Why small DB pension schemes should insure – longevity concentration risk

Why small DB pension schemes should insure – longevity concentration risk

Why small DB pension schemes should insure – longevity concentration risk 875 583 K3 Advisory

Welcome to the first of a series of blogs on why small DB pension schemes should insure and how they need to go about doing it for the best outcome.

Back to school

Please don’t feel intimidated as I take you back to your secondary school maths classroom. Your teacher asks the following question:

“What is the probability of getting 7 or more heads from tossing a fair coin 10 times?”

I’ll spare you the maths – the answer is 17%.

Now let’s flip the question and ask: what is the probability of getting 70 or more heads from tossing the same fair coin 100 times. This is the same proportion of heads as the original question but from a larger number of tosses.

The answer is now roughly 0.004%, i.e. very very unlikely.

What this shows is that the greater the number of tosses the much more predictable the outcome (i.e. number of heads) becomes and the likelihood of an extreme outcome (ie much more than 50% of heads) is significantly reduced.

You might all be wondering why I’ve been testing you. Well mortality in pension schemes works in a very similar way. The larger the number of members the more predictable your scheme’s mortality becomes and the lower the chance of a ‘bad event’ occurring.

It gets worse!

In our maths problem each toss of the coin had an equal weighting to any other, i.e. they each contributed either a head or a tail. In pension schemes each member does not contribute the same mortality risk. It is very common that a minority of members make up the majority of the liabilities. This has the effect of making your scheme mortality experience effectively dependent on the life expectancy of a very small group of high liability members and hence the probability of a bad outcome is materially higher.

It gets worse again!

The fact that mortality in your schemes is more unpredictable leads to a series of other secondary risks that you might not be aware you are running. For example, are you told that you have “hedged” your interest rate and inflation exposure? If so then that will be based on an estimate of the liabilities of your scheme. So, the more unpredictable your liabilities are due to mortality the more uncertain it is that you have correctly managed other risks such as inflation and interest rates.

How can you manage this risk?

Insurance is the only effective way to manage longevity risk. A bulk annuity takes away all the risk of a scheme including mortality.

But don’t insurers charge me more if I’m riskier?

No! Insurance companies have tens of thousands of policyholders and so their mortality experience is much more predictable. When they add in your small scheme to their book of business the impact on their mortality risk is negligible. In other words, although your scheme is very risky to you it is not so to an insurer. What this means is you get the same pricing as if you were a large scheme with lots of members. This makes the risk return payoff from buying insurance better value for smaller schemes as you aren’t penalised for the fact that your mortality risk is higher.

This blog covers a major reason why small schemes should insure. Our next blog will cover an equally big reason – the disproportionate expenses of running small schemes.

Nicola Duncan
Actuarial Consultant
+44 (0)7902 342369