Academic journal article Journal of Risk and Insurance

Managing Longevity Risk by Implementing Sustainable Full Retirement Age Policies

Academic journal article Journal of Risk and Insurance

Managing Longevity Risk by Implementing Sustainable Full Retirement Age Policies

Article excerpt

INTRODUCTION

In most of the Western world, life expectancy has increased steadily in the past century. For example, the life expectancy at birth in the United States has increased from 47.3 years in 1900 to 68.2 years in 1950 to 77.7 years in 2006 (National Center for Health Statistics, 2010, Table 24). More important for pension payments, the expected remaining lifetime at age 65 has increased from 13.9 years in 1950 to 18.5 years in 2006. The effect of improvements in life expectancy on the value of pension liabilities presents significant challenges for governments, pension funds, and life insurers. Furthermore, there is considerable uncertainty regarding the future development of life expectancy. We refer to systematic longevity risk as the uncertainty regarding the future development of mortality (Olivieri, 2001).

Some countries already consider setting the full retirement age dependent on the evolution of the survival probabilities. The full retirement age is the age at which an individual can collect his or her state pension without a penalty for early take-up rate. (1) In the United Kingdom, the Department for Work and Pensions is revising the pension age policy in order to make it affordable in the long term and fair between generations (see, e.g., Department for Work and Pensions, 2011). The State Pension age will be 66 in 2020 and gradually rise to 67 between 2026 and 2028 (Pension Act 2014). It also announced plans to legislate further increases to the State Pension age through a formula linked to life expectancy. The formula will be based on the principle that people should spend a given proportion of their lives receiving a state pension.

The Dutch government has implemented the law Wet verhoging AOW- en pensioenrichtleeftijd, which leads to a gradual increase pension age to 67 in 2021. Thereafter, the pension age is set by the following rule:

P - 65 = L - 18.26,

where P is pension age and L is the expected remaining lifetime at age 65. (2) Changes in retirement age are implemented 5 years after the announcement to allow individuals to plan their retirement. The proposed rules to adjust full retirement age in the Netherlands and the United Kingdom are different. This might be driven by the differences in types of pension scheme (defined benefit vs. defined contribution) in those countries.

The full pension age in the United States has also gradually increased and is set to gradually increase in the future (Diamond and Gruber, 1999). Between 2003 and 2009, the full retirement age increased annually by 2 months and will again annually increase by 2 months between 2021 and 2027. The increase in full retirement age does not necessarily mean that individuals have to retire later. Individuals can start receiving their social security benefits as early as age 62 or as late as age 70. Receiving benefits earlier than the full retirement age would reduce the benefits. For example, at age 62 the benefits are 75 percent of the retirement benefits at the full retirement age for a worker with a full retirement age of 66.

Biffis and Blake (2010) report that every additional year of life expectancy at age 65 is estimated to add at least 3 percent to the present value of U.K. pension liabilities. In addition, an increase in the life expectancy at birth of 1 year leads to an increase of 0.3 percent of GDP on average in state pension expenditure in the European Union (European Commission and the Economic Policy Committee, 2009). This clearly illustrates the need to consider interventions that can reduce longevity risk for pension and insurance providers. Natural hedging strategies, such as described in Wong, Sherris, and Stevens (forthcoming) and Luciano, Regis, and Vigna (forthcoming), can only partially hedge systematic longevity risk. In the United States, Social Security had 42,826,421 beneficiaries in Old-Age and Survivors Insurance at the end of 2009. In 2009, the total payments were $564. …

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