In recent years, we have become used to pension-scheme funding levels increasing as improvements in longevity tail off. At the same time, the shape of these defined-benefit cashflows has changed, with a particular reduction in interest rate and inflation risk at longer-dated tenor points. We explored this topic last year.
When discussing these changes in longevity, it is worth emphasising that they are due to the rate of future improvements in lifespans reducing; they are not due to higher mortality rates.
2019 and 2020 both began with lower mortality rates than average, as can be seen in Chart 2 below, but not low enough to meaningfully impact the prevailing trend. However, as we know, this has tragically been overtaken by developments related to COVID-19. The Continuous Mortality Investigation has provided a weekly summary of deaths, and the chart shows the large recent increase in the standard mortality rate. Yet while it is very clear what has happened, it is far less clear what will happen and what this means for pension-fund liabilities going forward.
The chart indicates the devastating toll the virus has had, and our first thoughts are with all those affected. But given our responsibility for pensioners’ retirement assets, we must also think about what this means for them. If we return to our initial discussion around future longevity trends, for example, there is no real certainty on the effect COVID-19 might have. There will certainly be a one-off reduction in pension-fund liabilities, but no one is yet able to predict anything beyond this at any level of confidence to make it applicable to valuations.
Practically, we would make the following points:
• Valuations are on a three-year cycle for many pension funds, so many of the changes in liabilities will be driven by wider changes in longevity over recent years (i.e. there will be a lot of noise).
• Will this be more of a one-off change, with no change in the previous trend around longevity?
• Given that many of those who have died from COVID-19 had pre-existing conditions, what are the implications for longevity expectations for the rest of the population?
• What are the implications for other diseases and illnesses? Research is now beginning to emerge which shows that, for example, cancer deaths are likely to be higher in the short term.
• What is the post-COVID outlook for healthcare? Historically, arguments have been made that austerity has been part of the reason for the flattening of longevity expectations (which is likely to be indirect, rather than due to cuts to the NHS budget). Is further austerity now likely at some point? It will probably not happen immediately, but some belt tightening is possible. On the other hand, I have already been told by my GP that video appointments will continue in the future, which could end up being a positive step for healthcare efficiency.
• At this early stage, it is difficult to find any high-conviction estimates of the actual impact on valuations. That said, informal estimates seem to be relatively small, with an order of magnitude around 1%.
Ultimately, we will have to keep watching these developments as it is an area where the results may not be as clear cut as one would imagine. For now, the emphasis is rightly on supporting those affected by the virus. But in time, the vast majority of pension funds will need to consider the impact of COVID-19 on interest rates, inflation, equity prices, credit spreads, etc, as these are the factors driving big swings in funding levels. Chart 3 below demonstrates how funding levels may have changed by the order of 10% in an exceptionally short timeframe.
Once there is time to digest these particular implications on longevity, it will be another reminder of the challenges faced by pension funds after a genuine self-sufficiency position is reached and of the basis risks between a liability benchmark and the actual liabilities. Although some of these risks can be hedged (such as longevity, the consumer price index to a degree, a dynamic approach to limited price indexation), it is our view that some return-seeking buffer is a ‘prudent’ way of addressing many of these unknowns.
Until then, these developments also continue to point to being pragmatic in setting tolerances around rebalancing back to a liability benchmark and not incurring unnecessary transaction costs.
Charts 1 and 2 produced with permission from Continuous Mortality Investigation Limited (CMI).
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