ISSUES & ANSWERS

Longevity and Pension Plan Sustainability

by Tom Ault & Troy Milnthorp, Aon Hewitt

Introduction

The life expectancy of Canadians has been increasing for decades. For defined benefit plan sponsors, the impact is simple and direct: retiring plan members will receive their pensions for longer. In fact, a 65-year-old male retiring today may expect over 40% more pension payments than a 65-year-old 40 years ago. 

A longer payment period means that plans need to hold more assets to ensure the promised benefit can be paid. Added to this, it is quite possible that life expectancy will continue to increase for decades to come. 

How life expectancy may end up being different to what we expect, and hence how long pensions will need to be paid, comprises longevity risk, and represents one of the most significant vulnerabilities today for pension plans. This focus on longevity comes at a time when there is already a heightened awareness of the risks associated with pension plans and continued questions around the sustainability
of defined benefit pensions in general.

This article discusses how longevity risk manifests itself and can be quantified, the traditional ways that pension plans can deal with longevity risk, as well as alternative methods to ensure pension plans remain sustainable.


How does Longevity Risk manifest itself and How is it quantified

As with all risks within a pension plan, the first step to managing longevity risk is identifying and measuring it. Once a risk is quantified, it can be included in all risk budgeting decisions for a pension plan. Longevity risk is no different.

We can identify three different elements of longevity risk, all of which have different characteristics:

 
  • Individual risk exists when the majority of the liabilities sit with just a small group of members (e.g. long-serving senior management). Ultimately, the experience of this subgroup (positive or negative) may drive the success (or failure) of the pension plan. For small plans, understanding where this concentration of risk may exist is key to plan risk management. For large plans, it is unusual to see such risk concentration.
  • Base table risk is the risk that a pension plan’s population life expectancy is different from the “average.” This can be quantified by using custom mortality tables that incorporate the plan’s own experience and socioeconomic analysis to ensure appropriate adjustments are made, rather than simply using an average.
  • Improvement risk is the risk that future improvements increase life expectancy more than we anticipate. This is a significant unknown, and while it is impossible to predict, analysis can be performed to establish “what-if” scenarios to quantify and put parameters around the range of possible outcomes.


Ways to Manage Longevity Risk

As with all risks within a pension plan, once it is identified and quantified, the first decision a sponsor can make is whether to externally insure or retain the risk. When a pension plan retains longevity risk, they are self-insuring (even if this is not a conscious decision). 

Typically, a sponsor will explicitly or implicitly hold reserves against the possibility of poor experience. It is unusual for there to be specific reserves for longevity. However, once longevity is quantified and the risk understood, it is a natural next step to establish whether the reserves held to protect against financial downturns would also withstand longevity “shocks.”

For many sponsors, longevity risk, and the additional variability that may prevail, may be the final straw. For such sponsors, an insurance solution may be desirable.  Longevity risk can be removed through a number of different means (many of which will remove all risks, not simply longevity risk):

 
  • Annuitization – buying annuities, either through a full or partial settlement (buy-out), or through a buy-in (where the annuity is held as an asset to the plan) removes most financial risks and longevity risk for the covered population.
  • Longevity swap/insurance – a relatively complex derivative-like product that insures the plan against future increases in life expectancy, but retains all other risks within the plan.

Alternate Plan Design Solutions

An insurance solution may be desirable for some, and for others the reserves held may be sufficient to cover “worst-case” longevity events.  For others, though, these options may not be affordable, or not considered cost effective and they may need to find other solutions to help manage longevity risk.

As plans continue to wrestle with the risk of longevity, they may need to consider alternative plan design solutions. Some possible examples:

 
  1. Increasing Retirement Age: If members are living longer, they will inevitably be receiving a pension for a longer period of time. As the post-retirement period for members exceeds their working years, it is not inconceivable to accept that members will have to work longer to achieve the same level of benefit over their lifetimes.    
 
  1. Extended Bridge Benefit: Research has shown that members will spend less in retirement than in their working careers. Once members hit a “magical” age (e.g. 80 or 85), they may no longer require as much money as they did during the first 10 to 20 years of retirement. One possible solution could be to extend the bridge benefit for members beyond age 65 to 80 or 85, and then provide a significantly lower benefit pension benefit for years beyond age 80 or 85.   Significantly reducing the lifetime payments to members beyond 80 or 85 would go a long way toward dampening longevity risk for the plan.
 
  1. End-of-life Annuities: Another option to addressing longevity risk is to pay members a pension from the plan until a certain age (e.g. 85) at which point an annuity is purchased from an insurance company.  Although this may be a costly option, in the end it would eliminate longevity risk for the plan once the annuities are purchased.
 
Note that some of these design elements may not be possible without some form of regulatory change.  

Those are just some of the way pension plans can approach longevity risk, but at core they share a common impetus: people are living longer, and pension plans need to deal with that fact. Although good for humanity, increasing longevity does put pressure on pension plans to pay promised benefits over a longer period of time. Over the past 10 years, longevity has contributed to increased contributions, benefit reductions and, in some cases, plan closures. The risk facing the pension industry today is real. Solutions are available, however, and plan stakeholders, regulators and providers need to work together to make sure pensions continue to meet their obligations to Canadians.

 
Troy Milnthorp, FSA, FCIA, Partner, Aon Hewitt

Troy is a Partner in Aon Hewitt's Saskatoon, Canada office. As a member of our retirement strategies team, Troy provides pension and actuarial consulting services to our clients locally and across the country. He is also the head of Aon’s Target Benefit Task Force in Canada and a member of the national Public Sector Pensions Team.

Areas of Specialization
Troy specializes in the design and implementation of retirement arrangements for organizations and executives. He has a broad knowledge of accounting principles and methods for pension and other benefit plan costs under Canadian and International accounting standards. Troy has extensive experience working with the public sector in Canada in all different aspects of retirement.

Background
Troy joined Aon Hewitt in October of 2000. Troy graduated from the University of Saskatchewan with a Bachelor of Science degree (Honours) majoring in Statistics. His affiliations and designations include:

- Fellow of the Society of Actuaries (FSA)
- Fellow of the Canadian Institute of Actuaries (FCIA)
- Former Council Member of the Canadian Pension and Benefits Institute, Saskatchewan Region

Tom Ault, FCIA, FIA, Partner and Pension Risk Settlement and Longevity Lead, Aon Hewitt (Canada)

Tom is a Partner and Actuary in Aon Hewitt's Retirement practice in Canada. He has 17 years of experience working as an actuarial consultant in the United Kingdom and Canada, enabling him to fully understand how different organizations approach risk management in their pension plans.

Areas of Specialization
Tom leads Aon Hewitt’s risk settlement and longevity consulting initiatives in Canada. His experience includes assisting a range of private and public sector organizations, multi-employer plans and insurance companies specializing in risk management, plan design, actuarial valuations, funding options, asset-liability work, mortality studies and longevity consulting.

Background
Tom graduated in 1999 from the University of Newcastle-upon-Tyne (UK) with a Masters of Mathematics and Statistics degree, Tom is a Fellow of the Institute of Actuaries (England), qualifying in 2004 and a Fellow of the Canadian Institute of Actuaries from 2006.
thomas.ault@aonhewitt.com | aon.com