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Actuarial Science and Insurance Series: insurance-and-pensions

Boomers and bust

The post-war generation expects to retire soon - and live it up. But their longevity could prove fatal to some companies paying out annuities for years to come, says Sean Farrell.

The baby boomer generation - those born in the population explosion after 1945 - had it all. They came of age in an era of sexual liberation, technological innovation, unmatched prosperity and cultural diversity. Now this huge cohort is about to turn 65 and expects to live it up in retirement - an expectation that has huge implications for the pensions industry. The industry has consistently underestimated longevity as advancements in healthcare and changes in lifestyle have significantly extended the biblical expectation of living for three-score years and ten. In fact, insurers now put the average British lifespan at 86.6 years. Pension schemes and insurers that provide annuities have so far coped with this miscalculation by passing the cost of paying out for longer to the next generation by lowering annuity rates. But the size of the baby boomer generation, which will drive the UK population of 65-and-overs from 10 million to 16 million by 2032, makes this an increasingly impossible strategy. Professor David Blake, Director of Cass Business School's UK Pensions Institute, believes this is a moment of reckoning for the industry. Insurers could go bankrupt. He says: "The reason the insurance industry has survived and managed to provide annuities and keep profitable is that there were only a small number of people retiring each year. "Any business that makes mis-takes has to get the next customer to pay for it. However, if there are large numbers of customers involved, this could bring into question the very solvency of the insurance industry. If insurers underestimate life expectancy by more than two years and are unable to pass these extra costs on to the next group of customers - because customers refuse to buy poor-value annuities - they could go bankrupt." In 2012 the insurance industry also faces tougher European capital rules, known as Solvency II, a kind of Basel II for insurers. This will force insurance companies to hold extra capital to cover longevity risk if it cannot be hedged. The Pensions Institute at Cass calculates that to remain profitable insurers may need to cut annuity rates by up to 10 per cent. In response, the industry has tried to find ways to hedge its bets - its longevity exposure - through the capital markets. For instance, in March Norwich Union transferred longevity risk on £475 million of older UK annuitants until 2018 through a longevity swap with a number of institutions. Still, the longevity swaps market remains illiquid and tiny compared with Britain's £1.3 trillion of private sector pension and annuity liabilities. Professor Blake has led the industry's call for the Government to issue longevity bonds to kick-start the market. These securities would pay coupons linked to the survival of a cohort of the population, for instance 65-year-old males. Those in favour of longevity bonds argue that they would allow a market price to emerge for longevity risk, creating a liquid market in longevity swaps, just as the decision to sell index-linked gilts in 1981 opened up the market for inflation swaps.

Government resistance
The Pensions Institute advocates a minimum of four bonds - one each for males and females at ages 65 and 75 - to provide market pricing for longevity risk between the ages of 65 and 90 and to encourage the development of a longevity swaps market for that period. Longevity risk peaks at around the age of 90 and the Government would retain the tail risk for those aged 90 and over. The Government has so far resisted the idea. The most recent statement by the Debt Management Office (DMO) noted that "by contrast with index-linked issuance, issuance of longevity bonds raises significant policy questions, in particular around the transfer of longevity risk onto the Government's balance sheet". The Government is, after all, heavily exposed to longevity risk through public sector pensions so why would it take on risk for the riskiest age group? John Fitzpatrick, a partner at Pension Corporation, which buys up pension liabilities, says: "If pension funds can't mitigate this risk, inevitably a percentage of companies would go into administration and their pension funds will go into the Government's Pension Protection Fund. Longevity bonds would be a cheaper risk for the Government as, ultimately, the last owner of that risk, while making the whole system more sustainable." Mr Fitzpatrick acknowledges that the industry needs to do more by standardising fragmented longevity indices and documentation. He is a Director of the Life & Longevity Markets Association, formed this year by financial institutions to bring consistency to the market. Everybody wins "Once we have created those indices and instruments, we will need a peer price for longevity," he says. "That is when I think the timing for the Government will be optimal." The Pensions Institute says the Government would ideally issue the bonds this year to provide time to prepare for Solvency II. But Tom Boardman, a Visiting Professor at the Institute who was until recently Director of Retirement Strategy and Innovation at the British insurer Prudential, says the DMO has got too much on its plate now. "They have said, 'While we have so much debt to raise, we haven't got time to think about anything new'." Mr Boardman thinks the DMO could find it tougher to sell gilts in future and that it will look at longevity bonds more seriously then. Solvency II's imminence will also concentrate minds, he adds. Professor Blake argues that "everybody wins" through longevity bonds because the Government will be able to charge a risk premium for the bonds while tapping new investors to service the national debt. Meanwhile, policyholders will benefit from stronger annuity rates and will be better able to support themselves in retirement without having to claim means-tested benefits. And ultimately there is a time bomb ticking under Britain's pensions. He says: "The Government couldn't let the banking industry go bust and it can't let the insurance industry go bust. They (the Govern-ment) have to raise £700 billion over the next five years and in that context £30 billion of longevity bonds would represent a trivial risk." And every year that goes by there will be more of those baby boomers retiring.

*Professor Blake is the co-author with Tom Boardman and Andrew Cairns of the Pensions Institute working paper Sharing Longevity Risk: Why Governments Should Issue Longevity Bonds (pensions-institute.org/workingpapers/wp1002.pdf).

Sean Farrell is a freelance business reporter.

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