Earlier this month saw Henry Allingham, Britain’s oldest man ever, celebrate his 113th birthday. How times have changed since Mr Allingham’s birth. He has lived through advances such as the birth of radio, development of the aeroplane, and discovery of antibiotics. But perhaps one of the greatest changes has been the phenomenal increase in life expectancy.
In 1896, the year of Mr Allingham’s birth, males in England and Wales were living on average to just 46 years of age. Today that has risen to 77 years, an increase of over 30 years (fig 1). While much of this increase is due to reduced childhood mortality, those who reach retirement are spending much longer in retirement too.
A hundred years ago, a 65 year old man could expect to live a further 11 years. Today that his risen to over 17 years (even before we allow for future improvements in lifespan). That equates to over 50% longer in retirement. Perhaps even more surprising is the fact that the majority of this growth has occurred in the last 15 years (fig 2).
Are these increases the greatest sign of human progress? Or will they turn from a success story to one of the greatest problems facing society over future generations?
The challenges of increasing longevity
Without doubt, increasing longevity is a huge issue for Local Authority pension funds. The longer pensioners live, the longer pension payments must be paid from the funds. So increasing life expectancy is a direct cost to funds and to the employers who support those funds.
With Local Authority pension funds totalling around £150 billion, the financial impact of longevity is huge. Just one year increase in life expectancy equates to a cost of around £5 billion. This represents a huge challenge for employers.
There are also wider social challenges from increasing longevity and demographic shifts.
Employers face the challenge of an ageing workforce coming up to retirement. We are now seeing the start of the post second world war baby boomer generation moving into retirement. Increasing numbers of retirees pose a challenge for employers in terms of manpower planning and retaining expertise of the most experienced employees.
Increasing longevity has implications for social care for the elderly as well. What are the future needs of an ageing population? Will those needs emerge later in life, as life expectancy increases? Or will the period of social care increase?
The nature of longevity risk
But how well is longevity risk understood by pension funds?
It is very different in nature to investment risk, lacking the in-your-face hurly-burly and glamour of stock markets... ...but that perhaps makes it all the more dangerous. For example, we have seen pensioner life span increase by over 2 years in the last decade alone. That equates to a cost of around £10 billion across local authority pension funds.
Longevity is far from uniform. There are significant variations in lifespan between funds, with the average member in the most long-lived funds living over four years longer than those in the most short-lived funds. There are variations within funds too, with differences in excess of ten years between different types of member within individual funds. In the past, funds have not been able to accurately assess the impact of their unique mix of members on their lifespan.
It may feel like a distant risk, affecting payments many years in the future. But like global warming, this gives it the potential to run out of control if it is not addressed while it still remains manageable.
Addressing longevity risk
Unsurprisingly, there is increasing recognition amongst pension funds of the risk they face from longevity. Research, conducted on behalf of Aberdeen Asset Managers in 2008, revealed that longevity was perceived to be the second biggest risk faced by the pension funds surveyed.
So what can pension funds do to take control of longevity risk?
First, as funds recognise the significance of longevity risk, they need to give it appropriate priority. In the past, longevity risk has not been actively considered by pension funds. All too often it has simply been treated as a problem to be measured every three years, rather than a risk that requires ongoing management and governance. Including longevity in the fund’s governance processes on an annual basis is an important first step for most funds.
The unique nature of each fund’s membership – and the unique resulting longevity profile – means that funds have work to do to understand the implications for them. Funds and their actuaries can now obtain an objective assessment of their membership’s longevity profile, by accessing pooled longevity data from other pension funds. This provides an objective starting point of their position today. It also allows longevity costs to be borne equitably by each employer, reflecting the differences in types of employees.
Annual monitoring of longevity, and equally importantly, other retirement demographics allows funds and employers to stay in control of these risks. Comparator information from other funds helps put these statistics in perspective. Longevity need not be the source of expensive surprises every three years. Indeed, funds may feel that a solid governance approach is more important than placing ever greater reliance on reserves for unknowable future improvements in longevity.
In times when increasing longevity is a difficult cost to bear, understanding and managing other retirement demographics becomes increasingly important. As a society, the cost of increased longevity must be addressed in part by the economic benefits of increased longevity. Those who wish and are able to continue in employment after traditional retirement ages must be given the opportunity to do so. Flexibility of roles, flexibility of hours and flexibility of retirement for the older workforce are all important. But to manage the challenge these changes will bring, and to understand how well they are meeting their employees needs, employers need to monitor retirement demographics (such as retirement ages and ill health retirement rates) for their employees and those from other funds in comparison.
Who carries the risk?
Finally, who should bear the longevity risk? Currently it is the employers (and tax payers, at least in part) who ultimately bear the risk of increased life expectancy.
In future, part of the risk may be borne by employees. A successful cost sharing model could achieve this. Whether the benefits to employers are felt in the short term (eg the 2010 valuation), or emerge only in the longer term, depends on the detail of the cost sharing model adopted. But to be fair, transparent and successful, the cost sharing model must be based on robust, representative data.
While cost sharing can address longevity risk in future accrual, it can do little to address risk relating to benefits accrued to date. The deal announced by Babcock and Credit Suisse in May was the first in which a UK pension fund transferred a significant element of its longevity risk to a third party, while retaining investment and other risks. It is anticipated that more such deals will follow.
Although the focus of such deals has been on private sector funds to date, there is little doubt of the appetite amongst insurers, banks and other investors to take on risk from public sector schemes too. If local government funds were to consider such options, they would first need to understand their current longevity risk as well as possible. Only then, could they make an informed decision of that type.
Longevity – cause for celebration or pensions hangover?
Increases in our longevity will undoubtedly continue to provide challenges for pension funds and employers... ...but there are practical steps that can be taken to rise to those challenges. For those schemes that address the challenges head on, increasing longevity should, ultimately, be a cause for celebration.
Figure 1: Expectation of life at birth (no allowance for future improvements); Males, England and Wales, 1896 to 2006
Figure 2: Expectation of life at age 65 (no allowance for future improvements); Males, England and Wales, 1896 to 2006