Longevity risk the biggest threat to UK & German corporate pensions

Longevity is the biggest risk facing corporate pension schemes in the UK and Germany and more likely to cause deficits than low-interest rates, according to Fitch Ratings, which underscores the expected increase in demand for longevity risk transfer and reinsurance.

The low-interest rate environment has been a major cause of deficits in corporate pension funds, especially in the UK and Germany where the defined benefit pension markets are largest.

However, there is an expectation that rates will increase over the medium term, according to Fitch, which should give the pension scheme operators a chance to recoup some of the losses or at least to get back on track.

Longevity risk, on the other hand, is not likely to be mitigated by a change in economic direction.

Fitch explains; “An increase in longevity beyond what has already been factored into expected pension obligations, however, would lead to an increase in deficits and would be highly unlikely to be reversed.”

Pension schemes tend to make assumptions based on actuarial mortality tables and their own risk analysis and research, as to how longevity improvements will impact their funding levels. But it’s impossible to accurately predict longevity, a single medical development could push longevity out by years, and Fitch says that increases are set to continue.

“Historically, pension schemes have tended to underestimate these improvements, suggesting their longevity assumptions may have to be revised up,” Fitch explains.

For UK FTSE listed corporate pension plan sponsors, just a two-year increase in longevity would add an estimated GBP£1.3 billion to the current average deficits, based on the prevailing interest rate, Fitch believes.

Regulatory regimes have different ways of dealing with pension fund deficits or shortfalls, whether due to longevity, a lower return, or other factors. However, the fact is that as longevity increases and deficits widen, pension plan sponsors in the UK, Germany and other countries are going to need an increasing supply of insurance and reinsurance capital for transferring longevity risks to.

Fitch also notes that pensions may be hurting themselves, by not applying the latest thinking to longevity calculations. The rating agency noted; “There is every incentive for companies to underestimate mortality improvements – an upward revision may materially change the deficits.”

If underestimated then the shortfall could be greater and the need for risk transfer heightened. The longevity swap, or the use of insurance intermediaries in order to directly access longevity reinsurance capacity is assured to increase as the deficits mount.

While longevity remains a bigger risk to pensions that the interest rate environment, it is still not being fully addressed. Many pension plans underestimate, as Fitch noted, hoping that future increases in rates may offset the exposure to a degree.

For some larger pension funds it is preferable to get the longevity risk off their books, by transferring it to reinsurance or risk capital through longevity swaps or total plan buyouts. As the appreciation of longevity exposure grows, it’s expected that the requirement for additional risk capital to support longevity risk transfer will result in capital market and ILS solutions being sought.