How can a pension plan hedge longevity risk?

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AcadiFi · Accepted Answer

Longevity risk — the risk that retirees live longer than actuarial assumptions — can add 5-10% to pension liabilities over decades as mortality improvements outpace expectations. Three hedging instruments exist: longevity swaps, buy-ins, and longevity reinsurance. In a longevity swap, the plan pays fixed amounts to a counterparty (bank or reinsurer) based on expected mortality, and receives floating amounts based on actual mortality. If participants live longer than expected, the plan receives more — offsetting the increased pension cost. Structurally these are indemnity-based (tied to the plan's own population) or index-based (tied to a public mortality index like LLMA, less basis-rich but more liquid). A $3B plan might hedge its retiree block — say 18,000 lives — through a 40-year swap with a reinsurer. Buy-ins bundle longevity with interest-rate and inflation matching, which makes them less surgical but more comprehensive. Longevity reinsurance sits behind insurers who have accumulated pension buy-in books. The UK market pioneered longevity swaps with deals exceeding £10B per transaction. Pricing reflects 'longevity improvements' assumptions — 1.25% annual mortality improvement might cost 3-5% of present-value liability. Basis risk exists if plan participants differ from national tables (typically wealthier retirees live longer). Capital treatment under Solvency II penalizes unhedged longevity, creating demand from insurers too. Reporting: quarterly mark-to-market of the swap, often creating P&L volatility on plan financials.

How can a pension plan hedge longevity risk?

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