in the liabilities. For example, the liability for that 55-year-old in 2017 would increase by about 7.3% when moving from the “projected to 2007” table to the generational table, if the pension is non-indexed. However, the increase is more significant—an increase of about 10.1%—if the pension is fully protected from inflation, thus illustrating the greater focus on longevity risk with an indexed plan.

It is a question of balance as to whether to project mortality rates using a generational table, or simply stop projecting improvements beyond, say, 2015. The latter helps contain the sponsor’s costs, but reduces the value of the protection received by the members under a DB plan.

Creating a mortality table begins with a study of actual rates of death experienced by a particular population in the recent past. While the rates of death experienced in the past are factual, future projections are fraught with uncertainty. Actuaries have no firm idea as to whether life expectancy will continue to increase year by year forever, or if there is some magical age beyond which it will be impossible for humans to live. Nor do they know when there will be a cure for some of the major diseases, nor how physical and mental health will be affected by the increasingly rapid pace of change that we all face. What is known, however, is that mortality rates are indeed influenced by a variety of factors. In addition to medical advances, rates are affected by gender, and the decline in smoking will have a significant impact. Income also influences longevity, although recent research from the U.K. suggests that marriage has a more important effect on longevity than income levels. Additionally, mortality rates for employee groups tend to be lower than mortality rates for the Canadian population as a whole, because there is a presumption that a minimum level of health is required in order to participate in the workforce.

While the Watson Wyatt mini-survey revealed key findings about U.K. plan sponsors, the increasing volume of European writings on longevity risk suggests that the focus on longevity is continent-wide. For example, there is much discussion in Europe as to how to immunize a pension fund against increasing life expectancy. While the traditional way has been to purchase life annuities, this has meant eliminating future investment gains that could have emerged through investing in equities. The French bank BNP Paribas tried to help plan sponsors resolve this by issuing a “longevity bond” that pays coupons which are proportional to the survival rate of a given population. Reception for the bond was lukewarm and it has since been withdrawn, but other innovative products will undoubtedly emerge.

While mortality tables may not be the sexiest of topics to discuss at a dinner party, it is important for plan sponsors to be aware of the issue when considering their pension risk management. It is the Woody Allens of this world that plan sponsors need to protect themselves against. Allen’s wish is not to achieve immortality through his work, but rather through not dying.

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Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

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