Differences in life expectancy across socio-economic groups could act as a barrier to the development of a longevity product tradable on capital markets, according to the OECD.

Pension funds and annuity providers should look to adapt their benefit structure or product offering to different segments of society as an alternative solution to managing their exposure to longevity risk, it said.

It made the comments in its 2016 Business and Finance Outlook, which was released this week.

The report focussed on the “fragmentation” in a variety of areas of life, including in financial markets, regulatory and legal regimes, and life expectancy.

Divergence in mortality across socio-economic groups makes it challenging for pension funds and annuity providers to mitigate longevity risk, the OECD said.

Their exposure to longevity risk tends to be more concentrated in higher socio-economic groups, it added, which could potentially limit the capacity for this risk to be passed to reinsurers.

The OECD has previously called for the development of capital markets solutions for longevity risk and in its latest report said that the “capital markets could potentially offer additional capacity at a lower cost”.

However, it went on to note that there are problems with the index-based longevity instruments that are needed to meet capital market investors’ need for transparency and flexibility.

Asked whether the OECD was giving up on or at least backing away from the idea of capital markets solutions fo rmanaging longevity risk, Pablo Antolín-Nicolás, principal economist and head of the private pensions unit at the OECD, said it was not.

“We still believe that market solutions are part of the overall solution to manage longevity risk,” he told IPE. ”We are just highlighting that socio-economic differences in mortality trends creates additional problems to develop market solution for managing longevity risk.”

According to the OECD, index-based hedging instruments have drawbacks because they do not provide a full transfer of the risk, which leaves pension funds or annuity providers with what is referred to as a basis risk – the potential shortfall between payments from a swap counterparty and payments owned to annuitants.

Divergence in mortality improvements means that  “[t]he magnitude of this basis risk can be significant, reducing the effectiveness of the longevity swap to hedge the longevity risk of the pensioners or annuitants”, said the policy organisation.

The OECD noted that very few index-based longevity hedges have been executed.

The four largest public transactions have all been in the Dutch market, where, according to the OECD, the very high coverage of the private pension system means that mortality among the population with annuities is “more likely to closely follow the trends of the general population, minimising basis risk and resulting in higher hedge effectiveness”.

The Life & Longevity Markets Association (LLMA) and the UK’s Institute and Faculty of Actuaries (IFoA) recently commissioned a research project that aims to develop a methodology for assessing basis risk for longetivity transactions. 

Another solution, according to the OECD, is for pension funds and annuity providers to diversify their longevity risk by “adapting product offerings to different segments of society”.

Policymakers, as the organisation has long argued, also have a role to play, by making accurate and timely mortality data available by socio-economic groups and encouraging product innovation.

The “ultimate solution”, however, according to the OECD, will be to target the causes of the differences in mortality and life expectancy by socio-economic factors.

To that end, the next step in the organisation’s research agenda is to estimate and quantify the potential impact of these differences on the well-being of retirees.

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