Author: Stefan Bäumler, Director, B&W Deloitte GmbH
Longevity and increasing life expectancy are two terms that are currently being discussed more and more frequently, particularly in connection with demographic developments and therefore also in the area of occupational pension schemes. While rising life expectancy refers to the increase in average life expectancy over time, longevity refers to the ability of people to live significantly longer than their average life expectancy. Both phenomena pose challenges for pension schemes.
Increasing Life Expectancy Prolongs the Period for Which Pensions are Paid
Since the first direct commitments were made by employers to their employees in the second half of the last century, life expectancy has increased by over 10 years for both women and men. At that time, employers had assumed significantly lower life expectancies and had made pension commitments that were quite generous by today’s standards. It was therefore assumed that pensions would not have to be paid for too long. Now, when employees are actually in the retirement phase, pensions will have to be paid for much longer on average than was originally thought. As a result, the financing costs are significantly higher than expected at that time.
The gradual increase in life expectancy is also reflected in the company balance sheets. The mortality tables on which the provisions are based have been gradually adapted to the increasing life expectancy. While there are numerous mortality tables for measuring pension obligations in the USA, UK and Switzerland, for example, the mortality tables developed and published by Heubeck are used almost exclusively in Germany. While the Heubeck tables are generally accepted for tax purposes, the only requirement under commercial law and US GAAP / IFRS is that the mortality tables represent best estimates based on current observed values. To derive the mortality tables, Heubeck always collects extensive source material in order to present the group of people benefiting from the company pension schemes as a whole as generally valid as possible. In particular, data from the statutory state pension system as well as statistics from company pension schemes and occupational pension schemes are used. In recent decades, there have been regular updates that have taken account of the increase in life expectancy. The latest version was published in 2018 under the name ‘Heubeck 2018G’.
Life expectancy according to this mortality table (generational table) depends on the year of birth, age and gender. The dependence of mortality on the year of birth takes account of increasing life expectancy. It was included in the tables for the first time in 2005. Before that, a distinction was only made between age and gender. Since 2018, the table has also taken socio-economic factors into account in the underlying mortality probabilities for the first time. The aim is to take account of the fact that a person’s actual mortality rate also depends on their wealth. Greater prosperity is often associated with a healthier lifestyle and better access to medical care and therefore has the effect of prolonging life on average.
Some accountants have worked on modelling so-called longevity trends, i.e. the change in mortality probabilities in the future. The so-called CMI (Continuous Mortality Investigation) approach attempts to refine the conclusions drawn from changes in mortality behaviour observed in the past using mathematical methods in such a way that individual longevity trends can be derived for each year of birth, age and gender. The Heubeck 2018G table can thus be used as a basis, but the longevity trends can be adjusted according to the CMI approach with the aim of being able to calculate pension obligations even more adequately.
Siemens AG have also thought about mortality in 2019 and developed its own mortality table, SiemensBio 2017/2023, based on observations within its own workforce. Unlike most other companies in Germany, Siemens AG certainly has a sufficiently large database to be able to make statistically significant statements about the mortality of its own workforce.
Adjustments to the Company Pension Scheme Benefit Commitments to Reflect the Increased Retirement Periods
Parallel to the adjustments in the mortality tables, many employer pension plans have been reduced within the scope of what is permissible under labour law and closed to new entrants. Some employers have also offered their active employees the option of settling the occupational pension scheme by means of a one-off payment in order to free themselves from these ‘old-style’ plans. In the case of newly established plans, for example, the pension amounts were not linked to the employees‘ salary development. At present, employers are even going one step further and have a preference for promising lump-sums or instalments instead of lifelong pensions in new plans, in order to avoid additional expenses even if life expectancy increases in the future.
Contribution based plans are particularly popular, where contributions are accumulated for the occupational pension scheme over the employee’s active period of service, with a certain performance guaranteed. When an in the pension plan included event occurs, the accumulated capital is then paid out. If a pension option is included, this is often offered in the form of an insurance solution. In this case, the longevity risk is shifted to an insurance company.
Options for Dealing with Longevity Risks
The longevity risk or chance exists for both employees and employers. If employees wish to cover their individual longevity risk, they are legally able to defer compensation and build up a lifelong pension in this way – e.g. in the form of direct insurance. Pension providers generally use the DAV tables to convert capital into a pension, which contain more cautious mortality probabilities than the Heubeck 2018G tables.
The employers also have the option of outsourcing longevity risks. For this they have a choice of insurance-based solutions or, alternatively, the option of asset-backing their direct commitments with reinsurance policies.
In addition, the outsourcing of pension commitments of terminated vested and retired employees to a pensioner company has been another way of getting rid of longevity risks for some years now. However, the DAV table is generally used as the basis for calculating the one-off contribution required for the outsourcing, at least in cases where the wording of the Federal Labour Court (BAG) ruling of 11 March 2008 is followed.
Since, following the law of large numbers, the average life expectancy of large portfolios usually does not deviate much from the statistical average and thus the calculated life expectancy, the drivers of outsourcing are mostly balance sheet aspects as well as the avoidance of the risk of further increases in life expectancy in the future. For smaller portfolios, however, the longevity risk itself also plays a major role. The smaller the portfolio, the greater the risk that no risk equalisation can take place in the collective. The extreme case is the pension of a single person. Here, of course, the actual life expectancy can deviate greatly from the average life expectancy.
Pension obligations and the associated risks often play a major role, particularly in the context of corporate transactions. The net pension obligations (i.e. the defined benefit obligation less any plan assets reserved to cover it) are regularly deducted from enterprise value and reduce the purchase price. In these cases, the longevity risk of the transferred portfolio should be considered. In connection with succession arrangements, for example, shareholder-managing directors, for whom higher average life expectancies can be assumed, should be mentioned as a particularly small portfolio. Differences in the mortality rates can also be recognised in specific sectors. There is statistical significance that indicates an increased longevity risk for some professional groups.
Summary
The increasing life expectancy of the population over time has a large impact on occupational pension obligations. For example, the value of existing lifelong pension obligations increases significantly due to longer periods for which pensions are paid. At the same time, the price of acquiring a lifelong pension from external pension providers has risen considerably over time. When setting up new company pension schemes, employers are increasingly focussing on shifting the longevity risk to external pension providers or the employees. Overall, increasing life expectancy means that more money is needed to finance pension plans than in the past.
As pleasing as the prospect of a long life is for all of us, financial security in old age is just as important. Innovative pension and financing concepts will be urgently needed.
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