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1 March 2011

PAYING THE PRICE FOR LIVING LONGER  – WHAT IS THE RIGHT

PRICE FOR REMOVING LONGEVITY RISK?

Life expectancy around the world is rising and there is no sign that this trend is about to

stop anytime soon. For companies that sponsor either active or closed Defined Benefit

pension plans increased longevity requires careful attention. Longevity swaps are

increasingly seen as a solution to reduce longevity risk in pension plans. But what is the

right price for removing longevity risk?

Over the past several decades, life expectancy has continued to rise. Recent UK research indicatesthat more than 2 million people presently aged over 50 in the UK will live to be older than 100 (17%

of the present population), and 33% of female babies born today can expect to live 100 years or

more.1 Estimates vary, but life expectancy now appears to be increasing at a rate of 1 to 3 months

every year. While the impact that this has on pension liabilities varies according to plan

demographics and the levels of interest rates, every year of additional life expectancy is generally

thought to add about 3-4% to the present value of pension obligations for a typical pension fund. 2 

Once again, it is not clear whether life expectancy will continue to rise at present rates but the risk is

clearly visible. For example, if, as a result of increasing public smoking bans, the number of smokers

were to fall, average life expectancy from birth could increase by between one and two years. This inturn would require an increase of between 8 and 10% in pension reserves.3 

Figure 1: Longevity swaps to date (source: AEGON Global Pensions)

DB plans and longevity risk

The fundamental underlying risk for any Defined Benefit pension plan (and its corporate sponsor) is

that the plan should be unable to meet its liabilities. Longevity risk  – the risk that the pension plan

has to provide benefits to its members over a longer period than expected  – is increasingly being

recognised as a major threat to pension plans and the companies that sponsor them.

1

http://research.dwp.gov.uk/asd/asd1/adhoc_analysis/2010/Centenarians.pdf2Sources: J.P. Morgan and AEGON

3On this note, Philip Morris announced in 2010 the possible loss of 176 jobs in its Netherlands factories, citing the

decrease in demand for cigarettes in the Netherlands. http://nos.nl/artikel/186161-philip-morris-schrapt-banen-in-nederland.html 

£ 3000 Mlnfor BMW by

Deutsche Bank &Abbey Life

£ 750 Mlnfor Berkshire

Pension fund by

Swiss Re

£ 1900 Mlnfor RSA by

Goldman Sachs &RothesayLife

£ 1500 MlnIndemnity swap

for Abbey lif e byDeutsche Bank

£ 500 MlnIndemnity swapfor Canada Lifeby JP Morgan

£ 100 Mln Indexswap for Lucida by

JP Morgan

£ 550 MlnIndemnity swapfor Babcock byCredit Suisse &Pacific Lif e Re

£ 475 MlnIndemnity swapfor Aviva by RBS

& PartnerRe

£ 70 Mlnfor PALL Pension

fund by J.P.

Morgan

Jan 2008

July 2008

Feb 2009

March 2009

May 2009

July 2009

Dec 2009

Feb 2010

Feb 2011

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2 March 2011

Longevity swaps and the derisking dilemma 

Longevity swaps can help pension plans  – and their corporate sponsors  – to protect themselves

from one of the major risks they face (the other major risk include asset risk, inflation risk and

interest rate risk). In addition, longevity swaps provide an excellent diversifying effect on a pension

fund’s portfolio, particularly for low risk portfolios (typical of closed Defined Benefit plans with older

members).

In calculating how much they 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 derisking solutions,

companies are faced with the dilemma of whether to take action now or not. When derisking is

affordable, it is often viewed as being less necessary. At times when the appetite for derisking

increases (typically when the risk materialises), it is also usually less affordable.

In the present environment, there are two elements at play that may be leading some pension funds

to hold back – the contrast between the pension funds’ perceived liabilities and their actual liabilities,

and the relative newness of the market in longevity swaps. However, as new regulatory regimes

(including Solvency II) will increasingly recognise longevity risk, it is likely that more companies will

start actively looking to protect their pension funds.

Pricing longevity risk

With a longevity swap, a variable stream of cash flows is exchanged for a fixed stream. When

looking to price a longevity swap, both parties to the swap need to agree on the best estimate of

future cash flows, which includes the most accurate and up-to-date mortality statistics. At present,

many pension funds rely upon a deterministic model, based on official actuarial tables against which

to measure their liabilities. While mortality rates have been improving for decades, actuaries have

repeatedly assumed that this growth would slow. It is this assumption that is now increasingly being

revisited.

Although current deterministic models can assist a pension fund to reach a best estimate of their

future cash flows, they do not always provide a good 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 are increasingly being used. A stochastic model enables the best estimate cash flows

and the related longevity risk to be calculated, taking into account diversification at all levels, the

latest statistical data for the specific country or region involved, and pension-specific mortality

experience.

When comparing the perceived liabilities of a pension fund using a deterministic model and the

actual ‘best estimate’ liabilities using a stochastic, pension-specific model, the deterministic model is

often revealed to underestimate future liabilities. Although this ‘liability gap’ needs to be bridged, it

should not be viewed as part of the cost of the derisking solution itself but rather be seen as a cost

adjustment that is required in recognition of the new best estimate of future liabilities.

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3 March 2011

Figure 2: Breakdown of longevity swap pricing (source: AEGON Global Pensions)

Once the best estimate cash flows have been quantified, the price of the longevity swap itself has to

be determined. When discussing pricing, a comparison is often made between longevity swaps and

interest rate swaps. There is, however, a key difference, as interest rate risk is a ‘tradeable’ risk and

the price of the swap is largely determined through supply and demand. In contrast to interest rate

risk, however, there is no market-based price-setting mechanism for longevity risk. Market playerstherefore generate best estimate projections and add a risk premium to compensate for the risk.

Insurers – a ‘natural counterparty’ 

The price of a swap also depends on the counterparty involved. Although longevity risk is not a

perfect match for mortality risk, the two can offset each other to some degree. As insurance

companies are well diversified and also carry mortality risk, they are able to assume longevity risk

more efficiently than other parties. Despite the lack of a liquid market, the existence of insurance

companies with mortality risk on their books therefore creates something of a ‘natural counterparty’

for longevity risk.

Although it is impossible to provide a general price for a longevity swap, a risk premium above best

estimate cash flows typically ranges between 3% and 7% for a pensioner-based portfolio. At this

price, the pension fund protects itself for a sum it can afford against a risk it cannot afford to have.

Conclusion

As with all risks, there is a temptation with longevity risk to wait and see how the market  – and

mortality tables  –  develop (‘it may never happen’). However, for companies with Defined Benefit

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 on your company. Once these calculations have been

made, it is possible to address the derisking dilemma and to find the right solution at the right price.

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5.000

10.000

15.000

20.000

25.000

30.000

35.000

40.000

45.000

50.000

1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86

   C   a   s    h   F    l   o   w     (   i   n

   T    h   o   u   s   a   n    d   s    )

Time (in years)

Total Pension Plan Cashflows

Current Valuation Expectation

Expected Cash Flows

Fixed Cash Flows

   C  a  s   h   F   l  o  w

Source: AEGON

Current Cash Flow Projection

Actual Best Estimate Cash Flows

Best Estimate + Risk Premium

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4 March 2011

AEGON and derisking

AEGON Global Pensions offers a broad range derisking capabilities (including buyouts and buy-

ins, liability driven investments and longevity swaps) in the UK, continental Europe and the USA. If

you are a multinational company with pension funds in one or more countries, AEGON Global

Pensions can help you decide on the most efficient derisking route, taking into account the cultural,

legislative and accounting aspects of your local pension schemes.

To find out more about our derisking capabilities, please contact AEGON Global Pensions.

Tel: +31 (0)70 344 8931 | aegonglobalpensions@aegon.com | www.aegonglobalpensions.com