Longevity swaps are increasingly seen as a solution to reduce longevity risk in DB pension plans. But what is the right price for removing longevity risk?
Over the past several decades, life expectancy has continued to rise. Estimates vary, but life expectancy now appears to be increasing at a rate of 1 to 3 months every year.
DP plans and longevity risks
The fundamental underlying risk for any Defined Benefit pension plan (and its corporate sponsor) is that the plan should be unable to meet its liabilities. Longevity risk – the risk that the pension plan has to provide benefits to its members over a longer period than expected – is increasingly being recognised as a major threat to pension plans and the companies that sponsor them.
Pricing of longevity swaps
Longevity swaps can help pension plans – and their corporate sponsors – to protect themselves from longevity risk. With a longevity swap, a stream of cash flows is exchanged for an alternative one.
When looking to price a longevity swap, both parties to the swap need to agree on the best estimate of future cash flows, which include the most accurate and up-to-date mortality statistics. Although the actuarial tables can assist a pension fund to reach a best estimate of their future cash flows, they do not provide a good picture of the measure of risk around the numbers. For this reason, in pricing a longevity swap, a stochastic (or probability-based) model of mortality rates are increasingly being used.
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