Longevity Hedging Risk: One Area the Market Fails to Deliver

Despite aging populations, the market for longevity risk products is underdeveloped, according to a study.

(January 31, 2012) – Hope is poor strategy for pension fund managers to rely on when faced with any risk, whether tail, interest rate or inflation, but perhaps especially so with longevity. 

An interdisciplinary study by four researchers, including finance and accounting specialists, has compared the two most common longevity-hedging strategies in the context of defined benefit pension plans. The ground-up hedging strategy transfers a portion of all future retirement payments, often in the form of a bond. 

Excess-risk hedging, in contrast, involves offloading longevity risk at a certain level. The most prominent example of the latter occurred in 2008, the insurance company Canada Life orchestrated a “survivor swap” with owners of insurance-linked securities. The researchers used historical data and a model to determine the optimal approach to longevity hedging for DB plans specifically, considering both cost and risk. 

Their conclusions, based on how pension plans have used the strategies and how they could optimize them, called for better options: “First, the market should design appealing longevity securities that can attract pension plans. As our results indicate, the pension plans are inclined to transferring more longevity risk with the excess-risk hedging strategy since it is less capital intensive and more cost effective.” 

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news.

Again, unlike most other risks facing pension funds, the authors argued that insurance companies and asset managers are failing to provide sufficient products to defray risk. Those that are available, are simply too expensive to justify. “The current high transaction costs in the capital market discourage the plans from transferring longevity risk,” the authors wrote. “This problem can be mitigated by standardizing longevity transactions. For example, we can promote consistent best market practices and publish tradable longevity indices. Such efforts will provide greater transparency and confidence for this market, and increase transaction activity.” 

Longer life spans are posing an acute problem in Japan particularly, which has both an aging population and widespread pension coverage. 

Read the whole article, “Managing Capital Market and Longevity Risks in a Defined Benefit Pension Plan,” here.

Boeing Roles Out Pension-Conscious Financial Metrics

Boeing Chief Financial Officer Greg Smith adds a new approach to the way the firm reports financial results to investors.

(January 31, 2013) — Boeing Co. is offering another way to showcase its financial results by supplementing its existing earning metrics with new measures that adjust for growing pension liabilities, giving a more accurate assessment of the health of its core business.

This new financial metric was revealed during a conference call, and is outlined on Boeing’s investor relations website.

The earnings measures are called “core operating earnings” and “core EPS (earnings per share),” and remove certain non-operating pension costs. According to Boeing Chief Financial Officer Greg Smith, focusing on core earnings that are unfettered by pension accounting effects driven by market fluctuations will better reflect the company’s operating performance. Smith predicts core operating earnings performance will improve by 5% in 2013 over 2012.

With $19.6 billion in unfunded pension liabilities, exacerbated by an historically low interest rate environment, the motivation for the new accounting method, Boeing spokesperson Chaz Bickers says, is to allow financial stakeholders to see how the underlying business is performing without the distraction of pension volatility. “The new metrics show earnings minus those pension expenses that are subject to market fluctuations,” Bickers explains to aiCIO. “However they do include pension costs relevant to business operations, such as pension service cost.”

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news.

To be clear: The new accounting reporting measure is supplemental to information Boeing currently provides. “It simply makes it easier to see how the business will be able to grow long-term because it removes large swings in earnings caused by our pension,” asserts Bickers, adding that financial analysts will likely use the reporting method to “give stakeholders a clearer picture.”

Despite the reality of pension plan fluctuations, Boeing’s adoption of liability-driven investment (LDI) since 2007 has minimized that pension distraction, Bickers acknowledges. “It’s had a positive impact on reducing the volatility of the pension, better matching assets to liabilities,” he claims. As of 2012, the plan’s fixed-income assets totaled roughly 50% with contributions of $1.6 billion–a reflection that the plan has actively taken steps to derisk.

“Their percentage of fixed income is about 11% above the average among corporate plan sponsors in the US,” Dave Wilson of Cutwater, one LDI provider, says.

Boeing’s efforts to increase transparency to investors through revised accounting reporting comes on the heels of other corporate plan sponsors, such as IBM, doing the same. “Some plan sponsors achieve transparency through pension accounting reporting and some through pension accounting methodology,” Sean Brennan, a consultant at Mercer, tells aiCIO. “Boeing didn’t change its pension methodology.” His comments allude to actions by AT&T, Verizon, and Honeywell–companies that switched their style of accounting to record gains and losses each year as opposed to recording them over a number of years. “Looking at the overall trend, there will be more of a focus on plan sponsors’ core businesses, whether its through derisking, changing accounting methodology and reporting, or settling liabilities through lump sums and risk transfers,” he adds.

«