Human longevity is always somewhat of a double-edged sword for those tasked with paying a defined benefit pension: increases in healthy lifespan are of course welcome from a human perspective, but make the job of providing a pension for life that much harder.
And longevity has been very hard to forecast with any accuracy: from the late 1990’s through to 2010 human longevity consistently ran ahead of actuarial predictions (see right), which was one cause of the funding pressure that mounted on UK DB pension funds over the last decade or so.
Since 2011 however a funny thing has happened: the improvements in longevity seen between 2000-2010 have slowed. What this means is that tomorrow’s generation (or in actuarial parlance “cohort”) is still expected today to live longer than today’s did, BUT, the fall in these improvements means that today’s 65 year old’s are expected to live less-long than 65 year old’s were expected to in say, 2010.
Now for many actuaries the annual release of the latest CMI model parameters is second only to Christmas in terms of interest & excitement 😂 This year’s is definitely important news for DB schemes. The latest data seems to confirm that the levelling off in improvements since 2011 is not a blip, and there is a growing industry consensus now that future improvements will be lower than they were from 2000-2011.
The result being that cohort life expectancies from this model are lower than all previous versions: a 65 year old today is expected to live just short of 22 more years today, compared to a little over 23 years in 2009.
The implications of this for individual schemes get quite nuanced, depending on how & when this gets incorporated into assumptions could bring schemes closer to funding than expected, and should have implications for the investment. Liabilities could be 2.5% lower (vs last year’s assumptions, more if latest update was longer ago) which could be equivalent to a couple of year’s expected funding gains in one go. The change in returns needed from the investment portfolio might fall by the order of 0.25% or 0.5% p.a., which is a significant move for many schemes who are not aiming for high-growth returns in the first place. An important caveat: the CMI model is based on England & Wales population data, there is debate as to how this applies to the more narrow demographic segments represented in any one pension scheme.
There are two deeper points brought out by this development:
- Don’t fall in love with the cashflows. As actuaries and investment consultants we can tend to get awfully attached to a scheme’s projected cashflows, they seem so clean and precise and look so nice in a chart! And it would make life so much easier if they were set in stone. It’s easy to forget that this is the amalgamation of the longevity of thousands of different individuals and there is quite some uncertainty around it. In particular one should exercise caution around cashflow-driven investing solutions, which try and match precisely the cashflows. While they can be a good tool for schemes in many cases and a sensible way to invest, it is always important to bear in mind that unless longevity has been hedged, the cashflows are not as fixed as we would like.
- Longevity risk could dominate as schemes become better funded and reduce risks in the investment portfolio, particularly for those schemes looking toward long-term run-off as opposed to buy-out. The sort of meaningful fluctuations we’ve seen in longevity projections over the last decade provide a decent guide for quite how much things could vary in the future – even in the absence of any game-changing medical advances which could really change things – and this risk could well end up being bigger than the moves in the investment portfolio. So it makes sense to start thinking hard about when to start using longevity hedging, before reducing investment risk past a certain point. This decision will tie back in to the scheme’s ultimate objective (particularly long-term run-off vs buy-out).
This is a great example of when trustees need their advisers: the scheme actuary & investment consultant working proactively together (particularly if approaching an actuarial valuation) – trustees should be expecting their actuary to be informing them of the timing and likely direction of the next longevity review, and expect their investment consultant to be coming simultaneously with a clearly thought-out recommendation for what this means on the investment side. This might boil down to a chance to move toward a more stable, lower-risk investment portfolio a bit earlier than planned as the scheme will no longer need the returns previously required, or even to begin the process of undertaking a buy-in or buy-out transaction which may now be affordable.
All of this is made so much easier if the scheme has a clear long-term funding and investment target in place (as suggested in the pension regulator’s latest annual funding statement). I might also say -although I would, wouldn’t I 😉 – that this is a great case study of why having the same firm providing joined up investment and actuarial advice (with a finger always on the pulse of buy-out markets) can be a major value-add for a scheme.