The dramatic rise in life expectancy has improved human well-being but future longevity uncertainty also poses a real challenge to pension funding levels that plan sponsors will need to proactively manage, says a report by PGIM, the global investment management businesses of Prudential Financial, Inc.
The report, “Longevity and Liabilities: Bridging the Gap,” highlights that longevity risk has often taken a backseat to investment and interest rate risk. The underestimation of human life spans by forecasters and the potentially sharp unanticipated increases in longevity resulting from medical breakthroughs, such as anti-aging genetic treatments, poses a real risk to pension funding levels. This risk is compounded by the “lower for longer” interest rate environment that has burdened plan sponsors with low discount rates.
“We have had a century of underestimating actual longevity experience,” says Taimur Hyat, PGIM’s chief strategy officer. “These annual forecasting errors can compound over time to be quite significant. Understanding, quantifying the true magnitude, and responding to the challenge of longevity risk is an important step for plan sponsors.”
“We evaluated the potential impact of further increases in life expectancy on liability values and found that longevity risk can be significant for certain plan profiles,” says Karen McQuiston, head of PGIM’s Institutional Advisory and Solutions team. “We would encourage plan sponsors to incorporate these potential dynamics into their risk management processes and recommend that plan sponsors measure and manage longevity risk, inflation risk, and interest rate risk in an integrated framework.”
While changes in longevity can materially affect the pension liabilities of all sponsors, the impact is magnified for pension plans with cost of living adjustments or inflation indexation, including many U.S. public pensions and U.K. public and corporate plans. In total, unmanaged longevity risk has the potential to worsen a plan’s risk profile, reduce funded status and lead to unforeseen costs, PGIM says.NEXT: Suggestions for managing longevity risk
PGIM suggests taking a three-pronged approach to managing longevity risk:
- Develop a robust framework to understand the problem: Plan liabilities should be evaluated on the richest set of longevity information available. Given the uncertainty around the timing and magnitude, asset-liability analyses should be stress tested based on different longevity improvement scenarios.
- Assess the investment and protection actions that can dampen the impact of longevity risk: In many cases assets, already straining to keep up with liabilities, must work even harder. It may be worth re-evaluating the portfolio’s allocation to growth assets, including real estate, private assets, diversified equity, and higher yielding fixed income. At the same time, plans will want to address the longer duration of their liabilities as their retiree pension payments stretch further into the future than initially assumed, looking both at ways to lengthen duration or find synthetic solutions.
- Evaluate the case for potential risk transfer actions: No investment strategy fully insulates against future longevity risk. Some plan sponsors may consider fully hedging against longevity-driven uncertainty by using longevity insurance or pension risk transfer for a portion of their plan.
PGIM’s latest paper builds on insights in “A Silver Lining: The Investment Implications of an Aging World,” which describes investment opportunities arising from an aging global population.
To download a copy of the new report, visit www.PGIM.comlongevity.