Defusing the retirement bombshell

The 2007-08 worldwide financial crisis forced numerous companies to take drastic steps just to survive. For instance, General Motors got rid of a pension plan that, in its then-underfunded state, could have hampered its recovery.

Canadian retirees could bear the brunt of similar crises. We live longer lives on average than at any time in history, yet many pension funds haven’t kept pace with this increase.

Government pensions are widely seen as insufficient. (Schemes like Ontario’s forthcoming provincial pension initiative may help.) Employer pension plans (like GM’s) aren’t fully guaranteed. In all this uncertainty, are individuals knowledgeable enough to fund their own golden years?

It irks Lars Stentoft, associate professor in Western University’s Economics and Statistics and Actuarial Sciences departments and Canada Research Chair in Financial Econometrics, that this problem doesn’t make the news. That hasn’t stopped him from studying it. “A former colleague was interested in risk and insurance. I saw a way of using my knowledge of derivative products together with his interest in insurance,” he says.

Their brainstorming resulted in a paper to explore the idea of equity traders taking on risks faced by pension funds. They propose developing investment instruments that act as insurance against the hazards of underfunded pensions.

Traditionally, pension funds spread “longevity risk” over large groups of people. The risk of paying out more than the premiums collected ought to be countered by not paying out for those who don’t live as long.

But that diversification strategy doesn’t seem to be working. Can pension funds persuade other organizations to take on this risk?

“We need to create products that would interest both the buy side (e.g. hedge funds) and sell side (pension funds) of the market,” Stentoft explains. “The buy side is interested in assuming that risk, since financial investment firms diversify their portfolios to hedge against downside risk of any one investment.”

So far, equities traders have avoided “buying” the risk of pensioners living longer, since they expect greater returns than what pension funds are willing to pay. The article Stentoft coauthored recognizes and explores this gap.

Here’s Stentoft’s basic overview of this gnarly problem: “Pension plans underestimate life expectancies and believe they will pay out much less in pensions. That means they believe this exposure is much less risky, so it should have a lower return.”

The Achilles heel in their argument? Longevity model after longevity model consistently underestimates average human lifespan. So while pension plans liken the risk they offer to that of GICs, equity traders peg it closer to that of penny stocks.

“Now that we’ve documented the problem, we can create ways to deal with it,” Stentoft says. He believes the answers lie in big data. “Insurance companies already look down to the postal code where people live. When I had to get insurance for my car, they asked about the colour of my car.” (Stentoft drives a red Mustang, a childhood dream of his.)

He acknowledges the political difficulties of using this type of information to improve longevity models. “But if we want to measure risk properly, we need to devise models that are individually tailored to who people are.”

Professor Lars Stentoft joined Western Economics on January 1, 2014 as a Tier II Canada Research Chair in Financial Econometrics. His appointment is joint with the Department of Statistical and Actuarial Sciences. He earned his PhD in Economics in 2004 from the University of Aarhus in Denmark and came to Western from the Department of Finance at HEC Montreal.

Professor Stentoft’s work has implications on how financial assets and derivatives are valued, how their risks are managed, and how financial policy is created and implemented. It is of particular interest to academics, practitioners in the financial industry, policymakers, and regulators. The end goal of his work is improved financial stability and a lower likelihood of future market crashes or financial crises.

This article originally published on the Western Science website.

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