FACTBOX – How longevity bonds may work

(This complements a story on longevity risk and capital
markets: [ID:nLDE62N177])

Apr 7 (BestGrowthStock) – Pension insurers have been lobbying the
British government to issue bonds linked to the longevity of the
population, to help pension schemes and insurers manage the
financial pressure of increased life expectancy.

Similar to the introduction of inflation-linked gilts first
issued for pension funds in 1981, the government could issue a
series of longevity-linked floating-rate bonds, creating a hedge
against the financial risks posed by increase life expectancy.

Here’s how the bonds would be structured:

* The bond pays coupons that reduce over time in line with
the actual mortality experience of a particular age group in the
population, such as 65-year-old males from the national
population: so the coupons payable at age 75, for example, will
depend on the proportion of 65-year-old males who survive to age
75.

* The bond pays coupons only and has no principal repayment.

* Coupon payments are triggered when the longevity risk is
high: so, for example, the first coupon might not be paid until
the cohort reaches age 75. The coupon payments continue until
the maturity date of the bond which might, for example, be 40
years after the issue date, when the cohort of males reaches age
105.

* The final coupon incorporates a terminal payment equal to
the discounted value of the sum of the post-105 survivor rates
to account for those who survive beyond age 105. The terminal
payment is calculated on the maturity date of the bond and will
depend on the numbers of the cohort still alive at that time and
projections of their remaining survivorship. It is intended to
avoid the payment of trivial sums at very high ages.

* If population survivorship is higher at each age than was
expected, the bond pays out higher coupons. This is what pension
plans and annuity providers need to help match the higher than
expected pensions and annuity payments they need to make.

* If, on the other hand, survivorship is lower at each age
than was expected, the bond pays out lower coupons. But the
pension plans and annuity providers are not likely to mind this,
since their pensions and annuity payments are also likely to be
lower.

Support for the idea:

* The Pensions Institute has cited a number of organisations
that support the concept of governments issuing longevity bonds.

* The UK Pensions Commission and the IMF agree the
government should consider their use to absorb tail risk for
those over 90, while the OECD and the World Economic Forum argue
that governments could improve the market for annuities by
issuing longevity indexed bonds and producing a longevity index.

* The UK Confederation of British Industry said the
government should drive development of a market in longevity
bonds.

Who benefits?

* Proponents say the government gains by having both a more
secure defined contribution (DC) pension savings market and a
more efficient annuity market, resulting in less means-tested
benefits and a higher tax take.

It earns a market-determined longevity risk premium, further
reducing the expected cost of the long-term national debt.

* Defined Benefit (DB) schemes have the opportunity to
reduce longevity risks and can hedge longevity risk exposure
prior to buy out.

* Insurers can potentially establish a mark-to-market
longevity risk term structure, and hence hold the optimal level
of economic capital or at least hold capital closer to the
economic level, in line with current proposals for Solvency II
regulation, due to take effect in 2012.

* Capital markets would get help to kick-start market
participation through the establishment of reliable longevity
indices and key price points on the longevity risk term
structure.

They can build on this longevity risk term structure with
liquid longevity derivatives.

* Investors get access to a new (longevity-linked) asset
class whose returns are uncorrelated with traditional asset
classes, such as bonds, equities and real estate

* Pension plan members would have a means of hedging the
longevity risk associated with purchasing an annuity at
retirement.

Investment Basics
(Source: Pensions Institute discussion paper – Sharing
Longevity Risk: Why Governments Should Issue Longevity Bonds)
(Reporting by Sarah Hills; Editing by Sara Ledwith)

FACTBOX – How longevity bonds may work