Hedging Longevity

Possibly the biggest risk faced by today's retirees is outliving their assets.  With active lifestyles and improvements in health care, life expectancy has been increasing steadily over the past seventy years.  Now it is having an impact on pension plans and other institutions.  These organization are having difficulty managing the tails of their liability because there are so few market participants that would naturally assume the risk that plans want to lay off.

Now Bloomberg reports that large investment banks are developing products for these institutions to hedge their risks.  These instruments are talking the form of longevity bonds and swaps, and the payout are based on indexes developed by Credit Suisse and JPMorgan.  These derivative are complex and illiquid, not least because their payouts will not be known for another twenty years or so.

These markets are very early in development and are limited to very large institutions.  Right now, the only mechanism for hedging longevity risk for the typical retiree is an annuity with a cost of living rider.  It seems to me that some combination of endowment contract and deferred annuity could be packaged to provide a contingent deferred annuity for pennies on the annual income dollar. 

What would it look like?  Assume the client is a male, age 65, wanting to produce $40,000 a year in income after he turns 85.  A 20-year Treasury strip is yielding about 4.5%, which is about the same as a 30-year strip.  The Social Security Administration estimates the life expectancy of an 85-year-old at 5.65 years, and the probability of a 65-year old reaching 85 at 40%.  The present value of the $40,000 per year single life annuity at age 85 with a 3.75% discount rate (giving the insurance company a 0.75% spread) is $181,709.  That investment would require the deposit of $75,344 today earning the current Treasury strip rate.  That alone is not bad; less than two years of income to ensure that incremental $40,000 per year for life.  However, if the probability of achieving age 85 is factored in, it would take a premium of only $30,138.  The downside is that there would be no benefit paid in the event of death before age 85, and annuity payments would stop at death after age 85.

These insurance companies are full of very smart marketing executives and pricing actuaries.  When they realize that this type of product is a natural hedge against their straight life insurance portfolio, in addition to the structure investment banking products being developed, I expect these longevity annuities to be available through the advisor market in 2-3 years.