Equity Markets Bounce Back and Special on Managing Longevity

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In brief

– Global equity markets rally over June
– Geopolitical risks in the Middle East led to increases in the price of oil and gold over the quarter
– The funding level of a typical pension scheme has stayed relatively flat over the quarter

Key considerations for trustees

– Have you got a longevity risk management plan?

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Following a tough May for equity markets they bounced back strongly to rally over June, returning double digits year-to-date.

The US Federal Reserve and European Central Bank decided against cutting interest rates at their respective June meetings, but signalled a willingness to do so should the global outlook not improve. These dovish signals from central banks continue to support growth markets and developed market 10 year government bond yields remain very suppressed. The Monetary Policy Committee also held rates primarily to keep its options open.

Uncertainty remains around the outcome of ongoing US trade disputes although they appear to be in a more favourable position than they were at the start of June. A deal was made with Mexico, putting a halt to Trump’s sudden and unexpected threat to impose tariffs on all Mexican imports into the US. Also, the US president and China’s President Xi Jinping reached an agreement to resume trade talks. However the outcome remains highly unpredictable.

Geopolitical risks in the Middle East stepped up another notch over the month. Iran is being accused of attacks that severely damaged two oil tankers and they also admitted to shooting down an American surveillance drone. This contributed to an increase in the price of Brent Crude oil and also acted as a catalyst in the rally of gold.

Ten candidates have become two in the race to replace Theresa May as Prime Minister. The results of a postal ballot of party members will be announced in the week beginning 22 July. Both candidates are in favour of making changes to the Withdrawal Agreement negotiated by May (although the EU firmly stated when extending the UK’s leaving date that there can be no re-opening of the withdrawal agreement).

Large falls in gilt yields over the quarter were matched by strong growth asset performance, meaning that the funding level of a typical pension scheme would have stayed relatively flat over the quarter.

Assumed asset allocation chart
The typical scheme used has an assumed asset allocation of 27% equities, 34% corporate bonds, 11.6% multi-asset, 4.8% property and 25% in liability driven investment (LDI) with the LDI overlay providing a 50% hedge on inflation and interest rates. This example scheme was 80% funded in 2015.                                             

XPS Investment Asset Class Views

XPS Investment Asset Class Views

Longevity special:

Finding a home for longevity risk

Longevity risk has historically been seen as an inherent part of running a pension scheme. But innovation in the market has changed this and getting a grip on longevity risk is no longer the preserve of large sophisticated schemes.

In this note we highlight how longevity risk can be managed within the same framework as investment decision making, much like Liability Driven Investment. When done well, this can lead to lower risk and smoother path to the long term funding target.

What is longevity risk?

Longevity risk is the risk that pension scheme members live longer than expected.

Pure longevity risk is a combination of three elements:

Three Elements of Longevity Risk

Bringing longevity risk into the frame

Trustees are familiar with the concept of setting a risk budget for their scheme and looking to diversify sources of return within their investment portfolio. Is it possible for pension schemes to apply this rationale to managing longevity risk?

Longevity journey plan projection graph

Longevity risk is normally measured over the lifetime of a scheme (e.g. a lifetime Value at Risk), compared to other risks which are often measured over one or three years. It is therefore more difficult to draw comparisons between longevity risk and other risks such as investment, interest rate or inflation.

What is the true cost of hedging longevity?

Longevity risk is unusual because it isn’t a rewarded risk in the traditional sense but there can often be a cost to remove it. For example when the risk is hedged with a longevity swap a more conservative life expectancy assumption typically increases the expected benefit cashflows by between 5% and 8%. This cost means longevity risk can often be considered as being rewarded for the purpose of decision making – i.e. you don’t incur the cost if you retain the risk.

However, this doesn’t in itself undermine the case for removing or hedging some or all of your longevity risk. This is the same principle as is employed in an efficient investment strategy which will seek to diversify return drivers rather than put all of the eggs in one basket. To complicate matters further, some ways of managing longevity risk do not involve cost at all. For example some member option-based approaches implicitly reduce longevity risk whilst improving a scheme’s funding level.

When using buy-in, longevity is one of several factors in the pricing. The buy-in pricing chart opposite shows the implied expected return relative to gilts of investing in buy-in which can fluctuate considerably over time. Buy-in pricing of pensioners often provides a return well above gilts, as is the case currently.

Therefore we need to break down the different sources of longevity risk in a scheme, understand the costs of removing them and weigh this up against the risk reduction this can offer.

Implied return from a buy-in

Longevity risk in context

To build a full picture, longevity risk should be considered both in isolation and at an overall level to capture the dilution with other uncorrelated risks.

We have used historic scenario analysis to look at how the scheme’s funding level would have been affected by market factors (including investment returns, interest rate and inflation) and compared alongside the impact longevity assumptions would have had on the funding level in each of the last 20 years.

The charts below illustrate the difference between the magnitude of longevity risk on two schemes, with higher and lower risk investment strategies:

Longevity risk chart

The impact of longevity is relatively more significant the lower the return target of the investment strategy. As most schemes are on a journey of de-risking, over time longevity risk will inevitably become progressively more material to overall risk.

The toolkit

There are a range of approaches that can be used to control and moderate the longevity risk a scheme is exposed to including:

Longevity risk approaches

Further you can reduce the base and trend risks through using the latest approaches, such as member profiling, to better estimate your membership’s characteristics. The more we understand about your scheme’s membership the better we can reflect how long your members are living and how this may change in the future.

In summary

Historically pension schemes have seen managing longevity risk as being a matter of black and white, but the reality is more shades of grey.

An approach that seeks to start from the best estimate of your membership combined with a granular assessment of the different groups within the membership, taken in the context of the wider strategy, could unlock the means to better control future funding of your scheme.

To discuss any of the issues covered in this edition, please get in touch with Alan Greenlees or Simeon Willis. Alternatively, please speak to your usual XPS contact.

View XPS Investment PDF here

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