Hedging Longevity Risk might be the least of our worries
From a mechanical perspective, finding something to “hedge” against longevity risk, i.e. the risk that pension payouts will increase due to improving mortality, is not particularly difficult. It is necessary to determine investment possibilities that will benefit from increased life expectancy.
Businesses that serve the aged such as nursing homes and medical products companies will be some of the sorts of things that will prosper in an increasingly aged economy.
Clever quants will be able to show that while the hedge is far from perfectly effective, it can be used to reduce the capital requirements of pensions and annuity exposures.
But there is a much larger question that is not likely to be addressed in looking at capital requirements for insurers and pension plans.
That is the issue of whether the economy will be able to sustain the aggregate effects of the aging of the populations in Japan, the US, Europe and China. Those investments in elderservice providers and elderproduct firms will provide a relative hedge. Those firms may do relatively better than the rest of the economy.
But on the whole, the economy might well be in the dumps, making the potential to earn the returns on investment needed to support the base level of pensions extremely difficult. We may well find out that it is not viable for an economy to both maintain its base promises to elders AND maintain a healthy economy at the same time.
Robert Schiller has described this problem well in a NYT Op Ed piece last spring. He describes an autonomous family farm where they must decide how to treat the family elders who are no longer able to work. If the farm has a bad year and harvest is poor, do they continue to feed the elders the same as in the good years and therefore starve the working members of the family? Or would that create a spiral that brought the entire family to ruin?
It would be good if we knew what happens to an economy that doubles the amount of total resources that are directed towards its non-productive elders. If there is a point where an economy would stop being viable, then the concerns about minor increases to pension benefits due to longevity increases are immaterial. The ruined economy sill simply not be able to pay the basic benefits.
It seems highly likely that the systems that were imagined in the last 100 years will not stand up to the pressures of the aging Baby Boomers. The discussion that at least in the US is not happening about funding for retiree medical and income needs may well be the wrong discussion. The discussion that is needed is to ask how the economy will survive the strain of the very large pool of elders.
Schiller’s family farm example leads to an immediate suggestion. One that many people are coming to privately, even if there is little public discussion. That suggestion is a complete rethinking of retirement and employment for elders. An honest evaluation of the real economic impact of the exploding numbers of elders is very likely to reveal that it is just not practical for an economy to provide for 20 – 25 years of leisure to a large fraction of its population.
This is a situation where our simple extrapolatory approach to assessing risk is inadequate. The future will most certainly be different from an extrapolation of the past.
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