Understanding Longevity Risk
And why it's getting harder to manage.
January 20, 2011
Unanticipated life extension is at the heart of longevity risk. Today, healthy living is at the forefront of western society as individuals choose to adopt a healthy life style in order to decrease the chance of illness and increase the chance of prolonging life. While it may seem odd to view something as beneficial as prolonging one’s life as a risk, from a financial perspective life extension can be very costly, indeed. All areas of the economy are deeply affected including insurance companies, governments, pension plans and individuals funding their own retirements.
Since 1900, according to the (U.S.) National Vital Statistics System, life expectancy at birth rose from 49 to 77 years. Over the same period, life expectancy at age 65 rose from 77 to 83 years and at age 85 from 89 to approximately 91 years. Developed economies expect to see an average increase in life expectancy at age 65 of approximately one year for each decade in the future. At the current level this implies that an individual turning 65 now will have to accumulate sufficient capital to fund retirement for 18 years on average. The bulk of longevity expansion occurred at the younger ages over the last century.
For investors with very long horizons, like pension plans and annuities, the longevity risk exposure is riskier because long term estimates of longevity and mortality are much harder to make. As well, being able to account multiple decades in the future for cash flow patterns and capital market factors like interest rates and expected long run asset returns is impossible exacerbating the situation. Cash flow matching and liability driven investing strategies have become popular mechanisms to manage these capital market risks but the longevity side has remained largely untapped.
There are a number of methods to minimize longevity risk that these “macro-scale” investors can pursue. Purchasing longevity insurance would be the most obvious. However, this method may be costly and would be dependent on several variables, including counter-party risk. My next blog post will discuss some of the instruments used in the longevity and life markets.