Is Longevity Risk Dying?

Some academics believe there is a cap to human life expectancy. What does this mean for pension liabilities?

Longevity may not always be the big risk to your portfolio it is now. In the summer of 2009, David Dorr, then-CEO of life settlements trading platform Life-Exchange Inc., claimed: “We are at the apex of the longevity growth curve.” Writing for the Journal of Structured Finance, he made the case that life expectancy is set to fall in the decades ahead.

The strain that a growing world population will place on resources, unsustainably high health care costs, poorer quality food, and falling living standards were all cited as factors that could increase mortality and even cause life expectancy to “drop quite dramatically.”

It is important to mention that Dorr went on to talk of arbitrage opportunities for investors in his asset class—which essentially bets on people dying earlier than expected—but his paper nevertheless raises an interesting issue: What if people stop living longer?

There is already evidence that life expectancy is not increasing at the rate it once was.

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First, the numbers: According to the World Bank, a Japanese person born in 2012 could expect to live 15 years longer than a compatriot born in 1960—an improvement of 3.6 months for every year. But much of this improvement came in the 1960s and 1970s: Between 1987 and 2012, Japanese life expectancy from birth improved by 2.3 months per year, half the rate of the previous 26 years and behind Germany, Australia, and the UK. In the first 12 years of the 21st century even the average life expectancy in the US improved by more than Japan.

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In the UK, there is similar evidence of improvements slowing. The Department for Work and Pensions reported last year that between 1973 and 2013, male life expectancy at age 65 improved by two months per year, from 13.1 years to 21.8 years. Between 2013 and 2058, the rate of improvement is forecast to halve.

America’s mortality improvement rate is also declining, according to data from the Society of Actuaries. Although this figure is different to longevity, it backs up work by renowned scientist Jay Olshansky. A professor at the University of Illinois and specialist in life expectancy and health, Olshansky has co-authored several research papers and articles arguing that the human body is not built to last.

In a 2005 co-authored report published in the New England Journal of Medicine, Olshansky and other academics argued that obesity trends in the US “threaten to diminish the health and life expectancy of current and future generations.”

“Unless effective population-level interventions to reduce obesity are developed, the steady rise in life expectancy observed in the modern era may soon come to an end, and the youth of today may, on average, live less healthy and possibly even shorter lives than their parents,” the report stated. “In fact, if the negative effect of obesity on life expectancy continues to worsen, and current trends in prevalence suggest it will, then gains in health and longevity that have taken decades to achieve may be quickly reversed.”

(CIO tip: Don’t sit next to Olshansky at dinner parties.)

So, does this mean longevity risk is dying?

David Blake, professor of pension economics at London’s Cass Business School, says it could be—but warns investors not to dump those hedging plans just yet.

“There is an upper limit to the human life span, and that appears to be around 115 years,” Blake says. He adds that “more and more people are approaching that upper limit” as each generation ages.

“That suggests an increasing number of people will survive to higher ages and will be dying in the range of 100 to 115. If that’s going to happen, there is still a long time until longevity isn’t a risk. Pension funds in the next 20 to 30 years definitely have got to work with longevity.”

Medical advances such as nanotechnology and gene therapy could also push up the number of centenarians as society as a whole ages—although, as Olshansky has argued, it would require an unprecedented rollout across the world’s population to make a meaningful impact on life expectancy.

Blake is also cautious on these advances, but for a different reason. “The real risk to society is that life expectancy increases at a greater rate than healthy life expectancy—that is what is going to challenge social welfare budgets,” he says.

A quick estimate indicates that, to reach 115, a 65-year-old retiring today on the average US pension of $29,000 a year would place a $1.45 million liability on his or her pension fund, without factoring in inflation.

“The big takeaway is that we all need to be saving like hell,” Blake concludes.

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There is another school of thought on longevity—and defined benefit pension CIOs should probably look away now.

In his trademark baggy jumper, paired with a ponytail and a long brown beard stretching comfortably over his chest, super-centenarian advocate Aubrey de Grey looks decidedly more like an advocate of New Age than old age. But he has a radical set of theories that would send shivers down the spines of most actuaries.

Described by Blake as a “wild card,” critics accuse the controversial author and theoretician of hunting publicity as much as he hunts for a “cure” to aging and degeneration. Most famously, nearly 10 years ago, de Grey voiced his belief that the first human to live to 1,000 is already drawing a pension.

Another CIO tip: Don’t sit de Grey next to your scheme actuary at dinner parties. What’s the average total pension for one 65-year-old retiring today if he or she reaches 1,000? $27 million.

Alan Brown Thinks Traditional De-Risking is Flawed

The former Schroders CIO, who also continues to serve as an advisor to its UK pension scheme, on the de-risking fallacy.

First you have to decide on your end goal. We want a very low probability of the sponsor having to write any more checks and think that corresponds to a technical provisions funding ratio of around 125%. How do you get from where we are—105%—to 125%? Not just by ratcheting up your liability-driven investing [LDI] hedges to 100%. By doing so, you will have exposed yourself to a significant correlation risk, unless you’ve got nothing but bonds on the asset side of the balance sheet.

Viewing liabilities in isolation from assets can get you into trouble. Although the long-run correlation between equities and bonds is low, it masks significant periods of either high positive or high negative correlations. So the nightmare scenario, like during the taper in 2013, sees bonds in a spectacular bear market and long-term interest rates rising so quickly that equities and other risk assets are crushed at the same time.

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This gives positive correlation between equity and bond returns, and if you have fully hedged your liabilities, although discount rates would be rising, you would get no benefit because you’ve hedged it all away. At the same time, the asset side of your balance sheet is being crushed. You now have to go to the finance director after you’ve told him you’ve battened down the hatches and hedged everything away, and explain why the funding ratio is under pressure again.

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Instead, you have to scale your bets and be agnostic towards your next step.

We are about 70% hedged to changes in real and nominal interest rates. That means a 1% move in interest rates, either up or down, impacts our funding ratio by about 4%. We’ve scaled our short duration position and know where we are. Many funds have no idea where they stand and will be much more exposed to changes in rates. The drop in yields we’ve just had (40 basis points) impacted our funding ratio by around 2%, but for many funds with much bigger short positions, the impact will be two to three times that.

Investors have become obsessed with market-cap-weighted benchmarks. For 30 years, people were saying, ‘Are you outperforming the gilt index?’ as interest rates went through a spectacular secular decline. The gilt market is way shorter in duration than most funds’ liabilities, but most portfolios were broadly matched to gilts and so were short duration. With a 30-year decline in interest rates, they took a massive hit. Following a “path-dependent process” is the right way to de-risk.

If our funding ratio recovers to 110% and continues up to 115%, and we start to think about taking more risk off the table, we will ask, ‘Why the improvement? Rising yields?’ In which case, it might make sense to increase the size of the hedges. Or did it improve because equities and other risk assets were on a tear? Then, the next step might be to reduce growth assets or change the makeup of them.

You don’t go in with a rigid, automatic plan which ratchets up the hedges every time the funding ratio hits a certain point. You have to ask the reason. In our last round of de-risking—in the fourth quarter of last year—we shifted half of our growth assets, which were entirely invested in a diversified growth strategy, to a bespoke, actively managed interest rate parity strategy. This improved the correlation between our assets and liabilities, and left us less exposed should we go through the kind of scenario we’ve been talking about.

When we reach another funding ratio target, I don’t know in advance what we’ll do, but this can only work because of the governance structure we have in place.

We have the financial director, consultant, lead investment manager, and trustees—all of whom have investment experience—together at the same time. We leave the unimportant decisions, such as which UK equity to buy, to the investment manager.

But the size and makeup of growth assets, and the size of the hedges against nominal and real interest rates, are collective decisions. If we’re on the wrong side of the argument, we don’t just fire the fund manager or consultant—it is a joint decision. We minute decisions in great detail, so if we find ourselves on the wrong side, we can look back at our assumptions—and whether they have proved to be incorrect. We then decide to move on or tough it out. That’s quite a different governance model.

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