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Home > Financial Risk Management Best Practice > Longevity and Annuities—The challenge of giving a secure pension

Financial Risk Management Best Practice

Longevity and Annuities—The challenge of giving a secure pension

by Dominic Grimley

This Chapter Covers

In recent years, the cost of securing a pension has been very volatile. At the same time, the demand for annuities has continued to increase significantly, with more currently latent demand expected to surface once more company pension schemes can afford to buy annuities in bulk. This raises question about the capacity in the annuity market and the drivers for pricing, as considered in this article. Topics covered are:

  • The difficulty of estimating longevity accurately.

  • The impact of longevity and other factors on annuities

  • The stresses and strains in the annuities market, focussing on the UK.

Introduction

Life expectancy has improved substantially; we know this because the UK has a relatively strong record of storing and analysing data on deaths. The annuity providers have models to consider how life expectancy varies by age, sex and wealth; and how benefit size and postcode can indicate the likely wealth of people. Where health and lifestyle information is available, the calculation can be refined much further to take into account the likely impact of this information. To consider future likely trends, these firms monitor the latest research on the underlying causes of death, with the big killers being heart attacks, strokes, and cancers, and on new healthcare improvements.

However, this does not lead to a clear answer for future changes in life expectancy. Healthcare innovations may reduce a cause of death, but may increase the incidence of other alternative ailments in later life. What we can say with certainty is that the current rate of increase in life expectancy is beyond what the originators of annuity policies considered 20, or even 10, years ago.

Over time, when we compare the life expectancy improvements which have been anticipated with those that have actually transpired over the years, there has been consistent underestimating of how much longer we will live in the future. So although research into this area has increased dramatically in recent years, giving much more knowledge about the key questions affecting longevity, it is less clear whether this has given narrower answers for future experience.

Longer lives may be good news for us on the face of it, but they are a major issue for providing a pension promise, since the cost and uncertainty over funding the promise are substantially increased.

From the standpoint of employers, longevity risks are one of many factors that have encouraged the closure of most final salary pension schemes in the private sector. Closure stops further pension being built up, but still leaves the uncertainty over the cost of the benefits already earned, which can only be fully addressed by purchasing annuities to pass these pension commitments to an insurance company.

The government, too, would love to be able to move away from guaranteeing a set level of benefit but, so far, it has only proved possible to restrain rather than stop the continued granting of pension promises in the public sector.

Impacts on Annuity Pricing

To say that annuity prices have been rising in recent years would be something of an understatement. Annuity prices have been driven upwards by a series of factors coming together:

  • The main asset class used for pricing annuities is bonds, and bond yields have fallen substantially, particularly since the summer of 2011. This means that insurers need to pay more for bonds to cover the same volume of annuity business - and that increases the price of annuities and worsens the annuity rate offered.

  • The fall in yields has been exacerbated by government initiatives to kickstart their economies through Quantitative Easing programmes. These were implemented by central banks buying back bonds, which drives up bond prices and further reduces the yield on bonds.

  • The expectations for inflation did not fall with the fall in yields. This has made the cost of a pension with inflation protection – a common feature of UK schemes for example - look particularly expensive.

  • Regulation has been tightening for insurance companies, as mentioned further below, pushing upwards the reserves required to back an annuity.

In this environment, increases in life expectancy have not been as visible in their impact on annuities. But annuities are sensitive to life expectancy – a one year increase in life expectancy can increase an annuity by as much as 4%. So, improved life expectancy has steadily pushed up annuity prices, while the low yield environment has produced more of a sudden and perhaps reversible shift in recent years.

In December 2012, one more factor pushed up prices in Europe. From that point - for some – annuity prices could not take into account the differences in life expectancy for males and females. This unisex pricing requirement has so far only taken effect in the individual annuity market, and so has not made pricing any worse for company schemes buying 'bulk' annuities.

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