No Country for Old Men

25 February 2008

As we discussed earlier in the month, “liability-driven investing” is often viewed as an enlightened approach to managing pension plan assets.  After all, what’s the use of beating an S&P 500 bogey when a plan’s liabilities are rising due to fluctuations in exchange rates or other factors.  Some pensions have opted to fully insulate themselves from the volatility of its liabilities by hedging away the financial risks that cause it.

But there are a few factors that can’t easily be hedged.  Chief among them is “longevity risk” - the risk that retirees live longer than the pension plan had expected.  This has put the spotlight on the mortality assumptions underpinning pension plans.  Apparently, since we stopped smoking during pregnancy and allowing our kinds to eat lead paint, we’re all living a lot longer.  Still, predicting the future of the human lifespan has been devilishly hard and remains open to opinion. 

Last week British pension regulators tried to standardize things a little - and, it hopes, prevent pension plans from using overly pessimistic mortality predictions in order to reduce funding shortfalls.  This article on the British Telecom pension plan says that the new regulations would immediately put the plan into hawk - knocking it from a slight surplus to a 2 billion pound deficit:

“Problems could widen further, according to [industry consultant John] Ralfe, as he believes ‘BT’s longevity assumptions remain weak’ so were the fund to state its mortality assumptions as being ‘medium cohort’ – i.e. two years longer than currently stated – the assumption is this would increase liabilities by £3bn to £45.9bn – 18% higher than currently reported.”

Specifically, the UK pension regulator (known officially as “TPR” for “The…Pension…Regulator”) said it would now keep a closer eye on plans that use over pessimistic mortality assumptions or that assume the century-long rise in longevity will eventually come to an end.  Warned the regulator:

“It is the regulator’s view that some projections that have been in common use can no longer be considered reasonable assumptions.”

Indeed, the proposal itself stipulates:

“Trustees should note that there have been significant recent developments in our knowledge of current trends in mortality, with some projections which have been in common use no longer likely to be considered reasonable assumptions.”

The problem is that many plans have been using these common assumptions for years.  Thus, according to one expert cited by IPE.com, 99% of British pension plans would have to adjust their assumptions as a result of this new proposal:    

“As a result, Marcus Hurd, senior consultant and actuary at Aon, said if companies were to adopt TPR’s proposed assumptions, then 99% of companies would need to strengthen their assumptions.

“He warned: ‘The effect would be to increase the UK’s reported pension liabilities by at least £75bn immediately. As the Regulator is assuming that the average 65-year-old pensioner retiring today will survive for a further 25 years until age 90 rather than age 85 as currently assumed by most companies.’”

In addition, say opponents to the proposal, these mandated “triggers” will create a moral hazard for pension trustees by lulling them into a false sense of security regarding their mortality assumptions (picture the Olympic Athletes’ Pension blinding adopting assumptions based on the average Joe).  

So what can a pension do?  Two broad strategies are attracting a lot of interest.  One is to sell the entire plan to someone else - maybe an insurance company - and get them to deal with longevity risk and various other headaches.  Thomson reports that there were more of these pension “buyouts” in Q4 ‘07 than in the first three quarters of the year combined.

Another option is to buy some kind of financial product that can mitigate or even cancel-out longevity risk.  Goldman Sachs and JP Morgan actually have products specifically designed to do just this.  Global Pensions reports on these two recent offerings:

“JPMorgan launched a longevity index in March 2007, initially in the US, UK and Wales. The index has since been rolled out to the Dutch market and is intended to be spread further afield in coming months.

“Named LifeMetrics, the index was created to help pension funds measure, manage and look at ways to tackle mortality and longevity exposure.

“In autumn 2007, Guy Coughlan, global head of pension asset liability management, JPMorgan, told Global Pensions the take-up of this product had varied from one country to another, despite each index being specifically designed to account for the differences of each market.

“Goldman Sachs’ QxX.L.S. was launched in December 2007. It was the first – and currently only – tradable index to give secondary market exposure to holders of both longevity and mortality risk, such as pension funds and insurance companies.”

Stricter mortality assumptions may lead to a boom in these types of products.  And while these new pension proposals will surely help prevent a future disaster for British pension schemes, experts note that they won’t come without pain.  One consulting firm estimates that the proposal will cause an immediate accounting loss of 75 billion pounds across the industry.   

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