Japanese pension funds need to begin hedging longevity risk

The largest public pension fund in the world, Japan’s Government Pension Investment Fund (GPIF), is becoming a perfect example of the need for Japan to adopt longevity risk management and longevity hedging strategies urgently in order to be able to meet their growing liabilities. Japan’s population is aging rapidly and at the same time the birth rate has declined meaning that pension fund shortfalls are a very real issue and the largest of these funds has taken to selling assets to help it make pension payouts.

In the financial year ending in March the GPIF had sold or cashed in a huge $31.77 billion of domestic and foreign bond assets to help it raise enough capital to meet pension obligations for its aging book of pensioners. According to Reuters it is the third year in a row when the pension fund has been a net seller of assets.

Japan’s population is aging rapidly, it has seen some of the largest increases in longevity of any western country and it has experienced a drop in birth rate which is also expected to exacerbate the problem further in future and lead to the total population number shrinking. The chart below from Reuters shows how Japan’s population will age over time.

Japan's ageing population - A longevity risk crisis waiting to happen

With Japan’s baby boomers starting to hit retirement age from next year onwards it’s expected that the GPIF’s liabilities will get higher going forwards and the fund is going to need to address this. In the year to March 2013 the pension fund is expected to need 8.87 trillion yen of cash to make pension payouts, that’s a huge $111 billion.

Something will have to be done. The GPIF is under pressure to improve the returns it makes on the assets and cash it manages, it is already taking steps to do this having recently announced some new managers who would look after investments in emerging market equities for it. It is likely that more will be needed than purely a new investment strategy though, even a sizeable investment in catastrophe bonds is not going to return enough for a fund this size to make up its shortfall.

Longevity risk transfer and longevity hedging seem like the only solutions for Japan’s GPIF. The only source of capital large enough to help a pension fund of this size deal with its longevity risks will be the global capital markets. At the size of deal the GPIF would need a longevity swap, buyout or reinsurance transaction may not be the answer, a longevity risk securitization may be more suitable for liabilities of this magnitude. The GPIF will not be the only Japanese pension fund facing this issue, given the rate of ageing in the country it will be much more widespread. The Japanese pension fund sector is most likely carefully studying the longevity risk transfer deals which have been completed in Europe and the U.S. and assessing which structures are most suitable for them. The question will be whether the capital markets have an appetite big enough for this much longevity risk.