Pension Mortality Assumptions

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PENSION & LONGEVITY

RISK TRANSFER

for

INSTITUTIONAL INVESTORS

Turbulence Ahead for U.S.

Plan Sponsors: Longevity

Risk on the Horizon

A

RI

J

ACOBS AND

M

ATTHEW

R. M

ALONEY

ARI JACOBS

is a senior partner and global retirement solutions leader at Aon Hewitt in Norwalk, CT.

[email protected]

MATTHEW R.

MALONEY

is a partner at Aon Hewitt in Norwalk, CT.

[email protected]

D

espite the growing interest in managing pension longevity risk globally, especially in the U.K., the topic has been f lying 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 mor-tality 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

risk. Their mortality assumptions have been on autopilot, ref lecting 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 lim-ited 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 inf lation 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 inf la-tion. (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 inf lation-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 “Mor-tality Improvement Scale BB Report” (published Sep-tember 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 com-binations, settlements, or curtailments.

A DEEPER DIVE INTO LONGEVITY RISK

Given the nascence of the pension longevity risk market, every practitioner seems to describe the com-ponents 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 representa-tive of the plan’s actual mortality experience.

For example, base mortality rates are inversely pro-portional to socio economic status, and yet few pension plans are valued using anything other than the IRS-mandated base rates. While the SOA published limited RP-2000 adjustment factors to ref lect certain demo-graphic 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-

or overstate the future cash f lows of the underlying population.

Measuring a pension plan’s basis risk requires a review of the plan’s specif ic experience and demo-graphic 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. tion that is generally healthier than the entire popula-tion. 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 geo-graphic 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 con-centrated in the years of retirement. To put this differ-ential 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: Increase in LE65 Approximate Increase in Benefit Obligation Highest to Lowest

Mortality by ZIP Code 5.0 years 17% White-Collar Relative

to Blue-Collar Retiree 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 geo-graphic concentrations, the difference in pension obliga-tion may be significant.

2. Trend Risk

The risk that over time, the rate of mortality improve-ment will differ from that implied by the most recent mortality projection scale, without any new rates being measured and published (also known as “mor-tality drift”).

Unless the SOA publishes revised base and improve-ment 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 less-than-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 experi-enced 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.”

3. Table Risk

The risk that over time, the rate of mortality improve-ment has differed from those assumed by the mor-tality 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 typi-cally make a one-time change in their reserve for the dif-ference between actual improvements after the release of new pension mortality studies, the SOA’s expected issu-ance 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 chal-lenges, 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.

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

E

X H I B I T

1

Average Increase in Obligation

Update from 71-GAT to 83-GAM

6% Update from 83-GAM to

RP-2000CH (with Scale AA)

5% Update from Scale AA

to Scale BB

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 lon-gevity 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 lon-gevity risks, it is helpful to make one additional distinc-tion—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 improve-ment (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. How-ever, 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 com-panies); 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.

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 lon-gevity risk in the U.K. All told, there have been £22 bil-lion 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 transac-tion that has really taken off in the U.S. is the single-premium 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 dispro-portionate impact that their pension plans have on their corporate balance sheets.

Given the size of the U.S. pension and life ance markets, one must ask why longevity-only insur-ance 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 distribu-tions), and

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.

E

X H I B I T

2

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.

Inf lation-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 inf lation indexation). This sensitivity would be even smaller without inf lation 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 f luctuated—going through its own bit of turbulence, but without consistently competitive pricing. Secondly, pensions are typically indexed to inf lation, 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 insur-ance 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 trans-ferred 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 lia-bilities. 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 near-term 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 insur-ance 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.