There's a perfect storm brewing and it's all the fault of baby boomers.
A report by the Bank of International Settlements (BIS) with the rather lengthy title "Longevity risk transfer markets: market structure, growth drivers and impediments, and potential risks" examines the impact of increasing numbers of "oldsters" and their increasing lifespans on the world's pension system. More, long-living people will result in longer payouts for both pensions and annuities, putting a strain on the sustainability of "saving for retirement" products, a situation that greatly concerns pension fund managers.
At the end of 2011, there were about $20 trillion worth of private pension assets globally with about 65 percent of them being defined benefit, a type of pension plan that is proving to be quite worrisome given the large pool of retirees who are planning to live to be 100 years of age looming in most developed nations. From a financial perspective, the total risk associated with each additional year of life adds between three and four percent to the present value of liabilities of a defined benefit pension plan. With the total global amount of annuity and pension-related longevity risk ranging from $15 trillion to $25 trillion, a one year increase in longevity will cost pension plans an additional $450 billion to $1 trillion, a huge risk.
As a prime example, Ontario Teachers' Pension Plan, one of Canada's largest pension funds, had 102 retired teachers over the age of 100 in 2011. On average, a typical teacher works for only 26 years before collecting a pension, meaning that an increasing number of teachers are collecting their pensions for far longer than they worked. Some of these very old teachers may well have collected pensions for twice as long as they worked. As well, in 1970, there were 10 working teachers for every pensioned retiree, by 2011, that ratio had dropped to 1.5 working teachers for every pensioned retiree. Such a system is, quite clearly, unsustainable.
To control their exposure to this risk, defined benefit pension funds are looking to transfer that risk to outside parties in one of three ways:
1.) Longevity Swaps or Longevity Insurance Transactions: The pension fund obtains protection from higher-than-expected pension payouts by making periodic premium payments to an insurer (re-insurer) based on the difference between the actual and expected pension mortality experience and actual and expected benefit payments. The sponsor remains directly responsible to the pension members but retains the risk associated with investments. Longevity swaps require the posting of high-quality liquid securities as collateral. In swaps, the risk is distributed broadly and in the case of longevity insurance, the risk is borne by the pension plan which is exposed to risks associated with the insurer.
2.) Buy-Out Transactions: All of the pensions assets and liabilities are transferred to an insurer in return for the payment of an upfront premium and are completely removed from the pension funds balance sheet. In this case, all risk (including longevity risk) is transferred to the insurer, however, pension members are at risk should the insurer fail. Back in 2012, I posted about a pension plan buy-out arrangement for General Motors. GM's pension obligations were purchased for $26 billion and Verizon Communication's pension was purchased for $7 billion by Prudential Insurance, transferring all of the risk to Prudential and, ultimately, the pension plan members should Prudential fail.
3.) Buy-in Transactions: The pension plan sponsor retains the assets and liabilities of the plan but pays a premium to an insurer that will result in the insurer making periodic payments that match the payments made by the pension plan. Risk transfer is only partial with the pension plan sponsor remaining responsible to the pension plan members and the insurer being exposed to counterparty (the risk to each party of a contract that the other party will not live up to its obligations) risks. The insurance policy itself is held as an asset by the pension plan, adding an additional level of risk should the insurer fail.
Here is a simple diagram showing the flow of cash in both buy-out and buy-in transactions to help you better understand where the problems could occur:
An alternate method of reducing pension risk is through the conversion of defined benefit plans to defined contribution plans where pension plan members are solely responsible for any funding shortfalls. Here is a bar graph showing how the percentage of assets held in defined contribution plans for six nations has grown as a percentage of total pension plan assets between 1999 and 2012:
All of this pension longevity risk transfer (LRT) is a new facet of today's markets and could well prove to be the next creative and untested financial instrument that brings the market to its knees, just as mortgage-backed securities created chaos in 2008. Given that the current funding state of defined benefit pension plans is pathetic at best, the longevity shock could well prove to be the undoing of many corporations. This factor will make it very tempting for companies to look to one of the transactions listed above to transfer their pension risk elsewhere.
Right now, the size of LRT markets are not terribly large, however, there is potential that the market for this type of creative risk transfer could mushroom. A key risk likes in counterparty default risk (again, the risk that one of the parties to the contract will not live up to its obligations) in the case of buy-ins, longevity swaps and longevity insurance as shown on this table:
Basically, transferring risk from one party to another can lead to undesirable consequences. As was seen in 2008, a proliferation of creative products led to the buildup of leveraged positions by investors that were not necessarily aware of the risks involved. As well, as the market for LRT products grows, unforeseen circumstances could prove disastrous. For example, should a cure for cancer be found, longevity would increase across the board, resulting in massive problems for those insurers involved in risk transference.
Let's close with a summary paragraph from the report:
"While LRT markets are not sizeable enough to present immediate systemic concerns yet, their massive potential size and growing interest from investment banks to mobilise this risk make it important to ensure that these markets are safe, both on a prudential and systemic level."
It will be interesting to see if anyone pays heed to the recommendations of the Bank before it's too late. With defined benefit pension plan funding rates dropping in the current zero interest rate environment, my suspicion is that we may well be seeing the beginning of the next financial crisis.
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