'Life-swapping': The Case For and Against Longevity Swaps

Could U.S. pension plans reduce risk by importing an idea from Europe?
by | February 18, 2010

Last week, the Economist reported a new European exchange for "longevity swaps." The idea is that market participants could make opposing bets on how long people will live. This would allow insurance companies and pension funds to hedge their risks of beneficiaries living too long. They would either pay an up-front premium, or a stream of payments when people die prematurely. This would enable life insurance companies to reduce their mortality risk of people dying too soon -- while annuity insurers and pension funds could take the opposite position and receive compensation if people outlive their actuarial assumptions.

In theory, it's worthwhile idea. Ever since the commodity exchanges started adding new contracts for financial futures and other products, and the largely unregulated swaps market arose, the ingenuity of the market-makers has exploded. You can trade almost anything for anything these days, so why not include mortality and longevity risk to the disciplines of the marketplace?

In the past, insurance companies were able to hedge their mortality risks by writing life insurance contracts through one division and annuity contracts through another. They are naturally hedged to the extent that early deaths in one population will likely coincide with early death in the other, and vice versa. The problem for pension funds is that their mortality risks are asymmetrical: They only gain if retirees die earlier than the actuaries expect. In theory, this could be remedied if pension funds also offered a death benefit to participants for a fee, but there just aren't many takers for that kind of protection, especially in the years after an employee retires.

This leaves us with the choice taken by most public pension funds, which is to add five years to the standard actuarial mortality tables, and hope for the best. That way, if the population outlives its past statistical patterns by five years, the pension fund will meet its obligations -- if it earns sufficient investment income, which seems the greater risk nowadays. In essence, the pension funds are self-hedging their risks, or at least the "fat tails" thereof. (That's a statistical term for the bulk of a probability distribution outside the specified standard deviation[s].) And if they don't need the protection because the actuaries prove right after all, the pension fund keeps the premium it would have paid to a third party.

It seems unlikely that public pension funds would be willing to pay an up-front premium to a counterparty to assure them that their retirees won't live too long. Not that it's a bad idea, but in light of the huge unfunded liabilities facing the public plans today, this is a solution looking for a problem. It would have been a great use of capital when many public plans were fully funded in 1999, along with some downside portfolio-protection insurance. It doesn't take a genius to figure out which product would have been more important in the past 10 years. Perhaps the Europeans will devise some successful variations that will be palatable to public plans, but for now, I would not expect to see a rush of buyers for this product.

For individuals, there might be a practical application. I wouldn't mind paying a fixed premium to assure that I won't run out of money in my personal savings in 401(k), 457 and IRA accounts by living too long. Still, I'd prefer to see a pension-exchange option as explained in my column earlier this month.

Perhaps the most important outgrowth of this new market for "longevity swaps" would be an increasing realization that extended longevity poses a huge risk to public pension plans, and deserves much greater attention than it has received to date. If younger workers start living into their nineties on a regular basis, there is no way that police and fire pension funds can remain solvent by making contributions on the basis of a 20- or 25-year career. To behave as if there is no cost to longer lives is to believe in miracles.

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