Why the UK needs longevity bonds

David Blake, director of the Pensions Institute at the Cass Business School in London, believes the UK government should issue longevity bonds to help create an efficient capital market for the transfer of longevity risk. But given the government’s reluctance to do so, he says, perhaps the private sector should step up.The whole purpose of a pension plan is for an individual to hedge their own longevity risk, professor David Blake, director of the Pensions Institute at the Cass Business School, points out.

“But if the pension plan has underestimated longevity risk there are severe problems, and this is happening now,” he says. “Everyone is focusing on the accumulation of the pension fund, no-one’s thinking seriously about de-cumulation. There are two questions that need to be considered: what age do you stop accumulating; and then how long do you live after retiring. It’s no longer about investing, it’s about optimal de-cumulation.”

An economist, Blake first started considering the design weaknesses of pension plans when he was doing his PhD 30 years ago, and in a bid to work on an under-researched area, he concentrated on pension funds.

Now, as director of the Pensions Institute, his focus is on providing the intellectual leadership behind the creation of  a new global capital market, namely the life market.

Within that context his argument is for the UK government to issue longevity bonds to help overcome the problem that there is insufficient capital in the insurance and reinsurance industry to hedge the longevity risk in all the pension funds in the country.

“The way an individual hedges their longevity risk is to buy an annuity, and in the UK you are obliged to do this. The annuity provider then has to deal with the longevity risk, but there are two components to longevity risk: a systematic or aggregate component, and an  individual or idiosyncratic component. The insurance industry is very good at dealing with idiosyncratic  risks, it simply pools these risks and this helps to reduce total risk by the law of large numbers. But it is the systematic trend risk that every annuitant lives longer than anticipated that is the real problem,” he says.

“The insurance industry is unable to hedge this trend risk efficiently without an aggregate hedging instrument and that’s where government-issued longevity bonds come in. Only the government can hedge aggregate risks such as inflation risk and longevity risk.”

He argues that the UK government has done this in other areas of the capital market, for example by issuing inflation-linked bonds.

“Inflation is an aggregate risk, just like longevity risk,” he says.

Within the de-cumulation phase of pension funds, Blake says there are three big risks: interest rates, inflation and longevity.

“Longevity is the only risk that can’t currently be hedged, unless you buy overpriced annuities,” he says.

The government is the obvious candidate for issuing longevity bonds, Blake says, and should have an interest in ensuring both an efficient annuity market and an efficient capital market for longevity risk transfer. The government is also best placed to engage in intergenerational risk sharing, which is what it would in effect be doing if it issued these bonds, he argues.

He also says £30 billion in longevity bonds would not be noticed in the context that the UK government is going to have to issue £700 billion in bonds in the next five years to pay for the financial crisis,  but would be enough to create a capital market and a market price for longevity risk which is what the private sector needs to create longevity swaps market.

He argues for an initial issuance of four bonds with 10-year deferment: M65 (for males aged 65 and starting to pay coupons at age 75), F65, M75 and F75.

However the government has given little support to the idea, and part of the agenda at meetings such as the Sixth Annual Longevity Risk Conference that has just been held in Sydney, is to discuss whether the private sector can itself create the needed market without government support.

“A few years ago BNP Paribas tried to issue longevity bonds but the market was not ready and they failed,” Blake says. “But when the investment banks and reinsurers moved in with longevity swaps,  it was a success. Private banks could possibly issue in the future.”

Blake says the BNP Paribas experiment showed that the market was not ready, but it also highlighted some design flaws and these have now been corrected.

A key design fault was that the BNP Paribas paid out coupons before they were really needed. Given a retirement age of 65, Blake, in his joint work with Tom Boardroom and Andrew Cairns, is recommending that there are no payments in the first 10 years since longevity risk does not really become a problem until after age 75.

A longevity bond is a combination of an annuity bond and a longevity swap, where the swap provides the hedge against annuitants living longer than expected.

To access the working paper written by Blake and Tom Andrew click here: Sharing Longevity Risk.