The Securitization of Longevity Risk and Its Implications for Retirement Security
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University of Pennsylvania ScholarlyCommons Wharton Pension Research Council Working Papers Wharton Pension Research Council 10-1-2013 The Securitization of Longevity Risk and its Implications for Retirement Security Richard D. MacMinn Illinois State University, [email protected] Patrick Brockett University of Texas at Austin, [email protected] Jennifer Wang National Cheng-Chi University, [email protected] Yijia Lin University of Nebraska Lincoln, [email protected] Ruilin Tian North Dakota State University, [email protected] Follow this and additional works at: https://repository.upenn.edu/prc_papers Part of the Economics Commons MacMinn, Richard D.; Brockett, Patrick; Wang, Jennifer; Lin, Yijia; and Tian, Ruilin, "The Securitization of Longevity Risk and its Implications for Retirement Security" (2013). Wharton Pension Research Council Working Papers. 128. https://repository.upenn.edu/prc_papers/128 The published version of this Working Paper may be found in the 2014 publication: Recreating Sustainable Retirement: Resilience, Solvency, and Tail Risk. This paper is posted at ScholarlyCommons. https://repository.upenn.edu/prc_papers/128 For more information, please contact [email protected]. The Securitization of Longevity Risk and its Implications for Retirement Security Abstract The economic significance of longevity risk for governments, corporations, and individuals has begun to be recognized and quantified. The traditional insurance route for managing this risk has serious limitations due to capacity constraints that are becoming more and more binding. If the 2010 U.S. population lived three years longer than expected then the government would have to set aside 50% of the U.S. 2010 GDP or approximately $7.37 trillion to fully fund that increased social security liability. This is just one way of gauging the size of the risk. Due to the much larger capacity of capital markets more attention is being devoted to transforming longevity risk from its pure risk form to a speculative risk form so that it can be traded in the capital markets. This transformation has implications for governments, corporations and individuals that will be explored here. The analysis will view the management of longevity risk by considering how defined contribution plans can be managed to increase the sustainable length of retirement and by considering how defined benefit plans can be managedo t reduce pension risk using longevity risk hedging schemes. Keywords Longevity Risk, Retirement, Securitization, Buy-Out, Longevity Swap Disciplines Economics Comments The published version of this Working Paper may be found in the 2014 publication: Recreating Sustainable Retirement: Resilience, Solvency, and Tail Risk. This working paper is available at ScholarlyCommons: https://repository.upenn.edu/prc_papers/128 Recreating Sustainable Retirement Resilience, Solvency, and Tail Risk EDITED BY Olivia S. Mitchell, Raimond Maurer, and P. Brett Hammond 1 1 Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © Pension Research Council, The Wharton School, University of Pennsylvania 2014 The moral rights of the authors have been asserted First Edition published in 2014 Impression: 1 All rights reserved. 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Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work. Contents List of Figures ix List of Tables xiii Notes on Contributors xv 1. Recreating Retirement Sustainability 1 Olivia S. Mitchell and Raimond Maurer Part I. Capital Market and Model Risk 2. Managing Capital Market Risk for Retirement 9 Enrico Biffis and Robert Kosowski 3. Implications for Long-term Investors of the Shifting Distribution of Capital Market Returns 30 James Moore and Niels Pedersen 4. Stress Testing Monte Carlo Assumptions 60 Marlena I. Lee Part II. Longevity Risk 5. Modeling and Management of Longevity Risk 71 Andrew Cairns 6. Longevity Risk Management, Corporate Finance, and Sustainable Pensions 89 Guy Coughlan 7. Model Risk, Mortality Heterogeneity, and Implications for Solvency and Tail Risk 113 Michael Sherris and Qiming Zhou 8. The Securitization of Longevity Risk and Its Implications for Retirement Security 134 Richard MacMinn, Patrick Brockett, Jennifer Wang, Yijia Lin, and Ruilin Tian viii Contents Part III. Regulatory and Political Risk 9. Evolving Roles for Pension Regulations: Toward Better Risk Control? 163 E. Philip Davis 10. Developments in European Pension Regulation: Risks and Challenges 186 Stefan Lundbergh, Ruben Laros, and Laura Rebel 11. Extreme Risks and the Retirement Anomaly 215 Tim Hodgson Part IV. Implications for Plan Sponsors 12. Risk Budgeting and Longevity Insurance: Strategies for Sustainable Defined Benefit Pension Funds 247 Amy Kessler 13. The Funding Debate: Optimizing Pension Risk within a Corporate Risk Budget 273 Geoff Bauer, Gordon Fletcher, Julien Halfon, and Stacy Scapino The Pension Research Council 293 Index 297 Chapter 8 The Securitization of Longevity Risk and Its Implications for Retirement Security Richard MacMinn, Patrick Brockett, Jennifer Wang, Yijia Lin, and Ruilin Tian The simplest notion of individual longevity risk is that it is the possibility that one will outlive one’s accumulated wealth. The risk of outliving one’s accumulated wealth has many unpleasant consequences for individuals and societies, and because the risk is increasing it must be addressed. If an individual is covered by a defined con- tribution (DC) plan, the employee contributes to the plan until retirement. The employer may or may not match the employee’s contribution. Accumulated wealth generated during the individual’s working life yields the wealth that the individual will use to generate a retirement income stream. If the individual is covered by a defined benefit (DB) plan, the employer guarantees to provide the employee a designated amount of money upon retirement up until the employee’s death. The employee may or may not contribute to the plan. The designated amount is based on the employee’s earnings, length of employment, and age. With a DC plan, the employee is responsible for ensuring that enough money has been contributed to the account to avoid longevity risk. With a DB plan, the employer is liable for ensur- ing that the plan does not run out of money before the employee dies. In the first case the individual faces the longevity risk, while in the second case the pension provider faces the longevity risk. Both plans have distinctive risks and in this chapter we examine the risks from the perspective of the individual and the institution. Longevity risk is important in part because of its size; international pension liabilities have been estimated at approxi- mately $21 trillion. Longevity risk is also important because as life expectancy increases, individuals must increase contributions to their DC plans to mitigate lon- gevity risk and the size of the necessary additional contribution is uncertain, as it depends in part on how life expectancies change over time. Hence the questions of interest here include: What happens to the financial well-being of a retired cohort in the event of an unexpected change in life expectancy or financial stability? What happens if it does not manage these risks? What happens if it does manage these risks using currently available instruments? How might it manage the longevity risk with longevity instruments? In what follows, we first explore the meaning of longevity risk and consider its magnitude. Next we consider how mortality and longevity risks have been The Securitization of Longevity Risk 135 transformed from pure risks to speculative risks. Subsequently we examine longev- ity risk and financial market risks from the perspective of those who bear them; we show a need for more longevity instruments in the retail market and some of the benefits of the existing longevity instruments in the wholesale market for longevity risk. A final section concludes. Longevity Risk Risk can be defined as the negative consequences of uncertainty. Both uncertainty (multiple possible outcomes) and negative consequences are necessary prerequi- sites for risk to exist (Baranoff et al. 2009). Since most people find longer life desir- able, the term ‘longevity risk’ needs further explication