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Erik Oppers

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Seven Billion Reasons to Worry: the Financial Impact of Living Longer

Posted: 04/11/2012 2:24 pm

Everyone wants at some point to stop working and enjoy retirement. In these uncertain economic times, most people worry about their pension. Now take your worries and multiply those several billion times. This is the scale of the pension problem. And the problem is likely bigger still: although living a longer, healthier life is a good thing, how do you afford retirement if you will live even longer than previously thought?

This so-called longevity risk, as discussed in the IMF's Global Financial Stability Report has serious implications for global financial and fiscal stability, and needs to be addressed now.

Here's the issue: governments have done their analysis of the aging issue largely based on best guesses of population developments in the future. These developments include further drops in fertility and some further increase in longevity. The trouble is that in the past, longevity has been consistently and substantially underestimated. We all live much longer now than had been expected 30, 20, and even just 10 years ago. So there is a good chance in the future people will live longer than we expect now. We call this longevity risk -- the risk we all live longer than anticipated.

Risky business

Why is that a risk, you may ask. We all like to live longer, healthy lives. Sure, but let's now return to those pension worries. If you retire at 65 and plan your retirement finances expecting to live another 20 years (assuming you have enough savings for at least that period), you would face a serious personal financial crisis if you actually live to 95, or -- well in your 100s.

You could rely on your social security system at that point, but the program is also counting on people not living much beyond their mid-80s in most countries. Your personal financial problem multiplies by the size of the population, and, for society as a whole, becomes a very large problem.

Our analysis presents some back-of-the-envelope estimates that indicate that this longevity risk, when aggregated over all individuals, could make the global cost of aging -- already recognized to be very large -- some 50 percent larger still if people live just three years longer than currently expected. These extra costs could have large negative effects on already weakened private and public sector balance sheets, making them more vulnerable to other shocks and potentially affecting financial stability.

And since most individuals and their pension plans do not adequately account for longevity risk, a large part of those additional costs of aging could fall on governments, as people who run out of retirement funds will likely rely on public programs designed to combat old-age poverty, such as social security schemes. Unfortunately, in the aftermath of the economic crisis many governments do not have the fiscal room to absorb these extra costs.

Admit you have a problem

So what does the report recommend? A first important step is governments, pension funds and other providers of retirement income, and individuals should recognize they run this risk and prepare for its financial impact.

Second, the risk should be shared among government and the corporate sector. One effective way to share the risk with individuals is to have them to work longer.

A third way to deal with longevity risk is to transfer it to those that can best bear its financial consequences. For example, pension funds in the United Kingdom and the Netherlands have transferred their longevity risk to insurers for a fee.

You might think governments' current fiscal worries eclipse aging and longevity risk; issues that are likely to start really biting only decades from now. But I argue we do need to fix the problem now for at least two reasons:

  • First, as with all retirement-related issues, the earlier they are dealt with, the easier the solutions are. We were all told to start planning and saving for retirement in our 20s. Those who waited to get serious until they were in their 40s and 50s know how difficult it is to catch up. Similarly, governments cannot wait until the problem is "in its 50s," so to speak.

  • Second, financial markets look forward and will -- sooner or later -- realize the potential effects of longevity risk on government finances. If these effects are left to languish without solutions and perceived to threaten fiscal sustainability, markets can respond long before longevity risk actually materializes -- witness recent parallels in government debt markets in countries facing threats to fiscal sustainability.

So it turns out, unfortunately, that the financial and fiscal problems associated with longevity may be a lot bigger than we thought. The good news is that if we act now, we can find solutions that limit hardship and disruption. The flip side is that if we delay action, the ultimate medicine will be a lot harder to swallow.

From iMFdirect blog

 
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