Longevity Risk, Retirement Savings and Financial Innovation

Abstract

Over the last couple of decades there have been unprecedented, and to some extent unexpected, increases in life expectancy which have raised important concerns for retirement savings and for the affordability of defined-benefit pension plans. We address questions concerning these topics by introducing longevity risk in the standard life-cycle model of consumption and savings decisions. We allow individuals to hedge this risk through endogenous saving and retirement decisions and, investigate the extent to which they would benefit from investing in financial assets designed to hedge shocks to survival probabilities. We find that, when longevity risk is calibrated to match forward-looking projections the benefits of such investment are substantial. This lends support to the idea that such hedging should be pursued by defined-benefit pension plans on behalf of their beneficiaries. Finally, we draw implications for optimal security design.