Britain should issue longevity-linked bonds - Pension Corp

LONDON (Reuters) - The government should issue bonds linked to the longevity of the population to help pension schemes and insurers manage the financial pressure of increased life expectancy, Pension Corporation said Tuesday.

Dramatic increases in life expectancy have left private sector pension funds and annuity providers with massive exposure to longevity, and there are few options currently available to hedge this risk on any significant scale within the private sector.

Similar to the introduction of inflation-linked gilts first issued for pension funds in 1981, the government could issue a longevity-linked government bond, creating a hedge against the financial risks posed by increase life expectancy, according to specialist British pension manager Pension Corp.

Such a move would help start a trading market for longevity risk, just as how index-linked gilts led to the creation of an inflation term structure and the development of inflation swaps.

"The government developed a much larger market where various parties traded to their optimal positions in regards to inflation," John Fitzpatrick, a partner at Pension Corp, told Reuters.

"That market is many multiples larger than the index-linked gilt market today. The same thing needs to happen to longevity," he said.

With the creation of a private sector longevity derivative market, price points along a mortality terms structure could be created.

As there would be a pure price for longevity risk, institutions such as pension funds and pension insurers could trade these derivatives on the Insurance Linked Securities (ILS) market.

The development of a pricing index would reflect market developments that impact longevity, such as medical advances and behavioural changes -- for example, fewer smokers.

"A number of pension insurers and annuity issuing insurers would buy these bonds" said Fitzpatrick.

"Pension funds want to hedge out all their longevity risk in a cost effective manner through insurance. The pension insurers want to get the risk out to the capital markets.

"In the long run, such a system would reduce the amount of longevity risk that the government is likely to have in the future," he said.

GOVERNMENT SECURITY

Another reason for the government's involvement would be to minimise the credit risk in such a security.

If private institutions issued the security, there would be elements of interest rate risk, credit risk and longevity risk in the bond, making it difficult to tell from the price alone which is related to credit risk and to longevity risk.

"If the government issued a longevity linked bond, investors would be able to compare the yield of the government longevity bond to that of a standard government bond and the resulting yield spread would show the yield premium for straight longevity risk," said Fitzpatrick.

Pension Corporation is not the first to urge government help with longevity hedging.

In May, the Pensions Institute appealed to the government to issue up to 35 billion pounds of longevity bonds by 2010, stating it would provide a fresh source of finance for the state.

However, the UK Debt Management Office (DMO) said in its Annual Review 2008/09 in August that the government has no plans to issue longevity bonds.

"The issuance of longevity bonds raises significant policy questions, in particular around the transfer of longevity risk onto the government's balance sheet," it said.

"In addition, the depth of the market for, and the potential liquidity of, this type of product are unclear," the report said.

A spokesperson for the DMO said the government's stance had not changed.

Pension Corporation said it would continue to lobby the DMO.

(Additional reporting by Cecilia Valente, Editing by Andy Bruce)