Pension funds refer to investment pools that include funds for retirees. These funds primarily come from an employee who saves for their future. In some cases, employers may also contribute on the employee’s behalf. A fund manager then manages these funds and invests them to achieve a specific goal. During this process, the pension funds will face various risks. One of these risks includes longevity risk.
What is Longevity Risk in Pension Funds?
Pension funds face longevity risk for all pensioners. Usually, each pension fund estimates the life expectancies of the pensioners. Based on that estimation, they make decisions. Longevity risk is when the life expectancies of the pensioners exceed the predicted rates by the pension funds. In other words, when retirees live longer than estimated, it constitutes a longevity risk.
Longevity risk in pension funds can be significantly detrimental to the funds. It can lead to increased costs in the form of higher pension payments. When the life expectancy of pensioners is low, the longevity risk will also be low. However, once this expectancy grows, the longevity risk in pension funds also increases. The number of retirees reaching retirement age also contributes to this risk. However, higher mortality rates can decrease this risk.
How does Longevity Risk in Pension Funds work?
Pension funds may have hundreds of pensioners or policyholders. Usually, the higher this number is, the higher the future costs for the pension funds will be. Similarly, employees reaching retirement age will also contribute to the pension funds costs. The longer retirees collect pension payments, the more these funds have to pay them.
Pension funds usually forecast the costs associated with these payments. For that, these funds consider various factors, one of which is the pensioners’ life expectancy. The longer pensioners live past their retirement age, the higher the costs for the pension funds will be. Therefore, longevity risk is when pensioners’ life expectancy exceeds the expected rate by the pension funds.
As mentioned, pension funds seek to forecast their payments to pensioners. However, when the life expectancy rate exceeds the predicted amount, the payout levels for pension funds will increase. But there are also other factors that may impact the longevity risk for pension funds. One of these includes the type of pension funds. Usually, defined-benefit pension funds have the maximum exposure to longevity risk.
How can Pension Funds manage Longevity Risk?
Longevity risk can be detrimental to pension funds. As mentioned, these risks can significantly increase the payout level, which results in added costs. However, pension funds can still manage longevity risk. The most common technique used by pension funds to do so is to transfer the risk. Usually, pension funds use various instruments to manage this risk.
These instruments may include longevity swap transactions or annuities. Pension funds can also use reinsurance as a way to mitigate longevity risk. However, transferring these risks will also come with additional costs. While pension funds can predict life expectancy rates, it is not possible to get accurate predictions. Therefore, these funds must consider whether it would be feasible to transfer these risks.
Pension funds face various risks, including longevity risk. These funds usually estimate their payout costs based on several factors. Among these, a critical factor includes pensioners’ life expectancy rates. If these rates exceed the expected level, the longevity risk in pension funds will be high. However, pensions funds can still manage these risks in various ways.