Tackling longevity risk by means of financial compensation

Abstract

The remarkable increases in life expectancy observed over the last decades have posed a major challenge to pension funds and annuity providers because of the related systematic longevity risk. This article proposes a variable payout life annuity where benefits have to follow the observed mortality and the interest rates obtained. This scheme is effective and efficient for annuity providers, who always have a fund that matches exactly the undertaken commitments to annuitants. On the other hand, potential reductions in the benefit payments can be felt by annuitants more bearable than those that include a safety loading. Specifically, the concept of observed survival probabilities is introduced and applied to: (a) translate a demographic change into the related financial adjustment; (b) decompose a demographic change into two effects, one stemming from the survival probability observations and the other from life table updates; (c) show that the financial compensation mechanism should run for single cohorts to avoid creating inequalities for older and smaller cohorts.