Longevity and pensions: protecting company pensions against longevity risk

1. Longevity and Pensions
Protecting company
pensions against
increasing longevity
Chris Madsen
Martijn Tans

2. Table of Contents
Introduction 1
1 Risks to the pension system 2
Estimating future mortality – how long can we expect to live? 2
Old age dependency in public plans 3
Changing face of pensions – pension reform 4
2 Longevity and private company pensions 6
The sources of pension plan risk 6
Addressing uncertainty in longevity 7
Longevity risk and other risks 8
Defined Contribution plans and longevity risk 10
Longevity – a challenge and an opportunity 10
3 Longevity solutions for pensions 11
Pension plans and longevity swaps 11
Pricing – and measuring – longevity risk 12
Index swaps versus indemnity swaps 13
Controlling pension risk 16
4 Hedging your longevity risk: one step at a time 17
5 Conclusion 18
Additional bibliography 19

3. Introduction
Over the past century and a half, retirement has changed from being a luxury into a perceived right.
Over the same period of time, life expectancy has steadily increased. However, as people have
come to enjoy longer lives, our pension systems have not been adjusted accordingly. In particular,
retirement ages and funding assumptions for pensions do not yet fully reflect the impact of longer-
lived populations. As a result, the three pillars of pensions – state-run social plans, company-sponsored
plans and private retirement savings – are facing unprecedented challenges.
In the first pillar, state pensions are based on the ‘pay-as-you-go’ system, which makes them particularly
vulnerable. State pensions use tax income from younger working generations in order to pay older
generations. In the second pillar, company-sponsored retirement plans have fortunately not been
allowed to be unfunded, but the actuarial assumptions that underlie the funding requirements for
Defined Benefit (DB) plans have historically trailed actual mortality levels, which means that funding
requirements have been too low. Although Defined Contribution (DC) plans are, by definition, not
subject to funding requirements, pensioners still require them to be properly funded in order to be
able to pay for their retirement. As longevity increases, more must be saved.
Pension systems are presently facing several trends. First, longevity has continued to rise, which
is desirable from a personal point of view but puts severe strain on our pension systems. Secondly,
the number of children being born per family is steadily decreasing. This puts additional pressure on
public pay-as-you-go systems. Today, with more people living longer lives and relatively fewer being
born, societies are faced with the challenge of looking after more people for longer with smaller
working age populations to help support them.
The pressure on state pension systems is already evident and it is clear that we will see continuing
major reforms in most countries over the coming years. At the same time, companies are also facing
similar pressures. In this paper, we focus on the impact of increasing longevity on companies and
company-sponsored DB plans, and discuss possible solutions.
When considering longevity risk to a plan, some of the most commonly asked questions are:
• How can a pension fund assess the longevity risk it is exposed to?
• How can a pension fund protect itself from longevity risk?
• What is a fair price for protection?
In addressing these questions, section 1 looks at longevity risks in the wider pension system; section
2 focuses on longevity risk and company pensions; section 3 takes a closer look at the available
solutions; and, in section 4, we provide seven guidelines on hedging longevity risk.
1

4. 1 Risks to the pension system
Estimating future mortality – how long can we expect to live?
One of the difficulties with preparing for an older population is that it is impossible to predict future
events. Yet pensions by their nature attempt to provide an element of financial security for the future.
In order to be able to make appropriate preparations, we need to have some idea of how long we can
expect people to live. For this purpose, funds have historically relied upon actuarial mortality tables.
These tables have typically been viewed as fixed – a snapshot of reality as it will be. For years, the
tables contained no assumptions for future improvements, which meant that the assumptions became
increasingly inaccurate with every year of additional improvement. As a result, when determining the
funding ratio of a pension plan, plans were implicitly looking more to the past than the future.
Over the past decades, life expectancy has continued to rise. Estimates vary, but life expectancy
broadly appears to be increasing at a rate ranging (at the moment) from 1 to 5 months every year,
depending on age group and geographical location (see figure 1). While the impact that this has on
pension liabilities varies according to interest rate levels and the specific demographics of each
individual pension plan, every year of additional life expectancy is generally thought to add about 4%
to the present value of pension obligations for a typical pension fund.
It can be argued that it is not clear whether this steady advance will continue, but the risk is clearly
visible and the trend has been in place for over a century. To bet against this trend is to wager that the
future will be very different. Yet, in the face of this steady trend, people have continuously predicted
that the long-term trend would taper off. Instead, the trend has stubbornly persisted (and even
accelerated recently for the older age groups). Although the rate of improvement is uncertain, it is
highly likely that improvements will continue – even if temporarily side-tracked by shocks to the system
such as natural catastrophes, pandemics or wars. In other words, although recent adjustments in
Figure 1: Learning from our mistakes? UK historical projections for life expectancy at birth
84
Actual
82
1971-based
80 1977-based
Life expectancy at birth (years)
1981-based
78
1985-based
76
1989-based
74 1991-based
1992-based
72
1998-based
70
2002-based
68 2004-based
2006-based
66
1966 1976 1986 1996 2006 2016 2026 years
Source: UK Office for National Statistics
2

5. official actuarial assumptions may have made longevity risk seem unpredictable and unquantifiable,
it is perhaps rather the case that assumptions have historically ignored the evidence rather than that
the risk is unquantifiable.
In addition to the long-term trend, there are also short-term effects that can alter the trends for certain
age groups for a decade or two. For example, in The Netherlands, if smoking were to be banned or
were to be so discouraged as to cause a significant drop in smoking levels, average life expectancy
from birth could be expected to increase by between one and two years, which alone would require
an increase of between 4% and 8% in pension reserves. This would show up as an acceleration in
long-term trends and is perhaps part of the increase that the Netherlands has experienced in the past
few years. 1 Smoking rates in the Netherlands remain at relatively elevated levels compared with other
countries, but are decreasing.
Figure 2: Male and female life expectancy at birth, more developed and less developed regions
1950-2300
110
100
90
Life expectancy at birth (years)
80
70
60 More developed regions
Female
Male
Less developed regions
50
Female
Male
40
1950 2000 2050 2100 2150 2200 2250 2300 years
Source: UN publication World Population to 2300 ST/ESA/SER.A/236
Old age dependency in public plans
As the strikes in France in 2010 demonstrated, pension reform is seldom easy. Nevertheless, given
the demographic changes, it is clear that reform is unavoidable. Global birth rates have dropped and
people continue to live longer. As fewer workers are left to support an increasing number of retirees,
pressures on the state pensions system (and the welfare state in general) will increase.
1 n this note, the cigarette manufacturer Philip Morris announced in 2010 the possible loss of 176 jobs in its Dutch factories,
O
citing the decrease in demand for cigarettes in the Netherlands. http://nos.nl/artikel/186161-philip-morris-schrapt-banen-
in-nederland.html
3

6. Figure 3: World total fertility and life expectancy at birth 1995-2050
2.9
76
2.8
2.7 74
2.6
72
Total fertility
Life expectancy at birth
2.5
70
2.4
2002 Total Fertility Rate
2.3 2002 Life Expectancy at birth
68
2.2
66
2.1
2.0 64
1995 2005 2015 2025 2035 2045 years
Source: UN publication World Population to 2300 ST/ESA/SER.A/236
Despite recent reforms aimed at opening up the pensions market, Europeans still derive most of
their income in retirement from the government – more than 80% in France and Belgium, and almost
three-quarters in Germany. 2 Only in the United Kingdom and the Netherlands is the figure below
50%. Compare that with 36% in the United States, where most people rely on income from private
retirement savings and there is less pressure on the state. In Japan, people on average work to the
age of 69, six years past the official retirement age. As fewer workers are left to support an increasing
number of retirees, pressures on the state pensions system (and the welfare state in general) will
increase.
The most immediate impact of increased longevity and falling birth rates will be upon states that
rely heavily upon ‘pay as you go’ pension systems, such as France, Poland, Hungary and others.
France provides a good example of a country with an urgent need to reform its pension system.
The Melbourne Mercer Global Pension index, compiled annually by Mercer and the Australian centre
for Financial Studies, ranks the French pension system in its present form eleventh out of thirteen
countries in terms of its sustainability. Changes will have to be made – and such changes are seldom
popular.
Changing face of pensions – pension reform
The large demographic shifts of the coming years and increasing longevity will have far-reaching
consequences across societies. Governments and businesses are already responding by re-examining
long-standing systems and practices, looking to redesign them to meet the challenges of the future.
Signs of change are already visible, with many governments and companies actively starting to look
at how they can empower and encourage an older workforce to continue to work productively.
Considering the stresses to all pillars in the pension system, it is clear that more reform is on the way.
Already several countries have raised their retirement age and more will follow. For example, in the
2 See the OECD Income-Distribution Database http://dx.doi.org/10.1787/888932371025
4

7. Figure 4: Old age dependency – number of people in EU receiving pensions in relation to the
number of people of working age in 2010 and as projected for 2060
2010 2060
Ratio 30% Ratio 30% - 39% Ratio 40% - 49% Ratio 50%
Sources: AEGON Global Pensions/Eurostat
UK, the state pension age has been raised to 66 from April 2020 (six years earlier than the previous
government had planned), rising to 68 in 2046. In addition, in order to encourage people to work
longer, the Default Retirement Age in the UK is being removed in 2011, which means that employees
will have the right to continue to work as long as they wish. Germany, which possesses one of the most
rapidly ageing populations in the developed world (see Figure 3), took a somewhat different approach
with the introduction of the ‘sustainability factor’ for state pensions in 2005. The sustainability factor
automatically changes the level of state pension depending on a number of factors, including longevity
and the number of contributors in the system. Similarly, both Finland and Portugal have introduced
explicit links between the level of state pension and increases in life expectancy. The OECD recently
estimated that pension reforms in OECD countries since the early 1990s have already reduced future
benefits on average by 20%. 3
These are just a few examples of recent pension reforms, but it is clear that states around the world
are looking to find ways to make their pension systems sustainable and it is clear that companies and
their employees will be affected by these changes. As state pensions continue to be reduced, people
will turn to company and private pensions to fill the gap. In an ageing world, pensions are becoming
increasingly important – and companies, like states, need to take steps to ensure that their pensions
are sustainable.
3 OECD, Pensions at a Glance 2011.
5

8. 2 Longevity and private company pensions
The sources of pension plan risk
The fundamental underlying risk for any pension plan and its corporate sponsor is that the plan
should be unable to meet its liabilities. In the past, the main potential causes for such a failure have
been considered to be a failure of investment strategy (equity risk for example) or an unexpected
change in interest rates and credit spreads that was not sufficiently matched by a valuation change in
liabilities. Increasingly, however, longevity risk – the risk that the pension plan has to provide benefits
to its members over a longer period than expected – is being recognised as a major threat to pension
plans and the companies that sponsor them.
As a rule of thumb, 10% mortality improvement adds one year to life expectancy, and one year of life
expectancy adds 4% to the required value of a pension fund’s reserves. Thus, a pension fund with a
funded ratio of 100% will see its funding ratio drop to 96% if it factors in one additional year of life
expectancy.
According to the UK Office for National Statistics, male life expectancy at birth in the UK has increased
from 70.0 in 1976 to 77.9 in 2009.4 This amounts to approximately an additional 32% of assets that
pension plans need to have available in order to cover their liabilities as a result of the increase in life
expectancy. If this trend persists, it clearly represents a significant challenge for pension funds and
their sponsors.
A pension fund is exposed to three sources of longevity-related risk:
• he first source of risk comes from the expected decline in future mortality rates. For more than
T
a century, mortality rates have decreased for all ages, both male and female. The rate of decline
over any one decade, however, has not been stable. It is therefore difficult to estimate what the
decline in mortality rates over the next decades will be. Developments in medical science, changing
habits (like consumption of alcohol or smoking), obesity, new diseases, climate change, disasters or
warfare may all affect mortality improvement, positively or negatively. This is called ‘trend risk.’
• he second source of risk is related to the difference in mortality rates between the overall
T
population and the pension fund-specific population. The risk here is that the fund comprises
certain groups of the population that experience higher or lower mortality (blue or white collar
workers, for example). This is also called ‘experience assessment error’ or ‘level risk’.
• he final source of risk comes from random fluctuations. Even if the mortality rate of a certain
T
individual is accurately estimated according to the model, this person may outlive their predicted
mortality range – purely due to chance. This risk is inversely related to the number of participants,
but can still be material even for plans with thousands of participants – especially if benefits
are weighted toward a few high earners. Although the impact of this final source of risk can be
surprisingly large, it is often completely disregarded in plan risk assessments.
4 For this and further information, see http://www.statistics.gov.uk/STATBASE/Product.asp?vlnk=333.
6

9. Figure 5: Three sources of longevity risk for pension plans
Longevity risk for the pension plan
=
Risk of decreasing mortality rates
Equal for all plans
beyond expected levels
+
Risk of experience assessment error More relevant if the plan has a
membership from specific groups
+
Risk of random fluctuation in plan More relevant if the plan lacks
diversification (small numbers or
experience
pronounced benefit distribution)
Source: AEGON
Addressing uncertainty in longevity
As a result of the steady increase in life expectancy, a significant amount of research has been carried
out in the past few years on the impact of increasing life expectancy on pension fund finances and
how best to model changing mortality rates. There is no single right answer. Some choose to model
a single permanent ‘shock’ to rates and then ensure that their pension plan is able to withstand such
a shock. A suitable shock for the purpose of modelling future changes may be in the order of a 20
to 40% instant change in mortality rates depending on plan size. Others may look to development
in other countries to gauge what longevity could realistically become in the foreseeable future. Still
others may choose to focus more on specific events such as a cure for cancer or the elimination of
smoking. All have merits in their own right.
In order to refine the different methods listed above, a stochastic (or probability-weighted) model
generates thousands of possible scenarios. This enables the pension plan to view its profile across a
universe of possible outcomes, weighing each, and determining what the more major risks to the fund
might be. The advantage of such a probability-based approach is that the fund itself is specifically
and uniquely modelled, and all sources of risk are properly addressed. The disadvantage of such an
approach is that it can be difficult to use in management communication due to its inherent complexities.
Despite this complexity, the stochastic model provides the best solution for modelling future risk due
to its ability to address exactly the nature of any change that a plan might be exploring.
While the reasons for mortality improvement vary and short-term mortality rate volatility can
fluctuate, the rate of improvement over the longer term has been remarkably stable (see figure 6) as
has the relative volatility around that trend. In fact, mortality has improved for decades.
7

10. Figure 6: Dutch mortality experience – mortality rates have been largely log-linear for the past
century
Spanish flu World War II Recent accelerated
mortality improvement
10.00%
1.00%
q(80+)
q(65-80) Smoking
q(45-65)
0.10%
1900 1920 1940 1960 1980 2000 Years
Sources: CBS, AEGON
Looking at the chart above, you may reasonably ask ‘why the sudden fuss now?’ It hardly seems a
surprise that mortality rates continue to improve. The fundamental reasons for improvements may
have changed over time, but, viewed over the long-term, mortality has improved over the past century
at least in a fairly predictable fashion. This log-linear trend is what most mortality rate models are
based on.
As can also be seen in figure 7, the older age groups have recently dipped below the trend line. This is
a concern not just because of the accelerating trend, but also because it has a much greater impact
now than in the past. Fifty years ago, an obligation to pay a pension at age 65 was less sensitive to
improvements (half the participants would not live that long). Obligations were much smaller as a
result. Now, an obligation to pay an annuity beginning at age 65 is a significant commitment.
While mortality rates have steadily decreased for over a century, mortality improvements have
not been constant over time. This can be explained by demographic factors such as a decrease in
smoking rates and better and quicker treatment for cardiovascular diseases (probably assisted by the
development of the mobile phone) .5 Pandemics and extreme temperatures can also have temporary
effects that persist for up to a decade or two. If these effects are combined in a stochastic model (as
in figure 6), different future scenarios with different probabilities can be investigated. Each of these
different scenarios may be worth considering for any given plan.
Longevity risk and other risks
While most pension funds recognise the relevance of longevity risk, positioning longevity risk within
a pension fund risk management framework is not straightforward. When viewed over the life of a
pension plan, our analysis shows that longevity risk is of a similar magnitude for a typical plan as
interest rate risk and equity risk.
5 his is one of many examples of how technology has additional, unplanned benefits. The mobile phone has helped in
T
bringing paramedics quickly to the scene of a cardiac arrest. When someone is having a heart attack, the quicker they can
be assisted, the more likely they are to survive. Minutes – or seconds – make a difference.
8

11. Figure 7: Past and future projected mortality rates for 75-year olds (male and female)
75 Years
7%
Male
6%
5%
Scenarios
4%
Female
3%
2%
1%
0%
1990 1995 2000 2005 2010 2015 2020 Years
Observed mortality
Source: AEGON
Many pension funds measure risk on the basis of 1-year Value at Risk (VaR): in an extreme one-year
event, how much will the funding ratio change? While this is a useful measure to demonstrate short-
term sensitivities, it is insufficient for long-term pension plan planning.
The following table looks at plan sensitivity to interest rates versus mortality rates in the short- and
long-term.
Short-term Long-term
Financial market risk High Low
Longevity risk Low High
On a short-term basis, the impact of longevity on a pension fund is never going to be extremely high.
In one year, our assessment of future mortality is not likely to change dramatically. Even if very few
plan members have died in a single year and the actual mortality is much lower than projected, most
plans will not automatically assume that future mortality rates will drop at the same rate. Longevity
risk emerges over time.
Over the longer term, however, the comparison is different. Interest rate movements from one year
to the next tend to have a relatively low correlation. Even if interest rates increase or decline rapidly
in one year, over a number of years, interest rate changes are more likely to even out. In fact, interest
rates are generally considered to be mean reverting.6
Longevity risk, however, is essentially different from interest-rate risk and equity risk. Thirty years
ago, mortality rates were very different from today and 30 years from now they may likewise be very
different again. Even the correlations over time (serial correlation) around the trend tend to be quite
high. In practice, what this means is that a one-year change in mortality rates is more likely to signal
future changes than is the case for interest rates. In this respect, mortality risk is a different creature
and should be treated accordingly.
6 ean reversion describes the inability of interest rates to continue to rise or fall indefinitely. As a result, they tend to
M
revert to a long-term mean value.
9

12. Defined Contribution plans and longevity risk
DC pension plans place the burden of risk entirely on the plan participant. For companies, DC plans
looked like a good solution for reducing the corporate sponsor’s pension risk (including longevity
risk). While there is some truth to this view, it ignores potential spill-over effects from inadequacies in
the alternative solutions. The pension gap in the UK was recently estimated to be approximately €370
billion or a shortfall of €12,000 per person per year.7 DC contributions have remained significantly
and consistently lower than DB contributions. Over the past couple of decades, western civilization
has not been very adept at saving.
While many of today’s workers may have been planning to retire between the ages of 60 and 65,
the trend to provide DC plans in place of DB plans will probably mean that workers will have to work
for longer (and save more). This in itself is an indirect way of increasing the retirement age, leaving
workers to decide for themselves when they will retire. The longer you work, the more comfortable
your retirement will be. Companies will need to be prepared for this shift in employee behaviour and
expectations.
Longevity – a challenge and an opportunity
Increasing longevity will not only affect pensions. Although it is only possible here to highlight the
most general developments, it is clear that considerable effort will also have to be put into enabling
older workers to continue to develop and be productive. In the light of the shrinking number of
younger workers, the continued availability of older, experienced workers may be seen as a positive
development. However, it is clear that both employer and employee attitudes and expectations will
need to change. Performance management, career paths, redundancy terms and remuneration
models will all need to be reviewed.
If we look at a national level, Finland provides a good example of how to approach an ageing
population. Finland carried out some groundbreaking work in the late 1990s in order to increase
the productivity and participation rate of older workers. The Finnish National Programme on Ageing
Workers (FINPAW) set out to address the very same issues facing companies today. FINPAW paid
particular attention to improving the ability of ageing workers to perform their work and attempted
to promote more favourable attitudes to older workers. The programme prepared the way for the
Finnish 2005 pension reform that delayed the age of retirement and adjusted the pension system to
increasing longevity rates.
As with Finland, companies need to look for new ways to make the most of an ageing workforce
– stimulating and enabling more people to stay in productive employment for longer. Already
organisations, such as the UK Employers’ Forum on Age (EFA) are working to help employers find new
ways to engage and employ their older employees for longer. Such programmes can help prepare
companies and employees for the challenges and opportunities ahead.8
7 Aviva, The Pensions Gap across Europe 2010.
8 he recent creation of the ‘Global Coalition on Aging’ (www.globalcoalitiononaging.com) is another example of businesses
T
voluntarily coming together in order to highlight and realise many of the opportunities that ageing populations will bring.
The Coalition’s aim is to approach ageing societies not as a problem but as an opportunity for all of us to live longer,
healthier and more productive lives.
10

13. 3 Longevity solutions for pensions
Pension plans and longevity swaps
Over the past few years, longevity swaps have been developed as a tool to help pension plans – and
their corporate sponsors – to protect themselves against longevity risk, one of the major risks they
face. In addition, longevity swaps provide an excellent diversifying effect on a pension fund’s portfolio
– particularly for medium to low risk portfolios. By viewing longevity swaps as an investment, plans
can now ‘duration’ match assets and liabilities – not just from an interest rate perspective, but also
increasingly from a longevity risk perspective.
In looking at the benefits of longevity swaps, a key question that is raised sooner or later relates to the
cost of the protection provided. In calculating how much a plan should be willing to pay for a longevity
swap, some companies may be faced with the challenge of reconciling their present estimates of future
costs with the potential ‘worst case’ scenario against which the longevity swap provides a hedge. As
with many de-risking solutions, companies are faced with the decision of whether to take action now
or not. The dilemma faced by companies is that when de-risking is affordable, it is often viewed as
being less necessary. Conversely, at times when the appetite for de-risking increases (typically when
the risk materializes), it is also less affordable.
In the present environment, there are two elements at play that may be leading some pension funds
to hold back from de-risking – the relative newness of the market in longevity swaps and the contrast
between the pension funds’ present best estimates of their liabilities and revised best estimate
liabilities based on new insights into longevity trends.
As with all risks, there is a temptation to wait and see how the market – and mortality tables – develop
(‘it may never happen’). However, for companies with DB pension plans, in the light of the present
demographic trends and regulations, it is a good idea to quantify the potential impact of longevity
risk now. This involves re-examining how a pension plan’s liabilities are presently evaluated. Once
these calculations have been made, it is possible to address the de-risking dilemma and to find the
right solution.
As new regulatory regimes (including Solvency II for insurers) will increasingly recognize longevity
risk, it is likely that more companies will start actively looking to protect their pension funds. At the
same time, insurance companies with mortality risk on their books, create something of a ‘natural
counterparty’ for longevity risk. Many hedge funds are also interested in assuming insurance risk,
such as longevity risk, as part of a diversified portfolio.
Although it is impossible to provide a general ‘one size fits all’ price for a longevity swap, a risk premium
above the revised best estimate cash flows (which are often different from the present best estimate
plan valuations) typically ranges between 4% and 7% for a pensioner-based portfolio. For most plans,
this can be seen as a fixed cost increase in order provide complete protection against a worst case
longevity loss of between 10% and 30% of the plan value. Not only do the plans protect themselves
against this worst-case (and potentially unaffordable) risk, but, by implementing a longevity swap,
they can also create an improved asset-liability matched portfolio. This improved portfolio can enable
them to re-allocate the risk into other asset classes, potentially allowing them to recapture more than
the risk premium paid.
11

14. Ultimately, the decision to de-risk will depend on both the plan’s and sponsor’s risk appetite. The
choice is not between the two extremes of no hedge versus a full hedge. Rather, the choice is
where the company wants to be (or can afford to be) on the risk spectrum. Most plans have actively
addressed the issue of equity and interest rate risk. Those plans should now include longevity risk in
their deliberations.
Pricing – and measuring – longevity risk
With a longevity swap, a variable stream of cash flows is exchanged for a fixed stream of cash
flows. When pricing a longevity swap, both parties need to agree on the fixed set of cash flows. This
represents the price and includes a risk premium (figure 8).
At present, most pension funds generate mortality assumptions upon which they base their best
estimate projection of future cash flows. However, these projections often trail improvements in
actual mortality rates, which results in them underestimating future liabilities. Although this ‘liability
gap’ needs to be bridged, it should not be viewed as part of the cost of the de-risking solution itself
Figure 8: Typical plan view of pricing: current best estimate versus revised best estimate and
the fixed cash flow level. Note that the fixed cash flow level may be more front-loaded in some
structures
100,000
90,000
80,000
Best Estimate + Risk Premium
70,000
Cash Flow (in Thousands)
Best Estimate Cash Flows
60,000
Current Cash Flow Projection
50,000
40,000
30,000
20,000
10,000
0
1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91
Time (in years)
Source: AEGON
but rather as a necessary cost adjustment in recognition of the new best estimate of future liabilities.
To the extent that such a gap is observed, it simply represents the expected adjustments that the next
actuarial updates will reflect.
Although deterministic models can assist a pension fund to reach a best estimate of their future cash
flows, they do not provide a picture of the measure of risk around the numbers. For this reason, in
pricing a longevity swap, stochastic (or probability-based) models of mortality rates may be used. A
stochastic model enables the best estimate cash flows and the related longevity risk to be calculated,
taking into account all sources of risk as well as considering the latest statistical data for the specific
country or region involved, and including plan-specific mortality experience without being specifically
constrained to a given mortality table.
12

15. Index swaps versus indemnity swaps
There are two main types of longevity swaps: index-based and indemnity-based swaps.9 In principle,
index-based swaps tie the swap payment to a specific country or segment mortality index, while an
indemnity swap covers the actual plan experience. The two types can be compared according to
effectiveness and cost. The effectiveness of an index swap depends on the pension plan’s performance
relative to the chosen index. An index swap introduces an element of basis risk, as the basis of the
plan necessarily differs from that of the index. The closer the two are, the better the index hedge.
Indemnity swaps introduce no basis risk as they indemnify the plan for actual experience.
While an index swap may seem like a simple solution, it requires a complex strategy to create an
adequate hedge for the fund (and even then it will not provide a complete hedge). In the UK market,
where several transactions have taken place, there have been only a few examples of a pension plan
index hedge.10 The market appears to have recognized that the current risk/reward trade-off of an
indemnity-based swap is superior for most plans.
Indemnity-based swaps are cash-flow based, providing full indemnity for the plan. For example, using
an indemnity-based swap, the pension plan would pay the provider fixed cash flows and the provider
would pay the plan floating cash flows. The fixed cash flows are based on accrued benefits only.
No future accruals and indexations are included, although they could be covered by future swaps
arrangements. The provider projects the cash flows based on the current participants and adds a
risk premium. In comparison with an index-based swap, such an arrangement is more complicated
to implement and administer, but provides greater value for a pension plan than simpler index-based
swaps.
The pricing of indemnity-based transactions and index-based transactions in the market presently
appear to be similar. The reason for this is that for a fully diversified pool of lives (such as an insurer’s
portfolio) it doesn’t make a significant difference how the risk is assumed. If you look at the marginal
volatility that an insurer experiences from the transaction, it is more similar to population volatility.
However, from the pension plan’s perspective, an indemnity swap is more valuable as it matches
existing volatility better. So, in general, it is more beneficial for a pension fund to carry out an indemnity
swap because it covers all risks, including basis risk, for a similar price to an index-based swap.
9 n this paper, our discussion focuses on q-forward index swaps, where the index used is a mortality rate for a specific
I
age group at a specific time in the future.
10 In 2010, Pall UK’s pension fund entered into a 10-year index swap.
13

16. Table 1: Comparison between indemnity and index swaps
Indemnity Swaps Index Swaps
Pricing More complex Straightforward
Involves fund-specific Only involves assessing risk of
mortality rates as well as chosen index mortality rates
conversion to cash flows
Hedging strategy Straightforward More complex
A single swap hedges all Finding the right combination of
relevant risk index swaps is not trivial and will
never be perfect
Effectiveness Complete Partial
Covers all levels of mortality Covers nationwide risk only and
risk ignores fund-specific risk
Source: AEGON
Table 1 demonstrates the relative ineffectiveness of an index swap. The scatter represents the
outcomes of scenario simulation, where the x-axis value is the present value of cash flows without
the swap and the y-axis the present value of cash flows of the portfolio with the swap. The scatter
shows how the distribution along the y-axis is not as wide as along the x-axis – the index swap has had
a dampening effect.
Figure 9: Scatter diagram of scenarios showing the sum of cash flows with and without an
index hedge in place. Even though using the hedge narrows the distribution of total cash
flow, reflecting the risk-reducing effect of the hedge, there is still significant residual risk. In
addition, as the hedge comes at a certain cost, there is no single scenario where the outcome
with the hedge is more favourable than the outcome without a hedge, as demonstrated by the
fact that all the points are above the diagonal. Even if priced more attractively (which would
cause a shift downward in the scatter ‘cloud’), the slope of the scatter makes it difficult for the
q-forward to come out ahead in all but a few scenarios.
With
Without
Source: AEGON
14

17. Figure 10: Scatter diagram of scenarios showing the total sum of cash flows with and without
an indemnity hedge. With the indemnity hedge in place there is complete certainty over the
total sum of cash flows that the fund is going to have to pay, reflected in the straight line.
The hedge comes at a cost, but for the extremely negative scenarios, where the sum of cash
flows is high, using the hedge results in a more favourable result for the fund. The fund has
effectively locked in a sum of cash flows and bought protection against adverse scenarios.
With
Without
Source: AEGON
However, it is also clear that significant residual basis risk remains.11 The swap also comes at a price,
reflected in the fact that the scatter is higher than the diagonal. In the case of the index swap, the
two factors together do not create a good outcome for the fund: for no single scenario does the
swap actually create a better result. The scatter is always higher than the diagonal. Even if priced
more attractively (which would cause a shift downward in the scatter ‘cloud’), the slope of the scatter
makes it difficult for the q-forward to come out ahead in all but a few scenarios. This is an example of
basis risk. In the end, although the basis risk may be manageable, it is vital that the plan understands
that it has assumed basis risk by entering into the trade.
The indemnity swap, in contrast, performs significantly better (figure 10). There is no residual risk and
the scatters are all on a straight line. And in the case of extreme events, the indemnity swap provides
the protection it was designed to provide. It is also clear that any downward change in price (vertical
shift of the line) directly moves further into a winning outcome for the plan.
Finally, the price for the two different types of swaps is presently similar. While index swaps may be
thought to have the potential to become more liquid, if a secondary market were to develop, and
arguably should trade at a lower price, this is a theoretical phenomenon only. It is clear that index
swaps have a better chance of developing into a liquid secondary market, but currently, the market for
longevity swaps does not exist and index swaps are generally priced at the same level as indemnity
swaps. In addition, liquidity can be seen quite simply as the ability to exit the transaction – and this
possibility can easily be structured into an indemnity swap.
11 ndex swaps also contain one more risk: re-investment risk. The index swap covers the fact that the index has changed over
I
a certain period, but does not cover the risk of having to buy a new index swap, which may be more expensive due to the
changed index.
15

18. Controlling pension risk
Longevity risk is one of several risks faced by company pensions and, as such, should not be addressed
in isolation. The first step to controlling pension risk is to identify which pension risks are present.
And – as different companies will have different tolerance for risk – it is important to address all the
risks and identify which need to be removed or controlled. Some companies may wish to remove all
risk in order to be able to concentrate on their core business. Others may wish to take some risk but
to remove inflation, interest or longevity risks. In managing pension risk, companies can choose from
a range of de-risking tools including:
• iability-Driven Investment (LDI) – LDI allows a pension fund to manage unwanted interest, inflation
L
and other asset risks by better matching liabilities with assets.
• ongevity swaps – As discussed above, longevity swaps enable pension funds to protect themselves
L
against the risk that their employees will live longer than previously estimated. Longevity swaps
allow companies to reduce the volatility of their pension plans.
• ension buy-ins – Buy-ins are insurance policies that are regarded as a separate asset class on
P
the pension fund balance sheet. They can be implemented by companies with pension funds that
are not fully funded and enable companies to use their available resources in the most effective
fashion. They differ from longevity swaps mainly in the fact that a form of asset risk is part of the
transaction.
• ension buy-outs – Pension buy-outs remove all pension risks by enabling a company to completely
P
transfer the accrued pension liabilities of a defined benefit plan to another provider in return for a
premium. A number of solutions have been developed, including phased buy-outs (where liabilities
are transferred in agreed stages).
By using a combination of the different solutions available, companies can de-risk their pensions in
stages, by country or by plan, reducing risk over time. Although a relatively recent addition to the ­
de-risking toolkit, longevity swaps perform an important function in reducing volatility and protecting
against extreme events.
Figure 11: The spectrum of de-risking solutions
Derisking solutions
Protect
balance
Longevity Swap sheet
Buyout
Buy-in
Remove longevity risk
Inflation overlay
Open DB Plan Interest overlay
Remove investment risk
Source: AEGON
16

19. 4 Hedging your longevity risk: one step at a time
The decision process involved in hedging the longevity risk of your pension fund can be lengthy, and
involves many different parties and stakeholders. It is helpful therefore to know in advance how to
approach the decision-making process and what the implementation of longevity swaps may entail.
The following guidelines are designed to support the sponsoring company in implementing a suitable
decision-making process.
GUIDELINE 1: START PREPARED
Although longevity risk is not new, only recently has the importance of this risk become fully
understood. Before the process of de-risking is started, the main team involved in driving the
de-risking process will need to understand the mechanics of longevity risk and the impact it has on
the pension plan.
GUIDELINE 2: DETERMINE YOUR OBJECTIVE
Hedging longevity risk can be part of a wider derisking strategy, or a first step to a full buyout, or
both. The longevity swap contract needs to be flexible enough to support any future plans. Your long-
term strategy, and the part that the longevity hedge will play in it, should therefore be clear before
you start discussing hedging options.
GUIDELINE 3: REVIEW DATA
Experience shows that longevity swaps are very sensitive to data accuracy. Implementing a swap
requires up-to-date and accurate data on your pension plan and its participants. Reviewing your plan
data may be of benefit to your plan in any case.
GUIDELINE 4: ESTABLISH INTERNAL SUPPORT FOR A LONGEVITY SWAP
In order to be able to progress with a longevity swap, it is essential to have the support and
understanding of the key stakeholders.
GUIDELINE 5: LOOK AGAIN AT THE VALUATION
Before you request a quote for a longevity swap, it is advisable to review the mortality assumptions
underlying your current valuation of liabilities in the fund. A key element in implementing longevity
swaps is reaching agreement on the best estimate of future cash flows, which involves comparing
respective views.
GUIDELINE 6: THE LOWEST QUOTE IS NOT ALWAYS THE BEST
Price is one of the main points of negotiation when agreeing on a longevity swap. However, as a contract
can last for 50 years or more, it is very important to have a trustworthy, professional counterparty
that can allow for the flexibility in the contract that is necessary to meet your future goals. So, in
addition to comparing prices, comparing providers and underlying structures is an important part of
the selection process.
GUIDELINE 7: SPECIFY YOUR NEEDS
Once the price is established and you have a found a flexible, trustworthy counterparty, you will need
to create a contract that suits your needs, now and for the future. Depending on your strategic goals,
flexibility may be required so as to be able to unwind the longevity swap or transfer it into a buyout
contract at a later date. Exit clauses, valuations and collateral agreements will all need to be agreed
upon before a contract can be signed.
17

20. 5 Conclusion
Pension systems are under stress. Each pillar of these systems – public, company and private – has its
own characteristics and challenges, but the current pressures are one-directional. The inability of any
one pillar to address the challenges it faces will have an impact on the other pillars. For companies,
therefore, it is important to consider public and social trends even as they address their own pension
risks.
Longevity looks set to continue to improve in the same way that it has for decades.12 For this reason,
pension plans and their company sponsors need to look at protecting themselves against longevity
risk. Although longevity risk may be viewed as a relatively new phenomenon, there are now a number
of de-risking solutions available, and both the market and technology have evolved sufficiently for
companies and pension plans to be able to address the longevity risk on their balance sheets.
In addressing longevity risk, companies will first need to revisit the best estimates of their future
pension liabilities and the risk around those estimates. This can be done through studying plan
mortality development relative to underlying actuarial assumptions and using a stochastic plan-
specific model. This exercise alone may help the sponsor to identify a potential liability gap that needs
to be filled. Only once a company or pension plan has a good picture of its future pension liabilities,
is it possible to address the costs and benefits of protecting the plan from further longevity risk
through a longevity swap. Although the trend for longer life is still heading resolutely upwards, there
is nevertheless uncertainty around the trend, and the pension plan and the company sponsor have to
judge whether they are willing to pay a risk premium of between approximately 4% and 7% to protect
against a possible cost of between 10% and 30% of the plan value.
In order to protect themselves against longevity risk, companies may prefer to look at indemnity
hedges rather than index hedges, as index hedges offer only partial protection and introduce basis
risk. In addition, the pricing of the two types of hedges are currently similar. Indemnity swaps provide
better protection and, although they are not tradable, they are reversible.
Increasing longevity is not only an issue for company pensions. In the end, all stakeholders (government,
companies and individuals) need to address the challenge of people living for longer. Preparations are
already being made to help keep more people active and working for longer, and we can expect to
see many more developments on this front over the coming years. The repercussions of this dramatic
success story will have an enormous effect on our societies. But the benefits of longer life also pose
a risk, and this is where companies need to start taking action now. The time has come to look again
at longevity risk and to investigate how best to protect against it.
12 ome people are even suggesting that science will enable us to extend our lifespan radically further. The Cambridge-based
S
SENS (Strategies for Engineered Negligible Senescence) Foundation under the leadership of its Chief Scientific Officer,
Aubrey de Grey aims to achieve ‘healthy lifespan without limit.’
18

21. Additional bibliography
Further AEGON articles on longevity and longevity swaps
‘A Dutch Perspective on longevity swaps’: http://www.aegonglobalpensions.com/Documents/aegon-
global-pensions-com/Publications/Events/2010/2010-A-Dutch-Perspective-on-longevity-swaps-The-
indemnity-based-swap-and-other-solutions.pdf
‘Why longevity swaps should also be viewed as an investment’: http://www.aegonglobalpensions.
com/Documents/aegon-global-pensions-com/Publications/Newsletter-archive/2010-Q1/2010-Why-
longevity-swaps-should-also-be-viewed-as-an-investment.pdf
‘A Practical View on Longevity Swaps’: http://www.aegonglobalpensions.com/Documents/aegon-
global-pensions-com/Publications/Events/2009/A%20Practical%20View%20on%20Longevity%20
Swaps%20-%20Netspar%20Dec%202nd%202009.pdf
‘Longevity Modeling and Longevity Protection’: http://www.actuariaatcongres.nl/presentaties/
Sylvain%20de%20Crom.pdf
‘PP Show 2010 – Longevity swaps hedges risk while retaining asset flexibility’: http://www.
professionalpensions.com/professional-pensions/news/1898635/longevity-swaps-hedges-risk-
retaining-asset-flexibility
‘Longevity Risk – Source and Mitigation’: http://www.actuariaatcongres.nl/pdf/Artikel%20Chris%20
Madsen.pdf
‘Fresh approaches to longevity risks’: http://www.aegonglobalpensions.com/Documents/aegon-
global-pensions-com/Publications/Events/2010/2010-Presentation-Andrew-Ward-and-Chris-
Madsen.pdf
Acknowledgements
The authors would like to thank the following people for their valued input and insight: Jeroen Bogers;
Sylvain de Crom; Ugo Hofman; Frans van der Horst; Thurstan Robinson; and Andrew Wood.
19

22. Contact details
AEGON Global Pensions
P.O. Box 85
2501 CB, The Hague
The Netherlands
Telephone: +31 (0)70 344 89 31
E-mail: aegonglobalpensions@aegon.com
Website: www.aegonglobalpensions.com
Disclaimer
This white paper contains general information only and does not constitute a solicitation or offer. No
rights can be derived from this white paper. AEGON Global Pensions, its partners and any of their
affiliates or employees do not guarantee, warrant or represent the accuracy or completeness of the
information contained in this white paper.
AEGON, April 2011
20