IMF highlights government and pension fund exposure to longevity risk, recommends hedging

by Artemis on April 11, 2012

The International Monetary Fund has published a chapter of its Global Financial Stability Report which discusses ‘The Financial Impacts of Longevity Risk’. In it they warns that the U.S. and other governments need to acknowledge the size of the longevity risks they are facing, put in place mechanisms for improved risk sharing between governments, private sector pension sponsors and individuals, provide better information on longevity risks and promote the growth of markets for the transfer of longevity risks.

The report discusses that it is likely that most governments and pension funds are underestimating their exposure to longevity risk, with an explanation that on average they found that longevity is underestimated by around 3 years. This can lead to as much as a 9% increase in liabilities they say, something that would cause pension plan sponsors to massively increase their contributions or face huge shortfalls.

The problem the IMF says is that many of the projections are still based on outdated mortality information and baseline population forecasts which have consistently underestimated how long people will live. Unexpected longevity beyond these forecasts presents a financial risk to governments and defined benefit pension providers and also to some pensioners who could run out of retirement funds themselves.

Risk transfer of longevity risks to the capital markets (or those better able to manage the risks) receives a lot of attention in the report, the chapter highlights a number of instruments in the market and suggests ways to improve the markets functioning. Interesting, and very valuable, to have this kind of input from a financial institution like the IMF.

The IMF suggests that governments as well as private holders of longevity risks should look at the possibility of selling longevity risks into the capital markets. They discuss ‘market-based transfer of longevity risk’, so where the longevity risk is transferred from parties who hold it (and don’t want it) to those better able to deal with it and who could benefit from unexpected increases in longevity. In this way it becomes a natural hedging market where by those who can benefit by acquiring longevity risk to offset other risk factors would buy it for a price set by the market.

The chapter goes into detail on a number of instruments such as buy-ins, buy-outs, longevity swaps and longevity bonds their pros and cons and what could be done to encourage liquidity in the marketplace.

The fact that the IMF are raising the profile of longevity risk at this time is likely to cause an increased interest in longevity risk transfer. Whether it will result in more deal-flow is uncertain but it will help to raise the profile of the instruments used and also of longevity risk as an asset class.

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