Mortality meets volatility in pension market

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“In this world nothing can be said to be certain, except death and taxes.” America’s first blogger Benjamin Franklin made this observation two and a quarter centuries ago and it has held true these many years.

With the latest developments regarding mortality assumptions, however, Franklin may want to consider a rewrite… (if he wasn’t, you know, certainly dead.) For the new world of pension mortality has made death anything but certain.

Also see: "Pension accounting: A return to the Wild West?"

Until recently, most mortality tables were “static,” meaning there were no explicit projections of future mortality improvements. These static tables were updated about once a decade, so mortality assumptions in most years introduced little uncertainty to liability calculations.

The Pension Protection Act of 2006 greatly accelerated the use of simple “generational” mortality assumptions. Generational assumptions are actually a combination of a base table and an improvement scale. They, too, are very predictable from year to year between updates of the underlying data.

A base mortality table assigns a probability of death at each age. While an improvement scale determines how quickly future years’ death probabilities will decline (usually), effectively estimating the impact of future longevity improvements. The longer a pensioner is assumed to live, the more benefits they will be expected to receive, and the higher the associated liabilities recognized by the plan sponsor.

MP-2014: Heat maps to the future

The source of recent death uncertainty is a paradigm shift in longevity thought contained in the Society of Actuaries’ Retirement Plans Experience Committee (RPEC) release of the “MP-2014” improvement scale in October 2014.

Culminating five years of analysis and research, MP-2014 delivers an impressive array of historical mortality improvement data distilled into two-dimensional, multi-colored “heat maps.” These quantitatively hallucinogenic exhibits are extremely difficult to interpret, as shown here:

(Though if you stare at one long enough, a three-dimensional pteranodon may pop out.)

Generally, however, they indicate mortality improvements leading up to 2007 (the last year of available graduated data) were quite strong. The historical heat map results are then extrapolated gradually over a 20-year “convergence period” toward a long-term improvement assumption of 1% for most ages relevant to pension valuations.

This 20-year convergence period places a lot of emphasis on recent mortality experience. Theoretically, a mortality improvement blip remains in play for two decades, adding real liabilities for what may just be a statistical anomaly.

“Mort-ility” is born     

In addition to heat maps, RPEC also included an intention to update data for emerging historical mortality experience at least every three years, perhaps even annually. So if you’re keeping score at home, MP-2014 moves away from simpler, less sophisticated improvement scales that change infrequently in favor of:

  • More complex mortality improvement scales that depend heavily on recent data
  • Frequent adjustments to recent data.

The combination of these two factors greatly increases the uncertainty of mortality’s impact on plan liabilities from year to year. Now sponsors already contending with investment and interest rate volatility are faced with another challenge, one that can be neither avoided nor hedged: mortality volatility.
Also see: "Avoid a pension risk management apocalypse."

Recognizing that there are very few phrases in the English language harder to utter than “mortality volatility” (say it 10 times fast), I will hereafter refer to this phenomenon using the newly coined term, “mort-ility”!

A number of actuaries expressed mort-ility concerns (though they didn’t call them that) during the MP-2014 comment period. They suggested shorter convergence periods may be more appropriate and would introduce much less mort-ility, as the impact of new data would work itself out of the long-term improvement assumption more quickly.

Reasonable alternatives

Much to their credit, RPEC accepted the comments of the actuarial community that the original MP-2014 exposure draft was “overly restrictive.” Allowances for reasonable alternative assumptions using the RPEC model were included in the final draft, giving actuaries and plan sponsors some much-needed flexibility.

Some actuarial providers (including my company) have designed their own standard mortality improvement scales that satisfy RPEC allowances, most of which use convergence periods much shorter than 20 years. If accepted as reasonable by plan auditors, these alternatives have the potential to significantly reduce mort-ility.

It didn’t take long for a real life demonstration of this.

Immediate mort-ility

In October 2015 — 12 months after their original report — RPEC unveiled its brand new MP-2015 improvement scale (while also offering 0% financing for 60 months for remaining MP-2014s on the lot).

MP-2015 uses the exact same construction methods as MP-2014, but includes two more years of mortality improvement data provided by the Social Security Administration.

The new data showed that the actual mortality improvement experience for 2008 and 2009 was significantly less than anticipated. Factoring the new data into MP-2015 reduces life expectancy compared to MP-2014 and cuts the corresponding pension liabilities for a typical plan between 1-2%. This only a year after many plans added 5-10% for the original implementation of MP-2014.

Mort-ility using an acceptable alternative assumption with a shorter convergence period (10 years in this example) was much less, as shown below:

So when it comes to year-end disclosures and operating expenses, you can’t stop mort-ility. You can only hope to contain it using shorter convergence periods. Death has certainly become uncertain, and new data is always on the way.

Mort-ility free funding and lump sums?

If there is a bright side to the mort-ility parable, it is that these assumptions have so far only been used to calculate accounting liabilities. Most other liability assumptions run through the Internal Revenue Service (speaking of certain taxes). The IRS hasn’t yet adopted the RPEC recommendations and will not implement new mortality assumptions until 2017.

What they decide regarding mortality improvement and convergence periods is important, as it will ultimately impact minimum funding requirements, lump-sum payments to individuals and possibly PBGC premiums. Here’s hoping that the mort-ility lessons of MP-2014/2015 have been learned by those decision makers.

Clark is a fellow of the Society of Actuaries and a member of the American Academy of Actuaries. And along with many other 47-year-old males in his cohort, he’s moving diagonally across the heat map in a northeasterly direction. A version of this blog originally ran on The Principal blog.

The subject matter in this communication is provided with the understanding that The Principal is not rendering legal, accounting or tax advice. You should consult with appropriate counsel or other advisers on all matters pertaining to legal, tax or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group (The Principal), Des Moines, IA 50392.

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