Faster Longevity Improvements Threaten Schemes

(February 7, 2012) — The rate at which people are living longer is speeding up, putting increased pressure on pension fund investors and their sponsoring companies. The Actuarial Profession used figures from the Office for National Statistics in the United Kingdom to work out that the rate of mortality slowed by 4% last year in that country. This meant 20,000 fewer people died in the UK than would have been expected, based on figures from the previous year.

Gordon Sharp of the Actuarial Profession said: “The last 20 years have seen unprecedented improvements in mortality rates, particularly for pensioners. We are able to say with confidence that the mortality improvement for 2011 has been well above the average.

“The separate improvement figures for men and women are almost identical, at 4.1% and 4.0% respectively. These compare with average rates of improvement of 2.9 % p.a. and 2.1% p.a. over the 10 years to 2010.”

Although these figures were based on the UK population, most developed nations have similar experiences. Last year, life expectancy in the United States hit an all-time high of 78 years and two months, according to the Centers for Disease Control and Prevention.

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These increases put pressure on pension fund managers who have to pay benefits to members for longer than they had initially expected. This has led to the ascent of longevity swaps; vehicles created to hedge the risk of pension fund members’ extended lifetimes.

Last year some £6 billion of pensioner longevity was ‘swapped’ out in the UK through deals with investment banks and insurers in an effort to avoid falling further into deficit. Sharp highlighted that those already drawing a pension had seen the most marked improvement. He said: “It’s also worth noting that, once again, the ‘golden cohort’ of people born around 1931 has shown continued strong improvements of nearly 5%.”

Ross Matthews, Head of Mortality Research at consulting and actuarial firm Punter Southall, said that if the 2011 fall in mortality rates continued, this would equate to an increase of up to 15% on pension scheme liabilities, potentially driving deficits by up to 50%.

Ross said: “Our longevity studies show that socio-economic characteristics of members can make up to ten per cent difference in scheme-funding levels, compared with just using general population data.”

Ross said pension fund investors and their sponsoring companies should look at longevity hedging through a swap or alternative vehicle to consider their viability.

Portfolio performance can be enhanced across market environments using a dynamic portfolio construction framework, according to a new research paper.

(February 6, 2012) — A dynamic portfolio construction framework will improve portfolio performance by adjusting asset allocation in accordance with a forecast of market risk, according to a recent paper.

“Portfolio management is moving toward a more flexible approach capable of capturing dynamics in risk and return expectations across an array of asset classes,” the paper written by Peng Wang and Yizhi Ge of Georgetown University and Rodney N. Sullivan of the CFA Institute assert. “The change is being driven, in part, by the observation that risk premiums vary as investors’ cycle between risk aversion and risk adoration and that the decision to invest—whether to take risk and how much—is the most important investment decision. Certainly, managers should take risks, but only if the returns appear to represent fair compensation.”

The authors conclude that the traditional strategic approach of fixed-asset allocation is outmoded, and that therefore, there is much-needed dynamic flexibility to the asset allocation process. When asked how dynamic portfolio construction compares with a risk parity strategy, Sullivan told aiCIO:

“While risk parity attempts to equalize risk across assets within a portfolio, a dynamic risk approach aims to adjust risk levels across the entire portfolio in accordance with a market risk forecast. While risk parity has generally the same asset weighting across all market environments in the short-term, our model dynamically adjusts portfolio asset allocations commensurate with the market risk environments.”

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The similarity between risk parity and dynamic portfolio construction, however, is that both approaches attempt to manage overall portfolio risk, the authors conclude. “We know we can manage risk, but we can’t manage return,” Sullivan said. “We can forecast risk, but we must take whatever returns are offered by markets.” Wang added: “Risk parity defines risk with volatility, while we think downside risk (tail risk) is more relevant.”

Read the paper “Risk-Based Dynamic Asset Allocation with Extreme Tails and Correlations” here.