OECD Says Annuity Providers Need Better Data to Address Longevity Risks

By Rick Mitchell

PARIS--Governments should help improve mortality data and longevity forecasting in an effort to “kick-start” the nascent market for annuities products designed to help people ensure they have enough income for a long old age, a top pension official at the Organization for Economic Cooperation and Development told BNA June 11.

Governments should also consider issuing longevity bonds aimed at helping insurance companies hedge for “tail risks” linked to increasing longevity, which would then encourage these companies to underwrite annuities products, said Juan Yermo, head of OECD's Private Pensions Unit in its Financial Affairs Division.

Yermo made his comments regarding the Paris-based organization's new OECD Pensions Outlook 2012, released June 11.

The 232-page report projects an average seven-year increase in life expectancy at birth in developed countries over the next half century that could strain national pension system resources and raise the risk that people will outlive their pension savings.

Yermo said private pension and insurance companies are also contending with the big questions of how to deal with longevity risk linked to increasing life expectancy.

“Going forward we don't really know if trend increases will be the one-to-two-years-per-decade increase we've seen in the past, or if it will be more or less than that,” he said.

Increase Private Pensions

The Paris-based economic policy think-tank advised its 34 member countries, which include the world's advanced economies, to among other things gradually raise retirement ages.

It said 28 OECD countries have such increases under way or planned, with half of OECD countries to set retirement at 65 and 14 to set it between 67 and 69. However, the report said only six of these countries' increases are likely to keep pace with improved life expectancy for men and only 10 countries' plans are likely to keep up with women's longer lives.

The organization suggested governments consider formally linking retirement ages to life expectancy, as Denmark and Italy have already done.

Another issue is that OECD members' recent pension reforms have cut future public pension payouts, typically by 20 to 25 percent, increasing risk of pension shortfall in countries that don't have mandatory private pension enrollment, including Germany, Korea, and the United States.

The report said workers in OECD countries retiring after a full career will be able to expect, on average, a public pension of just 50 percent of their salary. It said later retirement and greater access to private pensions is critical to closing this pension gap.

In nearly all the 13 countries that have made private pensions mandatory, pensioners can expect benefits of about 60 percent of earnings, the organization said.

Role of Annuities

As more countries implement such pension reforms, many of which include a move away from defined benefit schemes toward defined contribution schemes, they should also increase the role of private annuities offering protection from outliving income in old age, the report said.

Yermo said annuities are not always cost effective for “younger” retired people at age 65, but they “offer real value for money in protection for old age, beyond 85,” around which point the risk of outliving their pension savings increases.

“Governments should consider annuities as a kind of default in defined contribution arrangements, especially in compulsory DC arrangements where DC plays a major role in pension provision,” he said.

U.K. Example

Yermo said the market for annuities is still immature and needs government pushes on both the supply and demand sides to flourish.

On the demand side, policies are needed that require annuity providers to clearly communicate prices and other plan details so that consumers can make informed choices before enrolling, he said.

On the supply side, Yermo said the United Kingdom, which has one of the world's largest pension and insurance markets, has started to develop longevity risk products including capital market solutions, which take the form either of longevity swaps, longevity forwards, and similar products.

But he said hedge providers lack standardized data. “We think the government may have a role to play to really kick-start this market, by helping to provide up-to-date mortality tables, and to improve longevity forecasts for different groups of the population,” he said.

“This would allow hedge providers to base their products on up-to-date and better forecasts of longevity.…This could be done in the very short term without much regulatory work,” and could contribute to helping annuities providers to contend with tail risks.

“We think every government should be undertaking this,” Yermo said.

Longevity Bonds

The report suggested that governments also consider issuing longevity bonds. Longevity bonds could help the market for longevity risk protection to develop, “because they would allow life insurance companies to hedge some of the tail risks they are always concerned about and may be inhibiting their willingness to underwrite annuities,” Yermo said.

He said governments have already underwritten short-term, medium-term, long-term, and inflation index bonds that have been popular with investors. Only a limited number of private institutions would able to underwrite longevity bonds, because they are for such long-term risk.

“You are really talking about decades. The big advantage about the government is that it can engage in intergenerational risk sharing and it also that can benefit from higher tax intake from longer lived individuals that are working,” Yermo said.

He said one way the government can hedge itself from issuance of longevity bonds is to increase the state system retirement age, which then raises tax revenues, reduces public pension expenditure, and therefore helps ease financing of the system.

Capital Requirements

Yermo said EU Solvency II capital requirements could also give a boost to longevity bonds.

He noted that, under Solvency II, hedging instruments are taken into account in calculation of capital charges: To the extent that they reduce risk to the insurer or pension funds, the capital charges are reduced.

EU authorities are still “calibrating some of the capital charges that will be a key driver of the extent to which insurers and pension funds start using these hedging instruments,” he said.

“If they take these instruments into account in that calculation, that would provide a boost to longevity bonds,” he said.

(Appeared June 19, 2012)