How can we improve longevity tools?

A large scheme with tens of thousands of members will be able to carry out a reliable analysis of its actual mortality experience, and also have direct access to tools like longevity swaps to mitigate the impact of members living longer than expected.

There is good reason for these schemes to want to undertake this work – if members live an average of one year longer than expected, this could add £60bn to £70bn to UK private sector pension scheme liabilities.

It is important, however, to remember that 80 per cent of pension schemes have fewer than 1,000 members. Unfortunately, the same suite of longevity tools is not available to smaller pension schemes.

Smaller schemes should be doing more work than larger schemes to analyse their longevity risk 

It is very difficult for a small scheme to look at the mortality experience of its own membership and arrive at a reliable ‘best guess’ of the life expectancy of its members. There will simply not be enough data to produce a credible analysis.

Indeed, even if we were able to accurately predict the average life expectancy of a small group of members, we still have the significant problem of random variations in how long people actually live in practice.

To understand this, we can use the example of a one member pension scheme. Even if we know the life expectancy of the member in question, whether or not they are alive at given time points in the future is a binary issue.

If the member happens to live past their predicted life expectancy, then the pension scheme will likely run out of assets. The issues associated with relying on averages or ‘expectancies’ remain for schemes with just hundreds, rather than thousands, of members.

In addition to this we must consider key man concentration risk. A large proportion of a small scheme’s pension liabilities often sit with a small proportion of its members, usually current or former senior managers.

In this situation, even if we can estimate the ‘average’ life expectancy for each member accurately, there is a significant risk that the high liability members are the ones that happen to live longer than expected. 

Because of this, smaller schemes should really be doing more work than larger schemes to analyse their longevity risk. Trustees and employers should take this into account when formulating their integrated risk management framework.

Simple tools small schemes can use

Trustees and employers are used to seeing sensitivity analyses from actuaries that show the impact of members living longer than expected, but often these sensitivities are off-the-shelf and do not take account of the size of the scheme.

Arguably the sensitivity should be larger for a smaller scheme to account for the potential for greater variability in their experience.

Another simple approach is to ask your actuary to identify the top 10 individual member liabilities within the scheme, for example, and assess the additional liabilities if these members were to live five years longer than expected.

This is a reasonably straightforward calculation that gives the trustees and employer an insight into the level of concentration risk.

Some parties may question the value of this analysis. Members will live as long as they live, and we will only know the outcome many years from now.

These tools, however, provide a simple means of highlighting the level of risk run by the trustees and the employer, and specifically put into perspective the value of a buy-in or buyout with an insurance company.

Insurance companies are much better placed to deal with the longevity risk attached to a small number of pension scheme members than a standalone pension scheme, given that they can pool the risk across their business.

Murray Wright is a senior consultant and actuary at JLT Employee Benefits