A long-lived opportunity: longevity swaps market ripe for investment

Now trending: ageing

We are currently in the midst of a fundamental demographic shift. Forecasts by the Commonwealth Treasury suggest the proportion of Australians aged 65 and over is expected to rise to almost a quarter of our total population by 2050. At the same time, we can expect to live longer than ever before, the 2015 assessment by the Australian Bureau of Statistics of the average Australian life expectancy of 82.4 years is the highest ever on record. 

These trends are broadly consistent worldwide, with the World Health Organisation estimating the proportion of the world's population aged over 60 to nearly double from 12% to 22% between 2015 and 2050. While within the OECD, the average life expectancy has reached 80 years, a figure that increases by 3 to 4 months every passing year.

The net result seems fairly clear, whether at home or abroad, more people can expect to spend more time in retirement. It is unsurprising then that against this backdrop, interest has grown in the market for retirement income products such as life annuities. Expected Australian tax and regulatory changes are also likely to encourage shifts in the Australian annuities market.

Products such as life annuities can manage the financial consequences of a longer retirement by offering the certainty of fixed, indexed payments to a beneficiary of the product for life.

It is incidental to these products that product providers bear the costs of longevity risk, being the possibility that product beneficiaries may live longer than was expected.

Where does longevity risk currently live?

Despite its ageing demographics, longevity risk is not currently a major economic feature in Australia. The Australian life annuities market size has traditionally been modest. In a report by Standard & Poor's, it was noted in recent years that annuity products with longevity risk were backed by just 1.7% of total life insurance funds.¹ Defined benefit schemes, being the payment of a regular pension for life based on a beneficiary's salary and length of service with an employer, also carry longevity risk. However the size of defined benefit scheme coverage in Australia is similarly modest. According to data from the Australian Prudential Regulation Authority, only 6.6% of total superannuation assets are held by defined benefit funds.

Longevity risk, and therefore its management, is of far greater significance overseas where the size of the annuities and defined benefit scheme markets are much higher. In its recent Financial System Inquiry, the federal government noted the size of Australia’s annuity market is only around 0.3% of GDP, compared with 15.4% in the United States, 28.8% in Japan and more than 40% of GDP in some European countries. In aggregate, the International Monetary Fund has estimated that more than US$20 trillion in global pension assets have some exposure to longevity risk.

Tapping into live potential

Whether in Australia or internationally, investment funds and institutional investors have an opportunity to participate in the management of longevity risk. The Bank of International Settlements has estimated that the additional payout cost to providers for every year that longevity is underestimated ranges from US$450 billion to US$1 trillion. Providers of products such as life annuities commonly seek to manage longevity risk by transferring this risk to insurers by way of buy-out (where the liability to the beneficiaries under the product is wholly assumed by way of sale to the insurer) or buy-in (where in exchange for a premium, the insurer pays to the product provider amounts matching the liability to the beneficiaries). Non-traditional players in these markets, such as investment funds, institutional investors and banks can provide an alternative solution for the need to manage longevity risk by acting as third party longevity swap providers. In some cases, these types of investors may also finance their participation in longevity swaps by raising funds from investors through securitisation techniques.

Longevity swaps involve several basic components. In exchange for a product provider making fixed payments to the swap provider based on an amount of expected payments (that are modelled on a life expectancy index, or other longevity data) for the duration of the swap agreement, the swap provider pays the product provider variable amounts equal to those amounts that are payable to the modelled cohort of beneficiaries. As part of a longevity swap arrangement, the swap provider may in turn transfer onward the longevity risk to other investors or an insurer, either in full or in part.

The bottom line

With the certainty of demographic shifts, any increase in the offerings in the life annuities and retirement income product markets both in Australia and internationally will likely be matched by an increased interest in methods to hedge longevity risk. The potential investment opportunity represented by longevity swaps is worth some real consideration by entities such as investment funds and institutional investors.