1People save for a pension so they can retire after a productive career. But they are faced with the question how much to save: too much and you could have had an easier life, too little and you’ll worry about making ends meet until meeting the end. Actuaries call this uncertainty longevity risk: the risk of outliving your savings2.
Unlike market risk this is a risk you cannot hedge, someone has to bear it. Who can do this is the topic of this post. This matters because interplay between human life and (large) financial interests is shared only with the realm of assassins. And if you consider all possible careers there must be some dimension—or more likely several—on which actuaries and ninjas are at opposite ends of the spectrum.
The immediate issue with longevity risk is that if you don’t want to bear it yourself, you need to transfer it to someone likely to live longer than yourself. For much of history people relied on their children to look after them in old age in exchange for inheriting the family farm or business. The issuance of government bonds, firstly by the Republic of Venice, allowed people to convert their wealth into an income that could provide for their heirs or dependents—as well as for themselves in old age.
An interesting aspect of the early Dutch Republic ca. 1600 is that it financed itself with interest-only loans to named individuals, who had to present themselves to receive interest payments. Implicitly this meant the contract ended at their death and so the Republic bore the longevity risk—whereas the lender received lifelong income. Johan de Witt, Raadspensionaris (Treasurer) of the province of Holland, famously argued in Parliament in 1672 that they were overpaying by issuing bonds at the same price irrespective of the age of the buyer—clever merchants were buying them in the name of their children. De Witt’s proposal to remove this arbitrage improved the finances of the Republic but dented his popularity to the extent that he was gruesomely lynched later that year.
Longevity risk can be bourne collectively. Of interest is the concept of a tontine, where a group of (childless) similarly-aged individuals would pledge to name each other heirs. The inheritance of those that passed away early would support those members who lived longer. The design flaw that members now have a large financial interest in the premature deaths of their peers is the subject of at least one Agatha Christie novel.
As a result there are now laws regarding life insurance and regulating the companies that offer them. It is possible to buy a life annuity on someone else to benefit if they live longer than the insurer expect, but not life insurance3 to benefit from their early demise. This should prevent conflicts of interests escalating into interesting conflicts i.e. murder cases. Still the insurer or pension fund selling the life annuity benefits financially from the death of its customer, hence the need for regulation.
For issuers, a standardized product not tied to an individual life is easier to administer and manage. Such products are also tradable. This is the core of Arun Muralidhar’s proposal of governments issuing SelFIES—forward starting 20-year annuities indexed to the standard of living—that should provide savers with a guaranteed income in retirement. For those of us lucky to live beyond 90 years of age, we still need a fallback for the extreme longevity risk, and he suggests the government could provide for that.
Pension funds or life insurers may pool the risk, sort of as anonymised tontines. Those living beyond life expectancy are subsidized by those dying younger. This is a form of risk-sharing commonly encountered in insurance where idiosyncracies average out. This role goes beyond providing a long term savings or investment product. The fund remains exposed to macro-longevity risk—life expectancy changing from what policies were based on—but that will be the subject of another post.
No, this has nothing to do with my favorite post.
Of course the flip side is that if you pass away younger, the benefit goes to your heirs.
Except for a spouses, there can be a case to insure the income of a high-earning partner so their beneficiaries can maintain their standard of living.