Funding old promises is proving costly

When state pensions were introduced in the UK in 1909, the retirement age was set at 70, a grand old age that only a third of men then aged 20 lived to see. Indeed, average male life expectancy was just 48 and critics complained workers would spend their life contributing to a benefit they would never receive.

Roll forward a little more than a century and the retirement age has fallen to just 65 for men and, until 2018, will be lower still for women. Yet 80 per cent of today's 20-year-olds are expected to see their 70th birthday, and life expectancy has risen to 78.5 for men and 82.4 for women, according to the OECD.

Moreover, life expectancy is still rising, by about 2.5 years a decade.

This is an uplifting tale of human progress, one repeated, to a greater or lesser degree, worldwide. But there is downside; the rising cost to governments and companies alike of paying pensions and meeting retirees' long-term health and care needs.

Private sector companies, at least, are plotting an escape route from this morass, although they will not be out of the mire for decades.

The vast majority of companies have closed their defined benefit (or final salary) pension schemes to new members, while many have also been closed to further accrual for existing members.

Instead, private sector workers are being funnelled into defined contribution (money purchase) pension schemes, where they bear the "longevity risk" associated with living to a ripe old age, as well as investment and interest rate risk for good measure.

However, companies are still on the hook for the promises they have made to date, and rising longevity is making those promises ever more expensive.

According to David Blake, professor of pension economics at London's Cass Business School, companies started to focus on the issue in 2006, when global accounting changes meant pension deficits had to be recognised on corporate balance sheets.

But relatively few companies have offloaded their longevity risk. There are three main ways this can be done: a pension buyout, where an insurer is paid to take the entire scheme on to its own books; a buy-in, where part of a scheme is passed to an insurer; or a longevity swap, where just the longevity risk is offloaded.

There has been a reasonably steady stream of buyouts and buy-ins in the UK, but few elsewhere, primarily in the US and Canada.

One problem is cost. Scheme sponsors typically have to pay an insurance company a premium of 20-25 per cent over the accounting value of their liabilities in order to offload the risk.

And, although many insurers are keen to take on longevity risk, as it partially balances the mortality risk they are exposed to from selling life assurance, their appetite is not limitless.

Dan Mikulskis, co-head of asset liability management and investment strategy at Redington, a consultant, says: "The [insurance industry's] capacity for that kind of risk is never going to be sufficient to absorb all the corporate pension risk out there, but it does have a role to play in reducing longevity risk for some funds."

Prof Blake adds: "There is now a massive concentration of longevity risk with a small number of insurers."

He notes that investment banks, which had shown interest in entering the market, have been put off by tighter regulation in the wake of the financial crisis.

The take-up for longevity swaps has been lower still, with UK companies having hedged just £31bn of their total liabilities, estimated at £1.16tn by the Pension Protection Fund.

Mr Mikulskis says that for most schemes, longevity risk is still relatively minor. It becomes more important however when equity or interest rate risk diminish as funding levels improve.

Governments are re­spond­ing to rising life expectancy by raising retirement ages. The OECD says most of its member states will have retirement ages of at least 67 by 2050, a typical rise of 3.5 years for men and 4.5 years for women. Yet it argues governments "need to do more to encourage people to work longer and save more".

Prof Blake lauds two recent developments in the UK as potential solutions. First, the advent of "auto-enrolment" will ensure most of the 8m to 9m workers currently without private pension provision are enrolled in a scheme, unless they choose to opt out.

Second, the current government has explicitly tied rises in the pension age to movements in life expectancy.

"The idea is that the state pension age will rise so that every generation spends two-thirds of their adult life in work and one-third in retirement," he says. "We now, for the first time, have a kind of measure of intergenerational equality."

But other problems remain. "The thing that we haven't really confronted is long-term care," says Prof Blake. "I speak to a lot of people in local government and they say the two things that will overwhelm local au­thorities are the cost of adult social care - which is an uncontrolled item of expenditure in their budget - and their pension plans.

Mr Mikulskis sees little scope for governments to offload this healthcare-related risk.

"There are very few natural hedges; [there is a] shortage of people to take the other side of the trade," he says. "To some degree it's part of governments' role to take on this risk."

© The Financial Times Limited 2014. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation