According to the brief, insurance companies and defined benefit pension plans face the risk that retirees might live longer than expected. This risk might adversely affect both the willingness and ability of financial institutions to supply retired households with financial products to manage their wealth decumulation.
Longevity bonds, it explains, which involve no repayment of principal, would pay a coupon that is linked to the survivorship of a cohort, say, 65-year-old males born in 1945. If a higher-than-expected proportion of this cohort survived to age 75 - a development that would cost the insurance company or pension plan more than expected - the coupon rate would increase, offsetting some of the provider's cost.
The brief highlights the benefits that could flow from a transparent and liquid capital market in longevity risk, and argues that the government could play an important role in helping this market grow. The line of reasoning comes from the United Kingdom, but has validity for all countries with mature funded pension systems.
Key findings include:
- -- The bonds' coupon would rise if a cohort lived longer than expected, offsetting higher annuity costs.
- -- Longevity bonds would lower capital requirements for insurers and reduce risk for pension plan sponsors.
- -- Governments could take the lead in issuing such bonds and gradually shift most of the responsibility to the capital markets.