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Turbulence Ahead for U.S. Plan Sponsors: Longevity Risk on the Horizon ARI JACOBS AND MATTHEW R. MALONEY ARI JACOBS is a senior partner and global retirement solutions leader at Aon Hewitt in Norwalk, CT. ari.jacobs@aonhewitt.com MATTHEW R. MALONEY is a partner at Aon Hewitt in Norwalk, CT. matt.maloney@aonhewitt.com Despite the growing interest in managing pension longevity risk globally, especially in the U.K., the topic has been flying under the radar for U.S. plan sponsors. In fact, most pension actuaries in the U.S. have been on autopilot for years with respect to longevity issues. However, some turbulence is on the horizon, as plan sponsors are about to be dealt a financial blow to their pension costs in the form of new pension mortality assumptions. Updated mortality assumptions are expected to be released by the Society of Actuaries (SOA) later this calendar year. Meanwhile, the financial market for longevity insurance transactions between U.S. pension plans and financial institutions is thin, or even nonexistent, as more complete pension risk transfers (i.e., bulk annuities and lump-sum settlements) continue to attract plan sponsors concerned with longevity risk. Assessing the impact on plan costs and determining whether any available risk transfer options make sense for an organization will require plan sponsors to have a much more comprehensive understanding of the mortality assumptions underpinning the various alternatives. Mortality Assumptions at a Glance Mortality assumptions are made up of two components: 1. Base Rates The level of mortality in a population as of a given point in time. Base mortality tables typically vary by gender and age. The set of base mortality rates most frequently used for U.S. pension plan purposes today is the RP-2000 table, which was published by the SOA in 2000. 2. Improvement Rates The pace at which base rates are expected to change in the future. The most frequently used set of mortality improvement rates used for U.S. pension plan purposes today is Scale AA, which was published by the SOA in 1994. TIME TO TURN OFF THE AUTOPILOT For many years, most U.S. pension actuaries (and thereby the plan sponsors they advise) have been less focused on longevity PENSION & LONGEVITY RISK TRANSFER FOR INSTITUTIONAL INVESTORS
risk. Their mortality assumptions have been on autopilot, reflecting relatively minor periodic tweaks, but hardly keeping up with the dramatic changes in life expectancy in the U.S. over the past decade. Some of this has not been the actuaries fault; for two decades, the IRS has mandated mortality assumptions for minimum funding purposes, which many actuaries and plan sponsors have relied on for financial statement purposes as well. This mandate from the IRS was required by statutes aimed at standardizing this critical assumption to avoid actuarial discretion materially affecting tax revenue and benefit security. Contributing to U.S. pension actuaries use of autopilot was the fact that up until a few months ago, there had been little up-to-date research that they could use to assess the adequacy of their long-term mortality assumptions. For example, the RP-2000 mortality rates that form the basis of the IRS tables mentioned above are based on U.S. pension mortality experience from the early 1990s. Another reason that longer life expectancy has limited financial effect on U.S. sponsors is that the additional payments occur many years in the future. For example, the average 60-year-old female today is projected to live until age 85, when using current IRS-mandated mortality assumptions for minimum funding purposes. If she were to live one extra year, that additional year of payment is worth 30 cents today for each $1 of annuity benefit, because most U.S. pension plans do not provide inflation adjustments to benefits. The present value of that additional year would increase from 30 cents to nearly 60 cents if the benefit were indexed with inflation. (Out of all employers in Aon Hewitt s database of U.S. companies offering defined-benefit plans to new hires, only 2% of non-public employers provide inflation-indexed pension benefits and only one of these organizations was not a non-profit or mutual insurance company). All of these factors IRS-mandated tables for minimum funding purposes, the slow trickle of updates from the SOA, and muted financial effects made it easy for U.S. pension actuaries to keep their mortality assumptions on autopilot for years. But for the first time in a long time, some serious turbulence is showing up on the radar screen, and many sponsors might be in for a bumpy financial ride. So, what is going to cause all of this turbulence? The SOA is currently working on a comprehensive review of U.S. pension mortality assumptions, and expects to release the initial results of that study by the end of 2013. The implications of the study are expected to be more significant than those of the SOA s Mortality Improvement Scale BB Report (published September 2012), which provided actuaries with an interim mortality improvement scale that could be used in place of Scale AA. As such, the typical U.S. plan sponsor s views of longevity risk is poised for change. Many industry observers are expecting the SOA s report to be a source of great concern for sponsors once the regulators and auditors require the adoption of these new mortality assumptions. While recent guidance from the IRS all but rules out its use of new assumptions for minimum funding purposes before 2016, many audit firms will likely push the adoption of these new assumptions for year-end 2014 GAAP accounting and possibly sooner than that for special transactions such as business combinations, settlements, or curtailments. A DEEPER DIVE INTO LONGEVITY RISK Given the nascence of the pension longevity risk market, every practitioner seems to describe the components of longevity risk somewhat differently. For the purpose of this article, let us focus on three types of longevity risk to which pension plans are exposed: basis risk, trend risk, and table risk. Each risk is discussed in more detail below. 1. Basis Risk The risk that the current base mortality rates used to calculate plan obligations are not representative of the plan s actual mortality experience. For example, base mortality rates are inversely proportional to socio economic status, and yet few pension plans are valued using anything other than the IRSmandated base rates. While the SOA published limited RP-2000 adjustment factors to reflect certain demographic traits of a plan (i.e., white/blue collar status, and small/medium/large benefit size), many other factors drive variations in base mortality rates. The risk to the pension plan in this situation is that the current assumptions will perpetually under- TURBULENCE AHEAD FOR U.S. PLAN SPONSORS: LONGEVITY RISK ON THE HORIZON
or overstate the future cash flows of the underlying population. Measuring a pension plan s basis risk requires a review of the plan s specific experience and demographic profile. Pension plan experience differs from population-wide mortality (a form of basis risk in itself) in that pension plans cover a subset of the U.S. population that is generally healthier than the entire population. As such, SOA analyses provide a critical distinction from population-wide mortality studies, but they do not go deep enough into the details of plan-specific basis risk. As the largest single repository of U.S. pension plan mortality experience outside of governmental agencies, Aon Hewitt is able to provide metrics to help sponsors analyze their plans potential basis risk relative to other pension plans. Aon Hewitt s data have shown that the geographic distribution of a plan s population is one of the most critical drivers of basis risk. It is not that one s health is explicitly defined by their living in Aaronsburg, PA (16820) or Zuni, Virginia (23898); rather, these geographic differences are indicative of a person s relative socio economic status and their access to high-quality healthcare services. Specifically, Aon Hewitt s data have shown that the difference in life expectancy for a male retiree at age 65 (LE65) can vary by as much as 5 years, depending on his ZIP code. LE65 is a critical measure for pension plans, because the bulk of the cost for a pension plan is concentrated in the years of retirement. To put this differential of 5 years in perspective, the SOA s White Collar and Blue Collar adjustment factors in the RP-2000 Report create a variance of only 1.3 years in LE65 for this retiree. Below is a summary of this, including the implications on liability: Highest to Lowest Mortality by ZIP Code White-Collar Relative to Blue-Collar Retiree Increase in LE65 Approximate Increase in Benefit Obligation 5.0 years 17% 1.3 years 5% ZIP code is only one of a number of factors that can have a significant impact on a pension plan s liability. Meanwhile, current pension practices generally ignore these demographic differences and provide for the same liability for a participant living in any ZIP code. For sponsors with geographically diverse populations, these effects may be less dramatic; but for sponsors with geographic concentrations, the difference in pension obligation may be significant. 2. Trend Risk The risk that over time, the rate of mortality improvement will differ from that implied by the most recent mortality projection scale, without any new rates being measured and published (also known as mortality drift ). Unless the SOA publishes revised base and improvement rates adjusting for this disparity, such differences in actual improvement will be observed over a long time horizon in the form of greater-than-expected (or lessthan-expected) payouts. This risk was brought to the fore with the SOA s release of Scale BB in September 2012, which confirmed that recent mortality improvements have, on average, been considerably larger than those predicted by Scale AA. According to the National Center for Health Statistics (NCHS), in the first decade of the 2000s, males experienced an increase in LE65 at a rate that was approximately double the average annual increase between 1980 and 2000; meanwhile, females experienced increases that were seven times their 1980 2000 average. (See Exhibit 1.) Measuring trend risk is extremely challenging. Many academic papers and models have been devoted to the study and analysis of this risk, the details of which are too complex and too diverse to be summarized within the body of this article. There are many reasons why the pace of future longevity improvement might accelerate or decelerate, some of which remain unknown to us today. Demographic models are available to support the quantification of this risk, and sponsors with pension plans that are material to their corporate financial statements should consider performing such analyses. However, it helps to bear in mind that the most significant and hardest to predict component of trend risk could very well be the unknown unknowns. PENSION & LONGEVITY RISK TRANSFER FOR INSTITUTIONAL INVESTORS
E XHIBIT 1 Evidence of Mortality Drift Accelerate Future medical breakthroughs Genetic engineering Improved diagnostic techniques New medicines Replacement organs Breakthroughs in slowing the aging process Broader access to healthcare Reduced levels of smoking Decelerate Societal/lifestyle issues Surge in obesity levels Type-2 diabetes Certain cancers Cardiovascular diseases Sedentary lifestyles Difficult-to-predict events e.g., pandemics, wars, terrorism Limitations of healthcare infrastructure Limitations of government funding 3. Table Risk The risk that over time, the rate of mortality improvement has differed from those assumed by the mortality improvement rates, and the SOA publishes new mortality rates to compensate. An example of this is the difference between the SOA s recently published interim Scale BB relative to previous calculations under Scale AA. Since plans typically make a one-time change in their reserve for the difference between actual improvements after the release of new pension mortality studies, the SOA s expected issuance of updated base rates and new projection scales by the end of this calendar year have dramatically increased table risk for most U.S. plan sponsors. Measuring table risk also presents certain challenges, though these challenges are less technical in nature and more about the availability of information. Over short periods of time, quantification of pending changes, such as updating to the interim improvement Scale BB, will provide plan sponsors with a sense of any shocks looming over the near term. However, over longer periods, sponsors must rely on other data sources, such as a review of their own mortality data and those of third parties to estimate the potential mortality drift since the SOA s last study. Exhibit 2 shows the increase in benefit obligation for a typical pension plan under the last three major updates from the SOA. Historically, these updates have increased benefit obligations by 3 6% for a typical pension plan. TURBULENCE AHEAD FOR U.S. PLAN SPONSORS: LONGEVITY RISK ON THE HORIZON
E XHIBIT 2 Benefit Obligation Increase Update from 71-GAT to 83-GAM Update from 83-GAM to RP-2000CH (with Scale AA) Update from Scale AA to Scale BB Average Increase in Obligation 6% 5% 3% It should be noted that lately, this has been a one-way event for U.S. plan sponsors updates from the SOA have demonstrated greater-than-expected longevity improvement each time, increasing obligations. The original premise is that table risk is, in fact, a risk because current assumptions about mortality may be wrong in either direction. When discussing the various types of pension longevity risks, it is helpful to make one additional distinction intrinsic risk versus extrinsic risk. Basis and trend risk are intrinsic to life expectancy improvement (i.e., regardless of how regulators, actuaries, and plan sponsors set mortality assumptions, these risks will always exist). However, table risk is extrinsic to longevity improvement (i.e., it is a consequence of how pension mortality assumptions are developed and applied in the U.S.). Table risk could, in theory, be mitigated if the SOA were to adopt a policy of continuously re-evaluating and resetting mortality improvement assumptions (such as the process currently used in the U.K.). WHAT THE MARKETS HAVE SHOWN US Capital markets provide the opportunity to trade risks of all types, and longevity is no exception. However, due to the efficiencies of markets, one party (e.g., pension plans) will not typically have more information about longevity than another party (e.g., insurance companies); if they did, the other party would most likely avoid the trade. So because both basis risk and table risk are related to the availability of information, one should not expect markets to provide solutions for these risks. Rather, solutions for basis and table risk relate to more timely measurement and access to data about the plan s demographics. Paying lump sums is the only tool that allows a U.S. plan sponsor to hedge basis risk. Because the IRS mandates the mortality to be used in the payment of lump sums, the plan sponsor can settle its obligations at this fixed life expectancy whether or not it is consistent with the life expectancy of the plan-specific population. Markets do provide solutions for trend risk. Various capital market solutions abound, including derivative solutions, such as longevity swaps, and physical solutions, such as bulk annuities or buy-ins. Much has been made of the frequent and sophisticated transactions among pension plans and financial institutions dealing with longevity risk in the U.K. All told, there have been 22 billion in notional pension liabilities covered by longevity insurance transactions in the U.K. As discussed above, actuarial practices in the U.K. have generally mitigated table risk. And practices have also sprung up in the U.K. to set mortality assumptions based on participant postal codes, mitigating basis risk. This has left U.K. sponsors to focus on trend risk. Yet, among all of this longevity insurance activity in the U.K., the only type of pension insurance transaction that has really taken off in the U.S. is the singlepremium group annuity. Further, the largest annuity placements that have occurred recently in the U.S. have been driven by economic issues other than longevity risk; these placements have been driven by plan sponsor concerns about interest rate sensitivity and the disproportionate impact that their pension plans have on their corporate balance sheets. Given the size of the U.S. pension and life insurance markets, one must ask why longevity-only insurance transactions (such as longevity swaps) have not occurred in the U.S. There are two distinct features of the U.S. pension environment that help explain this phenomenon: 1. The availability of attractively priced full liability settlement options (including single-premium group annuity contracts and lump-sum distributions), and PENSION & LONGEVITY RISK TRANSFER FOR INSTITUTIONAL INVESTORS
2. The view that longevity trend risk is not material compared to other economic risks. Consider the following comparison of key features of the U.S. and U.K. markets: U.S. U.K. Inflation-Linked Benefits in Corporate Plans Uncommon Common Materiality of Trend Risk Low High Competitive Bulk Annuity Market Yes No Cost-Neutral Lump Sum Offers Yes No The Continuous Mortality Investigation (CMI) conducted by the Institute and Faculty of Actuaries in the U.K. has analyzed the impact on liabilities of the Long-Term Rate of Mortality Improvement (LTR). Sensitivity to changes of the LTR is a strong proxy for longevity trend risk in particular, LTR variance of about 0.5% generally observed in various studies and practice. In CMI Working Paper 63, they found that a 0.5% increase in LTR increased average retiree liability by about 1.25% (assuming an average age of 70 and inflation indexation). This sensitivity would be even smaller without inflation indexing. In the U.K., neither of the two key factors exist (at least with consistency). After the financial crisis, the appetite of U.K. insurance companies for group annuities dried up, driving prices considerably higher. The relative attractiveness of group annuities in the U.K. has since fluctuated going through its own bit of turbulence, but without consistently competitive pricing. Secondly, pensions are typically indexed to inflation, driving up the cost (and materiality) of trend risk to levels consistent with the 1.25% cited above. Meanwhile, U.K. sponsors have considerably reduced their interest rate risk such that a 100-basis-point reduction in interest rates reduces funding ratios by 6 10%, making the 1.25% material. Given that both of the key factors above are found in the U.S., the near-term likelihood of longevity insurance transactions is relatively low. There is a competitive group annuity market in the U.S., and sponsors can settle pension liabilities with lump sums at a value that is near GAAP liability. Further, due primarily to the lack of indexed benefits, the 1.25% trend risk cited above is actually quite conservative (actually <1%); meanwhile, U.S. sponsors tend to run interest rate risk of 10 12% of funded ratio, which dwarfs a trend risk of <1%. Interest in longevity insurance also seems to be growing among Canadian pension plans. In Canada, while the relative risk of longevity is typically lower than the U.K., the market for annuities is relatively thin, creating the potential for a pure longevity risk market because such solutions tend to be less capital intensive, allowing more parties to participate. Given that the market for group annuities in the U.S. should remain robust and competitive, billions of dollars in pension plan liabilities are expected to be transferred to insurance companies via annuity purchases. At present, annuity providers prefer to retain longevity risk as a natural hedge against the mortality risk in their life insurance books of business, but there are fundamental differences in the demographics of these two sets of liabilities. This sets the stage for future discussions about longevity risk transfer from these insurance companies to reinsurance companies. A CALL TO ACTION: MEASURE YOUR LONGEVITY RISK AND CONSIDER YOUR ALTERNATIVES The time has come for plan sponsors to prepare for some financial turbulence starting later this year, as the SOA releases its forthcoming report, thrusting U.S. pension longevity risk issues into the spotlight for the first time in more than a decade. The forthcoming report will likely create nearterm table risk for U.S. plan sponsors. If they have not yet done so, plan sponsors should begin measuring the table risk associated with these changes for year-end 2013 or 2014. Sponsors should use this as an opportunity to understand their plans basis and trend risks as well. The tools are out there to support such analysis, and a clear understanding of these risks will empower the sponsor to more holistically consider mitigation tactics such as settlement strategies and the longevity insurance products that may gain momentum in this new turbulent era. To order reprints of this article, please contact Dewey Palmieri at dpalmieri@iijournals.com or 212-224-3675. TURBULENCE AHEAD FOR U.S. PLAN SPONSORS: LONGEVITY RISK ON THE HORIZON