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Financial Impact of Living Longer Worse Than Pension Plans Think

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An IMF analysis says advanced economies would need to set aside half of their GDP today to pay for a three-year increase in longevity that is actuarially likely by 2050. While aging occurs slowly and imperceptibly, its financial effects can be catastrophic if not addressed now, the IMF’s Global Financial Stability Report argues.

The report written by IMF economist S. Erik Oppers says that government liability for social security systems is based on estimates of fertility and longevity. Over the past several decades, governments have consistently underestimated longevity projections and thus have underestimated their pension liabilities. If people live just three years more than expected in 2050, which is in line with the average underestimates of the recent past, the funding gap to pay retirement benefits would be 1% to 2% per year—an amount equal to 50% of 2010 GDP.

This gain in longevity will come as a huge shock to public and private pension schemes that are already woefully underfunded. The problem of ameliorating old-age poverty, the report says, should therefore be addressed today while the remedy will be easier to endure than the bitter medicine that would be needed 40 years hence.

The IMF report recommends “risk sharing between businesses, the government and individu­als” as a means of dealing with the problem. People have spontaneously been extending their working years as their awareness of their longevity has grown, but the report suggests that governments should mandate higher retirement ages for pension purposes and corporations should commensurately raise their standards for the number of years workers remain employed.

“Longer working lives can offset longer life spans, essentially keeping the number of years in retirement (and thus financial retirement needs) fairly constant,” the report says, adding that “the extra labor income would also generate additional tax revenue, offsetting some of the public sector’s costs.”

A novel policy approach recommended in the report is a transfer of longevity risk from pension plans to insurers, who can handle the risk for a fee. In the words of the IMF report, “the risk would be transferred from those who hold it, including individuals, governments, and private providers of retirement income, to (re-)insur­ers, capital market participants, and private compa­nies that might benefit from unexpected increases in longevity (providers of long-term care and health care, for example).”

This approach, still in its infancy, is gaining ground in the U.K. and the Netherlands. U.K. transactions totaling 8 billion pounds, or $12.7 billion, for the years 2008 to 2010 rose in 2011 alone to 9 billion pounds.The largest such transaction involved a 3 billion-pound longevity swap provided by Deutsche Bank for Rolls Royce’s pension plan last November. While representing a start, the risk transfer market represents “just a fraction of the existing risk,” the report says.

The IMF report concludes that risk-sharing and risk transfer mitigation efforts, if undertaken now, “can be implemented in a gradual and sustainable way.” Conversely, the report warns, “delays would increase risks to financial and fiscal stability, potentially requiring much larger and disruptive measures in the future.”