longevity risk leads to better investment decisions
5 April 2016
Pension trustees and sponsors are getting fed up with bad news. Since the turn of the century I’m hard pressed to recall a single three-year period where everything went right. In the first few years the equity market was crashing following the dot-com boom of the late 1990s; then when it recovered actuaries were increasing longevity assumptions because of the “cohort” effect; then we had the Lehman crisis and then the Eurozone crisis; and we’re now in a world where real interest rates in many markets are negative. Each of these things have hurt pension schemes and pushed up costs for sponsors.
So it’s not surprising that almost all my pension scheme clients are now on some kind of de-risking journey. They’re designing plans for when they’re going to be selling their growth assets and when they’re going to buy more bonds to match their liabilities. They’ve simply had enough pension risk, and want to focus on their day jobs without worrying about their scheme.
Some call these de-risking strategies their “flight plans”, “road maps” or “journey plans”, but whatever the name, the goal is simple – reduce risk as and when it’s affordable, and as the pension scheme moves into its paying-out phase.
As always, the golden rule of investment is to never take unnecessary risks. In other words, you want to make sure that you’re taking as little risk as possible whilst targeting whatever level of return it is that you need. So these de-risking plans are all about taking risk down in a measured way – trying to minimise the impact on overall portfolio return at each point.
Early in the de-risking journey it’s likely that you’ll get the best result by selling down equities – probably the riskiest asset you own – whilst later in the de-risking journey you’ll be trying to match pension payments as accurately as possible, maybe with an LDI strategy. At each stage you want to trade-off the benefits of risk reduction, with the costs of doing so.
Which risk isn't getting the attention it deserves?
A lot of work goes into designing these de-risking plans, but most of the time one key risk is ignored or at best not given the attention it deserves: longevity risk. For a scheme early in its de-risking journey this probably isn’t a big problem (as longevity risk is probably quite small compared to the risk of having half the fund in equities) but for schemes closer to the end of their journey ignoring longevity risk is just plain wrong.
Too often I see journey plans where it’s assumed that the scheme will manage out of ALL investment risk before starting to address longevity risk. To me that doesn’t make sense; the last few steps of investment de-risking will probably have next to no impact on the TOTAL risk level whatsoever, but they will be reducing returns. So ignoring longevity risk can result in BAD investment decisions – ones that reduce return for no meaningful risk reduction benefit. The right answer has got to be to deal with longevity risk progressively, so that as you move through the de-risking journey your focus shifts in a phased way from dealing with investment risks to dealing with longevity risk.
But when do you start dealing with longevity risk, and how fast? To answer these questions fully we need to know how big the longevity risk is, and how much it costs to deal with. We’ve got pretty good at answering the second question, but historically the whole pensions industry has struggled a bit with the first.
This is why I’m so excited by the launch of LCP Life Analytics, our latest longevity modelling tool, because without being able to quantify longevity risk and properly understand its interaction with investment risks, I simply couldn’t be sure that my investment advice was as good as it could be.
You can learn more about this topic by reading my colleague Michelle Wright's blog "Is your longevity risk really 5%?" - read it here
Do you know how much longevity risk your pension scheme is running?
By answering three simple questions, you can get an overview of how longevity risk might look in your scheme - start here