LAST REVIEWED Jun 08 2020 9 MIN READ
Understanding longevity risk is important when choosing what type of plans you will offer your employees. There are several ways in which longevity risk can affect your plans, including by requiring more cash flow than what you initially anticipated. Here we discuss what longevity risk is, why it matters, and factors to consider when evaluating longevity risk.
What Does Longevity Risk Mean?
Longevity risk is a term used to describe the instance in which actual survival rates and life expectancies are longer than what was assumed by insurance companies. This risk can result in more cash flow required to fulfill the terms of your insurance or pension plan, as well as several other types of plans such as annuities.
Why Does Longevity Risk Exist?
Longevity risk exists as a result of the increased life expectancy of pensioners, policyholders, and other individuals of retirement age. Longer life expectancies can require higher payout amounts than what your fund or company originally anticipated.
What Kind of Plans Are Susceptible to the Highest Levels of Longevity Risk?
Plans that are most susceptible to high levels of longevity risk include annuities and defined-benefit pension plans that include guaranteed lifetime benefits for policyholders.
Understanding Longevity Risk
As average life expectancy trends continue to rise, it’s important to understand what this means for your plan or annuity. Even small changes in life expectancies can cause serious solvency challenges for insurance companies and pension funds.
Unfortunately, calculating reliable longevity risk measurements can be challenging as the impact of medicine on life expectancy is still unknown. What’s more, individuals reaching retirement age are significantly growing, with 95 million people expected to be at retirement age (65 and older) by 2060, says Investopedia. This is a large increase compared to the estimated 55 million as of 2020.
What Entities Are Impacted by Longevity Risk?
Several people and entities are affected by longevity risk. This risk impacts the government because they must fulfill the funds they have promised to retirees through health insurance and pensions. This is true even in the case of a shrinking tax base to support these funds. Additionally, longevity risk impacts corporate sponsors because they must fulfill the retirement and healthcare obligations to their retired employees. Longevity risk also affects people who have little or no ability to depend on corporations or the government to fund their retirement.
How Do Organizations Transfer Longevity Risk?
Organizations can transfer longevity risk in a few ways, with a simple way being via a Single Premium Immediate Annuity (SPIA). An SPIA is an annuity in which the policyholder pays a lump sum, or premium, to the insurance company in exchange for guaranteed payments over a set period of time. Potential challenges with this strategy are the possibility of material credit risk exposure and large asset transfers to third parties.
Another option for organizations is to use reinsurance of the liability to eliminate longevity risk and retain underlying assets. This method spreads out the premium over a set duration of time rather than paying a single premium. Using this method allows premiums and claims to align and moves uncertain cash flows to certain cash flows.
Factors to Consider When Transferring Longevity Risk
When an organization transfers longevity risk for an insurer or pension plan, there are a few factors to consider. The first factor is the current mortality trends. The second factor is the longevity risk trend, which is a projection of the risk-based on an aging population.
Questions to Ask to Evaluate Longevity Risk
The following are the most important questions to ask when determining longevity risk for retirees:
From what age is life expectancy rates measured?
Measuring life expectancy from birth is the most common way of evaluating this factor, but is typically not useful for people entering retirement age. While obvious, it’s important to note that the person is still alive after turning 65 when evaluating longevity risk. This is because as you get older, your life expectancy grows. Not accounting for this can result in underestimated life expectancy rates for individual retirees.
Is life expectancy calculated based on the current year’s mortality rates or anticipated future mortality rates?
A common source used to find mortality rate data is the Social Security Administration’s Period Life Tables. These tables form life expectancy calculations based on data from one year. For example, someone who is 70 would have a life expectancy based on calculations found for different age groups in the analyzed year. For instance, the data would look at how many 65-year-olds died in that particular year in addition to other ages. This method is useful because it relies on actual data, but it often underestimates life expectancies due to the constant increase in life expectancy trends. An alternative is to use a cohort life table, which bases life expectancy calculations on the same person’s mortality over time.
What population is used to calculate mortality and survivorship?
Resources like the Social Security Administration’s Period Life Tables base their calculations of mortality rates on the general U.S. population. However, this is not always accurate, as socioeconomic differences can influence mortality rates. For example, people with a higher level of income and higher education tend to live longer than their counterparts. This isn’t necessarily due to causation, or that higher education income results in living longer, but could be a result of certain traits that increase lifespan in this population.
What Is the Sample Individual Annuity Mortality?
The sample individual annuity mortality is a table produced by the Society of Actuaries (SOA) in 2012. This table used mortality data derived from annuity purchasers, as these individuals tend to have a longer lifespan than the average person. The data includes estimates of future mortality rates and does not only rely on data from a single year like some other tools. The sample individual annuity mortality can be used to estimate longevity risk for policyholders and pensioners. For example, an organization could base its planning horizon on pensioners or policyholders living 30 years after their 65th birthday.
As the average life expectancy increases, so does the longevity risk associated with annuity and pension plans. Understanding the factors associated with longevity risk can help you decide what type of plan is right for you, and Human Interest is here to guide you. For more information on longevity risk and how it impacts your plan, talk with one of our financial professionals today.
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