The Impact of Aggregate Mortality Risk on Defined Benefit Pension Plans

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Defined benefit (DB) pension coverage has declined substantially in recent decades in both the United States and the United Kingdom, and aggregate mortality risk is one of the factors that has been explicitly blamed in the United Kingdom. Aggregate mortality risk is the risk that the average DB plan participant will live, and receive benefits, longer than expected. In this paper we focus on two aspects of aggregate mortality risk: the possibility that plan providers use mortality forecasts that are biased upward, compared to putatively unbiased forecasts; and the possibility that future improvements in mortality are greater than those predicted by unbiased forecasts. Our findings indicate that the life tables commonly used to determine pension plan liabilities probably understate mortality improvements, and therefore plan liabilities, by substantial amounts, especially for men and for younger workers. However, even if plan providers were to base their calculations on unbiased forecasts of mortality, they would still be exposed to aggregate mortality risk. Our calculations show that there is a 5% (1%) annual risk that a mortality shock could unexpectedly increase annual plan liabilities by 1.07% (1.41%) or more. Longevity bonds are a potential means by which pension plans could transfer aggregate mortality risk to those most willing to bear it. The mortality-related component of the returns on such bonds, had they been available in the past, can be priced using the Capital Asset Pricing Model. The results suggest that pension plans might be able to transfer aggregate mortality risk to the financial markets at negligible cost.