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Is your pension safe from longevity?

Two of my colleagues, Stephen Richards and Gavin Jones, recently presented a paper to the actuarial profession on the financial aspects of longevity risk. The paper was very well received. One key theme was the oft-unappreciated risks in defined-benefit pension schemes.

It turns out that the greatest concentration of private-sector longevity risk lies not with insurance companies, as one might expect, but with companies’ defined-benefit pension schemes. Despite being about 10 times the overall size, pension sch-emes are not as tightly regulated as insurance companies’ annuity liabilities.

A crucial example of this is that an annuity from an insurance company is guaranteed, whereas a pension from an employer’s scheme is not. Sadly, many pensioners have discovered this difference over the past few years, with some scheme members losing everything.

This difference between annuities and pensions is surprising and worrying,as both do exactly the same job – namely paying an income in retirement for life.

In recognition of this, the regulations surrounding pension schemes are being tightened. One example is that certain schemes can no longer pay pensions from the scheme itself, but they must now secure the benefits with an insurance company. This turns the pension from a promise into a guarantee. This new law only applies to small schemes with less than 50 members, however, which leaves pensions from bigger schemes still not guaranteed.

So if pensions are not guaranteed, surely it is only scheme members who should worry? Not quite. Investors need to worry as well.

If investors do not like the idea of investing in longevity risk, it is not enough to avoid buying shares or bonds of insurance companies. Many household names in the FTSE-100 index of leading companies have very big pension schemes relative to their market capitalisation, as the table below shows.

But perhaps longevity risk is not so frightening if it is held in a company where it is a daily business activity. Investors should be wary of longevity risk when it is a sideline to a comp-any’s main business but they can be much more relaxed about holding shares in companies whose core competence it is to price and manage longevity risk.

These companies are the handful of UK insurers with a track record of writing and managing big annuity portfolios. What should in-vestors do if they find they own companies with unexpected exposure to this risk? Perhaps they should en-courage those companies to transfer the risk to someone whose business it is to manage it.

Copies of Stephen and Gavin’s paper are available at www.sias.org.uk/papers/longevity.pdfICI 352%BAE Systems 242%BT 224%Rolls Royce 199%Royal & Sun Alliance 182%Land Securities 3%The British Land Company 2%Liberty International 2%Vodafone Group 1%Source: Lane, Clark and Peacock Annual Survey, 2004.Size of scheme is taken as the greater of assets and liabilities.

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