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Longevity and PensionsProtecting company pensions against increasing longevity
Chris MadsenMartijn Tans
Table of ContentsIntroduction 1
1 Risks to the pension system 2
Estimatingfuturemortality–howlongcanweexpecttolive? 2
Oldagedependencyinpublicplans 3
Changingfaceofpensions–pensionreform 4
2 Longevity and private company pensions 6
Thesourcesofpensionplanrisk 6
Addressinguncertaintyinlongevity 7
Longevityriskandotherrisks 8
DefinedContributionplansandlongevityrisk 10
Longevity–achallengeandanopportunity 10
3 Longevity solutions for pensions 11
Pensionplansandlongevityswaps 11
Pricing–andmeasuring–longevityrisk 12
Indexswapsversusindemnityswaps 13
Controllingpensionrisk 16
4 Hedging your longevity risk: one step at a time 17
5 Conclusion 18
Additionalbibliography 19
1
IntroductionOverthepastcenturyandahalf,retirementhaschangedfrombeingaluxuryintoaperceivedright.
Over the same period of time, life expectancy has steadily increased. However, as people have
cometoenjoylongerlives,ourpensionsystemshavenotbeenadjustedaccordingly. Inparticular,
retirementagesandfundingassumptionsforpensionsdonotyetfullyreflecttheimpactoflonger-
livedpopulations.Asaresult,thethreepillarsofpensions–state-runsocialplans,company-sponsored
plansandprivateretirementsavings–arefacingunprecedentedchallenges.
Inthefirstpillar,statepensionsarebasedonthe‘pay-as-you-go’system,whichmakesthemparticularly
vulnerable.Statepensionsusetaxincomefromyoungerworkinggenerationsinordertopayolder
generations. In the second pillar, company-sponsored retirement plans have fortunately not been
allowedtobeunfunded,buttheactuarialassumptionsthatunderliethefundingrequirementsfor
DefinedBenefit(DB)planshavehistoricallytrailedactualmortalitylevels,whichmeansthatfunding
requirements have been too low. Although Defined Contribution (DC)plansare, by definition, not
subjecttofundingrequirements,pensionersstillrequirethemtobeproperlyfundedinordertobe
abletopayfortheirretirement.Aslongevityincreases,moremustbesaved.
Pension systems are presently facing several trends. First, longevity has continued to rise, which
isdesirablefromapersonalpointofviewbutputsseverestrainonourpensionsystems.Secondly,
thenumberofchildrenbeingbornperfamilyissteadilydecreasing.Thisputsadditionalpressureon
publicpay-as-you-gosystems.Today,withmorepeoplelivinglongerlivesandrelativelyfewerbeing
born, societies are faced with the challenge of looking after more people for longer with smaller
workingagepopulationstohelpsupportthem.
Thepressureonstatepensionsystemsisalreadyevidentanditisclearthatwewillseecontinuing
majorreformsinmostcountriesoverthecomingyears.Atthesametime,companiesarealsofacing
similarpressures. Inthispaper,wefocusonthe impactof increasing longevityoncompaniesand
company-sponsoredDBplans,anddiscusspossiblesolutions.
Whenconsideringlongevityrisktoaplan,someofthemostcommonlyaskedquestionsare:
• Howcanapensionfundassessthelongevityriskitisexposedto?
• Howcanapensionfundprotectitselffromlongevityrisk?
• Whatisafairpriceforprotection?
Inaddressingthesequestions,section1looksatlongevityrisksinthewiderpensionsystem;section
2 focuses on longevity risk and company pensions; section 3 takes a closer look at the available
solutions;and,insection4,weprovidesevenguidelinesonhedginglongevityrisk.
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1 Risks to the pension system
Estimating future mortality – how long can we expect to live?Oneofthedifficultieswithpreparingforanolderpopulationisthatitisimpossibletopredictfuture
events.Yetpensionsbytheirnatureattempttoprovideanelementoffinancialsecurityforthefuture.
Inordertobeabletomakeappropriatepreparations,weneedtohavesomeideaofhowlongwecan
expectpeopletolive.Forthispurpose,fundshavehistoricallyrelieduponactuarialmortalitytables.
Thesetableshavetypicallybeenviewedasfixed–asnapshotofrealityasitwillbe.Foryears,the
tablescontainednoassumptionsforfutureimprovements,whichmeantthattheassumptionsbecame
increasinglyinaccuratewitheveryyearofadditionalimprovement.Asaresult,whendeterminingthe
fundingratioofapensionplan,planswereimplicitlylookingmoretothepastthanthefuture.
Over the past decades, life expectancy has continued to rise. Estimates vary, but life expectancy
broadlyappearstobeincreasingatarateranging(atthemoment)from1to5monthseveryyear,
dependingonagegroupandgeographicallocation(seefigure1).Whiletheimpactthatthishason
pension liabilities varies according to interest rate levels and the specific demographics of each
individualpensionplan,everyyearofadditionallifeexpectancyisgenerallythoughttoaddabout4%
tothepresentvalueofpensionobligationsforatypicalpensionfund.
Itcanbearguedthatitisnotclearwhetherthissteadyadvancewillcontinue,buttheriskisclearly
visibleandthetrendhasbeeninplaceforoveracentury.Tobetagainstthistrendistowagerthatthe
futurewillbeverydifferent.Yet,inthefaceofthissteadytrend,peoplehavecontinuouslypredicted
that the long-term trend would taper off. Instead, the trend has stubbornly persisted (and even
acceleratedrecentlyfortheolderagegroups).Althoughtherateofimprovementisuncertain,itis
highlylikelythatimprovementswillcontinue–eveniftemporarilyside-trackedbyshockstothesystem
suchasnatural catastrophes,pandemicsorwars. Inotherwords,althoughrecentadjustments in
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Figure 1: Learning from our mistakes? UK historical projections for life expectancy at birth
Source:UKOfficeforNationalStatistics
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officialactuarialassumptionsmayhavemadelongevityriskseemunpredictableandunquantifiable,
itisperhapsratherthecasethatassumptionshavehistoricallyignoredtheevidenceratherthanthat
theriskisunquantifiable.
Inadditiontothelong-termtrend,therearealsoshort-termeffectsthatcanalterthetrendsforcertain
agegroupsforadecadeortwo.Forexample,inTheNetherlands,ifsmokingweretobebannedor
weretobesodiscouragedastocauseasignificantdropinsmokinglevels,averagelifeexpectancy
frombirthcouldbeexpectedtoincreasebybetweenoneandtwoyears,whichalonewouldrequire
anincreaseofbetween4%and8%inpensionreserves.Thiswouldshowupasanaccelerationin
long-termtrendsandisperhapspartoftheincreasethattheNetherlandshasexperiencedinthepast
fewyears.1SmokingratesintheNetherlandsremainatrelativelyelevatedlevelscomparedwithother
countries,butaredecreasing.
Source:UNpublicationWorldPopulationto2300ST/ESA/SER.A/236
Figure 2: Male and female life expectancy at birth, more developed and less developed regions
1950-2300
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Old age dependency in public plansAsthestrikesinFrancein2010demonstrated,pensionreformisseldomeasy.Nevertheless,given
thedemographicchanges,itisclearthatreformisunavoidable.Globalbirthrateshavedroppedand
peoplecontinuetolivelonger.Asfewerworkersarelefttosupportanincreasingnumberofretirees,
pressuresonthestatepensionssystem(andthewelfarestateingeneral)willincrease.
1Onthisnote,thecigarettemanufacturerPhilipMorrisannouncedin2010thepossiblelossof176jobsinitsDutchfactories,citingthedecreaseindemandforcigarettesintheNetherlands.http://nos.nl/artikel/186161-philip-morris-schrapt-banen-in-nederland.html
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Despite recent reforms aimed at opening up the pensions market, Europeans still derive most of
theirincomeinretirementfromthegovernment–morethan80%inFranceandBelgium,andalmost
three-quarters in Germany.2 Only in the United Kingdom and the Netherlands is the figure below
50%.Comparethatwith36%intheUnitedStates,wheremostpeoplerelyonincomefromprivate
retirementsavingsandthereislesspressureonthestate.InJapan,peopleonaverageworktothe
ageof69,sixyearspasttheofficialretirementage.Asfewerworkersarelefttosupportanincreasing
numberofretirees,pressuresonthestatepensionssystem(andthewelfarestate ingeneral)will
increase.
Themost immediate impactof increased longevityand fallingbirthrateswillbeuponstates that
rely heavily upon ‘pay as you go’ pension systems, such as France, Poland, Hungary and others.
France provides a good example of a country with an urgent need to reform its pension system.
TheMelbourneMercerGlobalPensionindex,compiledannuallybyMercerandtheAustraliancentre
forFinancialStudies,rankstheFrenchpensionsysteminitspresentformeleventhoutofthirteen
countriesintermsofitssustainability.Changeswillhavetobemade–andsuchchangesareseldom
popular.
Changing face of pensions – pension reformThe largedemographic shiftsof thecomingyearsand increasing longevitywill have far-reaching
consequencesacrosssocieties.Governmentsandbusinessesarealreadyrespondingbyre-examining
long-standingsystemsandpractices,lookingtoredesignthemtomeetthechallengesofthefuture.
Signsofchangearealreadyvisible,withmanygovernmentsandcompaniesactivelystartingtolook
athowtheycanempowerandencourageanolderworkforcetocontinuetoworkproductively.
Consideringthestressestoallpillarsinthepensionsystem,itisclearthatmorereformisontheway.
Alreadyseveralcountrieshaveraisedtheirretirementageandmorewillfollow.Forexample,inthe
2SeetheOECDIncome-DistributionDatabasehttp://dx.doi.org/10.1787/888932371025
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Figure 3: World total fertility and life expectancy at birth 1995-2050
Source:UNpublicationWorldPopulationto2300ST/ESA/SER.A/236
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UK,thestatepensionagehasbeenraisedto66fromApril2020(sixyearsearlierthantheprevious
governmenthadplanned),risingto68in2046. Inaddition, inordertoencouragepeopletowork
longer,theDefaultRetirementAgeintheUKisbeingremovedin2011,whichmeansthatemployees
willhavetherighttocontinuetoworkaslongastheywish.Germany,whichpossessesoneofthemost
rapidlyageingpopulationsinthedevelopedworld(seeFigure3),tookasomewhatdifferentapproach
withtheintroductionofthe‘sustainabilityfactor’forstatepensionsin2005.Thesustainabilityfactor
automaticallychangesthelevelofstatepensiondependingonanumberoffactors,includinglongevity
andthenumberofcontributorsinthesystem.Similarly,bothFinlandandPortugalhaveintroduced
explicitlinksbetweenthelevelofstatepensionandincreasesinlifeexpectancy.TheOECDrecently
estimatedthatpensionreformsinOECDcountriessincetheearly1990shavealreadyreducedfuture
benefitsonaverageby20%.3
Thesearejustafewexamplesofrecentpensionreforms,butitisclearthatstatesaroundtheworld
arelookingtofindwaystomaketheirpensionsystemssustainableanditisclearthatcompaniesand
theiremployeeswillbeaffectedbythesechanges.Asstatepensionscontinuetobereduced,people
willturntocompanyandprivatepensionstofillthegap.Inanageingworld,pensionsarebecoming
increasinglyimportant–andcompanies,likestates,needtotakestepstoensurethattheirpensions
aresustainable.
3OECD,PensionsataGlance2011.
Figure 4: Old age dependency – number of people in EU receiving pensions in relation to the
number of people of working age in 2010 and as projected for 2060
Ratio<30% Ratio30%-39% Ratio40%-49% Ratio>50%
Sources:AEGONGlobalPensions/Eurostat
2010 2060
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2 Longevity and private company pensions
The sources of pension plan riskThe fundamental underlying risk for any pension plan and its corporate sponsor is that the plan
shouldbeunabletomeetitsliabilities.Inthepast,themainpotentialcausesforsuchafailurehave
beenconsideredtobeafailureof investmentstrategy(equityriskforexample)oranunexpected
changeininterestratesandcreditspreadsthatwasnotsufficientlymatchedbyavaluationchangein
liabilities.Increasingly,however,longevityrisk–theriskthatthepensionplanhastoprovidebenefits
toitsmembersoveralongerperiodthanexpected–isbeingrecognisedasamajorthreattopension
plansandthecompaniesthatsponsorthem.
Asaruleofthumb,10%mortalityimprovementaddsoneyeartolifeexpectancy,andoneyearoflife
expectancyadds4%totherequiredvalueofapensionfund’sreserves.Thus,apensionfundwitha
fundedratioof100%willseeitsfundingratiodropto96%ifitfactorsinoneadditionalyearoflife
expectancy.
AccordingtotheUKOfficeforNationalStatistics,malelifeexpectancyatbirthintheUKhasincreased
from70.0in1976to77.9in2009.4Thisamountstoapproximatelyanadditional32%ofassetsthat
pensionplansneedtohaveavailableinordertocovertheirliabilitiesasaresultoftheincreaseinlife
expectancy.Ifthistrendpersists,itclearlyrepresentsasignificantchallengeforpensionfundsand
theirsponsors.
Apensionfundisexposedtothreesourcesoflongevity-relatedrisk:
• Thefirstsourceofriskcomesfromtheexpecteddeclineinfuturemortalityrates.Formorethan
acentury,mortalityrateshavedecreasedforallages,bothmaleandfemale.Therateofdecline
overanyonedecade,however,hasnotbeenstable.Itisthereforedifficulttoestimatewhatthe
declineinmortalityratesoverthenextdecadeswillbe.Developmentsinmedicalscience,changing
habits(likeconsumptionofalcoholorsmoking),obesity,newdiseases,climatechange,disastersor
warfaremayallaffectmortalityimprovement,positivelyornegatively.Thisiscalled‘trendrisk.’
• The second source of risk is related to the difference in mortality rates between the overall
population and the pension fund-specific population. The risk here is that the fund comprises
certaingroupsofthepopulationthatexperiencehigheror lowermortality(blueorwhitecollar
workers,forexample).Thisisalsocalled‘experienceassessmenterror’or‘levelrisk’.
• Thefinalsourceofriskcomesfromrandomfluctuations.Even if themortalityrateofacertain
individualisaccuratelyestimatedaccordingtothemodel,thispersonmayoutlivetheirpredicted
mortalityrange–purelyduetochance.Thisriskisinverselyrelatedtothenumberofparticipants,
but can still be material even for plans with thousands of participants – especially if benefits
areweightedtowardafewhighearners.Althoughthe impactofthisfinalsourceofriskcanbe
surprisinglylarge,itisoftencompletelydisregardedinplanriskassessments.
4Forthisandfurtherinformation,seehttp://www.statistics.gov.uk/STATBASE/Product.asp?vlnk=333.
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Addressing uncertainty in longevityAsaresultofthesteadyincreaseinlifeexpectancy,asignificantamountofresearchhasbeencarried
outinthepastfewyearsontheimpactofincreasinglifeexpectancyonpensionfundfinancesand
howbesttomodelchangingmortalityrates.Thereisnosinglerightanswer.Somechoosetomodel
asinglepermanent‘shock’toratesandthenensurethattheirpensionplanisabletowithstandsuch
ashock.Asuitableshockforthepurposeofmodellingfuturechangesmaybeintheorderofa20
to40%instantchangeinmortalityratesdependingonplansize.Othersmaylooktodevelopment
inothercountriestogaugewhatlongevitycouldrealisticallybecomeintheforeseeablefuture.Still
othersmaychoosetofocusmoreonspecificeventssuchasacureforcancerortheeliminationof
smoking.Allhavemeritsintheirownright.
Inorder torefinethedifferentmethods listedabove,astochastic (orprobability-weighted)model
generatesthousandsofpossiblescenarios.Thisenablesthepensionplantoviewitsprofileacrossa
universeofpossibleoutcomes,weighingeach,anddeterminingwhatthemoremajorriskstothefund
mightbe.Theadvantageofsuchaprobability-basedapproachisthatthefunditselfisspecifically
anduniquelymodelled,andallsourcesofriskareproperlyaddressed.Thedisadvantageofsuchan
approachisthatitcanbedifficulttouseinmanagementcommunicationduetoitsinherentcomplexities.
Despitethiscomplexity,thestochasticmodelprovidesthebestsolutionformodellingfutureriskdue
toitsabilitytoaddressexactlythenatureofanychangethataplanmightbeexploring.
While the reasons for mortality improvement vary and short-term mortality rate volatility can
fluctuate,therateofimprovementoverthelongertermhasbeenremarkablystable(seefigure6)as
hastherelativevolatilityaroundthattrend.Infact,mortalityhasimprovedfordecades.
Figure 5: Three sources of longevity risk for pension plans
Source:AEGON
Longevity risk for the pension plan
Riskofdecreasingmortalityrates
beyondexpectedlevelsEqualforallplans
Riskofexperienceassessmenterror Morerelevantiftheplanhasamembershipfromspecificgroups
Riskofrandomfluctuationinplan
experience
Morerelevantiftheplanlacksdiversification(smallnumbersorpronouncedbenefitdistribution)
=
+
+
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Lookingatthechartabove,youmayreasonablyask‘whythesuddenfussnow?’Ithardlyseemsa
surprisethatmortalityratescontinuetoimprove.Thefundamentalreasonsforimprovementsmay
havechangedovertime,but,viewedoverthelong-term,mortalityhasimprovedoverthepastcentury
atleastinafairlypredictablefashion.Thislog-lineartrendiswhatmostmortalityratemodelsare
basedon.
Ascanalsobeseeninfigure7,theolderagegroupshaverecentlydippedbelowthetrendline.Thisis
aconcernnotjustbecauseoftheacceleratingtrend,butalsobecauseithasamuchgreaterimpact
nowthaninthepast.Fiftyyearsago,anobligationtopayapensionatage65waslesssensitiveto
improvements(half theparticipantswouldnot livethat long).Obligationsweremuchsmallerasa
result.Now,anobligationtopayanannuitybeginningatage65isasignificantcommitment.
While mortality rates have steadily decreased for over a century, mortality improvements have
notbeenconstantovertime.Thiscanbeexplainedbydemographicfactorssuchasadecrease in
smokingratesandbetterandquickertreatmentforcardiovasculardiseases(probablyassistedbythe
developmentofthemobilephone) .5Pandemicsandextremetemperaturescanalsohavetemporary
effectsthatpersistforuptoadecadeortwo.Iftheseeffectsarecombinedinastochasticmodel(as
infigure6),differentfuturescenarioswithdifferentprobabilitiescanbeinvestigated.Eachofthese
differentscenariosmaybeworthconsideringforanygivenplan.
Longevity risk and other risksWhilemostpensionfundsrecognisetherelevanceoflongevityrisk,positioninglongevityriskwithin
apensionfundriskmanagementframeworkisnotstraightforward.Whenviewedoverthelifeofa
pensionplan,ouranalysisshowsthat longevityrisk isofasimilarmagnitudeforatypicalplanas
interestrateriskandequityrisk.
Figure 6: Dutch mortality experience – mortality rates have been largely log-linear for the past
century
Sources:CBS,AEGON
0.10%
10.00%
1.00%
Spanish flu World War II Recent accelerated mortality improvement
Smoking
1900 1920 1940 1960 1980 2000 Years
q(45-65)
q(65-80)
q(80+)
5This is one of many examples of how technology has additional, unplanned benefits. The mobile phone has helped inbringingparamedicsquicklytothesceneofacardiacarrest.Whensomeoneishavingaheartattack,thequickertheycanbeassisted,themorelikelytheyaretosurvive.Minutes–orseconds–makeadifference.
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Manypensionfundsmeasureriskonthebasisof1-yearValueatRisk(VaR):inanextremeone-year
event,howmuchwillthefundingratiochange?Whilethisisausefulmeasuretodemonstrateshort-
termsensitivities,itisinsufficientforlong-termpensionplanplanning.
Thefollowingtablelooksatplansensitivitytointerestratesversusmortalityratesintheshort-and
long-term.
Short-term Long-term
Financialmarketrisk High Low
Longevityrisk Low High
Onashort-termbasis,theimpactoflongevityonapensionfundisnevergoingtobeextremelyhigh.
Inoneyear,ourassessmentoffuturemortalityisnotlikelytochangedramatically.Evenifveryfew
planmembershavediedinasingleyearandtheactualmortalityismuchlowerthanprojected,most
planswillnotautomaticallyassumethatfuturemortalityrateswilldropatthesamerate.Longevity
riskemergesovertime.
Overthelongerterm,however,thecomparisonisdifferent.Interestratemovementsfromoneyear
tothenexttendtohavearelativelylowcorrelation.Evenifinterestratesincreaseordeclinerapidly
inoneyear,overanumberofyears,interestratechangesaremorelikelytoevenout.Infact,interest
ratesaregenerallyconsideredtobemeanreverting.6
Longevityrisk,however,isessentiallydifferentfrominterest-rateriskandequityrisk.Thirtyyears
ago,mortalityrateswereverydifferentfromtodayand30yearsfromnowtheymaylikewisebevery
differentagain.Eventhecorrelationsovertime(serialcorrelation)aroundthetrendtendtobequite
high.Inpractice,whatthismeansisthataone-yearchangeinmortalityratesismorelikelytosignal
futurechangesthanisthecaseforinterestrates.Inthisrespect,mortalityriskisadifferentcreature
andshouldbetreatedaccordingly.
Source:AEGON
Figure 7: Past and future projected mortality rates for 75-year olds (male and female)
0%
1%
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4%
5%
6%
7%
1990 1995
Observed mortality
2000 2005
75 Years
2010 2015 2020 Years
Female
Scenarios
Male
6Meanreversiondescribestheinabilityofinterestratestocontinuetoriseorfallindefinitely.Asaresult,theytendtoreverttoalong-termmeanvalue.
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Defined Contribution plans and longevity risk DCpensionplansplacetheburdenofriskentirelyontheplanparticipant.Forcompanies,DCplans
looked likeagoodsolution for reducing thecorporatesponsor’spension risk (including longevity
risk).Whilethereissometruthtothisview,itignorespotentialspill-overeffectsfrominadequaciesin
thealternativesolutions.ThepensiongapintheUKwasrecentlyestimatedtobeapproximately€370
billionorashortfallof€12,000perpersonperyear.7DCcontributionshaveremainedsignificantly
andconsistentlylowerthanDBcontributions.Overthepastcoupleofdecades,westerncivilization
hasnotbeenveryadeptatsaving.
Whilemanyoftoday’sworkersmayhavebeenplanningtoretirebetweentheagesof60and65,
thetrendtoprovideDCplansinplaceofDBplanswillprobablymeanthatworkerswillhavetowork
forlonger(andsavemore).Thisinitselfisanindirectwayofincreasingtheretirementage,leaving
workerstodecideforthemselveswhentheywillretire.Thelongeryouwork,themorecomfortable
yourretirementwillbe.Companieswillneedtobepreparedforthisshiftinemployeebehaviourand
expectations.
Longevity – a challenge and an opportunity Increasinglongevitywillnotonlyaffectpensions.Althoughitisonlypossibleheretohighlightthe
mostgeneraldevelopments,itisclearthatconsiderableeffortwillalsohavetobeputintoenabling
older workers to continue to develop and be productive. In the light of the shrinking number of
youngerworkers,thecontinuedavailabilityofolder,experiencedworkersmaybeseenasapositive
development.However,itisclearthatbothemployerandemployeeattitudesandexpectationswill
need to change. Performance management, career paths, redundancy terms and remuneration
modelswillallneedtobereviewed.
If we look at a national level, Finland provides a good example of how to approach an ageing
population. Finland carried out some groundbreaking work in the late 1990s in order to increase
theproductivityandparticipationrateofolderworkers.TheFinnishNationalProgrammeonAgeing
Workers (FINPAW)setout toaddress theverysame issues facingcompanies today.FINPAWpaid
particularattentiontoimprovingtheabilityofageingworkerstoperformtheirworkandattempted
topromotemorefavourableattitudestoolderworkers.Theprogrammepreparedthewayforthe
Finnish2005pensionreformthatdelayedtheageofretirementandadjustedthepensionsystemto
increasinglongevityrates.
As with Finland, companies need to look for new ways to make the most of an ageing workforce
– stimulating and enabling more people to stay in productive employment for longer. Already
organisations,suchastheUKEmployers’ForumonAge(EFA)areworkingtohelpemployersfindnew
waystoengageandemploytheirolderemployeesfor longer.Suchprogrammescanhelpprepare
companiesandemployeesforthechallengesandopportunitiesahead.8
7Aviva,ThePensionsGapacrossEurope2010.8Therecentcreationofthe‘GlobalCoalitiononAging’(www.globalcoalitiononaging.com)isanotherexampleofbusinesses
voluntarilycomingtogetherinordertohighlightandrealisemanyoftheopportunitiesthatageingpopulationswillbring.TheCoalition’saim is toapproachageingsocietiesnotasaproblembutasanopportunity forallofus to live longer,healthierandmoreproductivelives.
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3 Longevity solutions for pensions
Pension plans and longevity swapsOverthepastfewyears,longevityswapshavebeendevelopedasatooltohelppensionplans–and
theircorporatesponsors–toprotectthemselvesagainstlongevityrisk,oneofthemajorrisksthey
face.Inaddition,longevityswapsprovideanexcellentdiversifyingeffectonapensionfund’sportfolio
–particularlyformediumtolowriskportfolios.Byviewinglongevityswapsasaninvestment,plans
cannow‘duration’matchassetsandliabilities–notjustfromaninterestrateperspective,butalso
increasinglyfromalongevityriskperspective.
Inlookingatthebenefitsoflongevityswaps,akeyquestionthatisraisedsoonerorlaterrelatestothe
costoftheprotectionprovided.Incalculatinghowmuchaplanshouldbewillingtopayforalongevity
swap,somecompaniesmaybefacedwiththechallengeofreconcilingtheirpresentestimatesoffuture
costswiththepotential‘worstcase’scenarioagainstwhichthelongevityswapprovidesahedge.As
withmanyde-riskingsolutions,companiesarefacedwiththedecisionofwhethertotakeactionnow
ornot.Thedilemmafacedbycompaniesisthatwhende-riskingisaffordable,itisoftenviewedas
beinglessnecessary.Conversely,attimeswhentheappetiteforde-riskingincreases(typicallywhen
theriskmaterializes),itisalsolessaffordable.
Inthepresentenvironment,therearetwoelementsatplaythatmaybeleadingsomepensionfunds
toholdbackfromde-risking–therelativenewnessofthemarketinlongevityswapsandthecontrast
between the pension funds’ present best estimates of their liabilities and revised best estimate
liabilitiesbasedonnewinsightsintolongevitytrends.
Aswithallrisks,thereisatemptationtowaitandseehowthemarket–andmortalitytables–develop
(‘itmayneverhappen’).However,forcompanieswithDBpensionplans, inthelightofthepresent
demographictrendsandregulations,itisagoodideatoquantifythepotentialimpactoflongevity
risknow.This involves re-examininghowapensionplan’s liabilitiesarepresentlyevaluated.Once
thesecalculationshavebeenmade,itispossibletoaddressthede-riskingdilemmaandtofindthe
rightsolution.
Asnewregulatoryregimes(includingSolvencyIIforinsurers)will increasinglyrecognizelongevity
risk,itislikelythatmorecompanieswillstartactivelylookingtoprotecttheirpensionfunds.Atthe
sametime, insurancecompanieswithmortalityriskontheirbooks,createsomethingofa‘natural
counterparty’for longevityrisk.Manyhedgefundsarealso interested inassuming insurancerisk,
suchaslongevityrisk,aspartofadiversifiedportfolio.
Althoughitisimpossibletoprovideageneral‘onesizefitsall’priceforalongevityswap,ariskpremium
abovetherevisedbestestimatecashflows(whichareoftendifferentfromthepresentbestestimate
planvaluations)typicallyrangesbetween4%and7%forapensioner-basedportfolio.Formostplans,
thiscanbeseenasafixedcostincreaseinorderprovidecompleteprotectionagainstaworstcase
longevitylossofbetween10%and30%oftheplanvalue.Notonlydotheplansprotectthemselves
against thisworst-case(andpotentiallyunaffordable)risk,but,by implementinga longevityswap,
theycanalsocreateanimprovedasset-liabilitymatchedportfolio.Thisimprovedportfoliocanenable
themtore-allocatetheriskintootherassetclasses,potentiallyallowingthemtorecapturemorethan
theriskpremiumpaid.
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Ultimately, the decision to de-risk will depend on both the plan’s and sponsor’s risk appetite. The
choice is not between the two extremes of no hedge versus a full hedge. Rather, the choice is
wherethecompanywantstobe(orcanaffordtobe)ontheriskspectrum.Mostplanshaveactively
addressedtheissueofequityandinterestraterisk.Thoseplansshouldnowincludelongevityriskin
theirdeliberations.
Pricing – and measuring – longevity riskWith a longevity swap, a variable stream of cash flows is exchanged for a fixed stream of cash
flows.Whenpricingalongevityswap,bothpartiesneedtoagreeonthefixedsetofcashflows.This
representsthepriceandincludesariskpremium(figure8).
At present, most pension funds generate mortality assumptions upon which they base their best
estimate projection of future cash flows. However, these projections often trail improvements in
actualmortalityrates,whichresultsinthemunderestimatingfutureliabilities.Althoughthis‘liability
gap’needstobebridged,itshouldnotbeviewedaspartofthecostofthede-riskingsolutionitself
butratherasanecessarycostadjustmentinrecognitionofthenewbestestimateoffutureliabilities.
Totheextentthatsuchagapisobserved,itsimplyrepresentstheexpectedadjustmentsthatthenext
actuarialupdateswillreflect.
Althoughdeterministicmodelscanassistapensionfundtoreachabestestimateoftheirfuturecash
flows,theydonotprovideapictureofthemeasureofriskaroundthenumbers.Forthisreason,in
pricingalongevityswap,stochastic(orprobability-based)modelsofmortalityratesmaybeused.A
stochasticmodelenablesthebestestimatecashflowsandtherelatedlongevityrisktobecalculated,
takingintoaccountallsourcesofriskaswellasconsideringthelateststatisticaldataforthespecific
countryorregioninvolved,andincludingplan-specificmortalityexperiencewithoutbeingspecifically
constrainedtoagivenmortalitytable.
Figure 8: Typical plan view of pricing: current best estimate versus revised best estimate and
the fixed cash flow level. Note that the fixed cash flow level may be more front-loaded in some
structures
Source:AEGON
0
10,000
20,000
30,000
40,000
Ca
sh F
low
(in
Th
ou
san
ds)
Time (in years)
50,000
60,000
70,000
80,000
90,000
100,000
1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91
Current Cash Flow Projection
Best Estimate Cash Flows
Best Estimate + Risk Premium
13
Index swaps versus indemnity swapsTherearetwomaintypesoflongevityswaps:index-basedandindemnity-basedswaps.9Inprinciple,
index-basedswapstietheswappaymenttoaspecificcountryorsegmentmortalityindex,whilean
indemnity swap covers the actual plan experience. The two types can be compared according to
effectivenessandcost.Theeffectivenessofanindexswapdependsonthepensionplan’sperformance
relativetothechosenindex.Anindexswapintroducesanelementofbasisrisk,asthebasisofthe
plannecessarilydiffersfromthatoftheindex.Thecloserthetwoare,thebettertheindexhedge.
Indemnityswapsintroducenobasisriskastheyindemnifytheplanforactualexperience.
Whilean indexswapmayseem likeasimplesolution, it requiresacomplexstrategy tocreatean
adequatehedgeforthefund(andeventhenitwillnotprovideacompletehedge).IntheUKmarket,
whereseveraltransactionshavetakenplace,therehavebeenonlyafewexamplesofapensionplan
indexhedge.10Themarketappearstohaverecognizedthatthecurrentrisk/rewardtrade-offofan
indemnity-basedswapissuperiorformostplans.
Indemnity-basedswapsarecash-flowbased,providingfullindemnityfortheplan.Forexample,using
anindemnity-basedswap,thepensionplanwouldpaytheproviderfixedcashflowsandtheprovider
would pay the plan floating cash flows. The fixed cash flows are based on accrued benefits only.
No futureaccrualsand indexationsare included,although theycouldbecoveredby futureswaps
arrangements.Theproviderprojectsthecashflowsbasedonthecurrentparticipantsandaddsa
riskpremium. Incomparisonwithanindex-basedswap,suchanarrangement ismorecomplicated
toimplementandadminister,butprovidesgreatervalueforapensionplanthansimplerindex-based
swaps.
Thepricingof indemnity-basedtransactionsand index-basedtransactions inthemarketpresently
appeartobesimilar.Thereasonforthisisthatforafullydiversifiedpooloflives(suchasaninsurer’s
portfolio)itdoesn’tmakeasignificantdifferencehowtheriskisassumed.Ifyoulookatthemarginal
volatilitythataninsurerexperiencesfromthetransaction,itismoresimilartopopulationvolatility.
However, from the pension plan’s perspective, an indemnity swap is more valuable as it matches
existingvolatilitybetter.So,ingeneral,itismorebeneficialforapensionfundtocarryoutanindemnity
swapbecauseitcoversallrisks,includingbasisrisk,forasimilarpricetoanindex-basedswap.
9 Inthispaper,ourdiscussionfocusesonq-forwardindexswaps,wheretheindexusedisamortalityrateforaspecificagegroupataspecifictimeinthefuture.
10In2010,PallUK’spensionfundenteredintoa10-yearindexswap.
14
IndemnitySwaps IndexSwaps
Pricing Morecomplex
Involvesfund-specific
mortalityratesaswellas
conversiontocashflows
Straightforward
Onlyinvolvesassessingriskof
chosenindexmortalityrates
Hedgingstrategy Straightforward
Asingleswaphedgesall
relevantrisk
Morecomplex
Findingtherightcombinationof
indexswapsisnottrivialandwill
neverbeperfect
Effectiveness Complete
Coversalllevelsofmortality
risk
Partial
Coversnationwideriskonlyand
ignoresfund-specificrisk
Figure 9: Scatter diagram of scenarios showing the sum of cash flows with and without an
index hedge in place. Even though using the hedge narrows the distribution of total cash
flow, reflecting the risk-reducing effect of the hedge, there is still significant residual risk. In
addition, as the hedge comes at a certain cost, there is no single scenario where the outcome
with the hedge is more favourable than the outcome without a hedge, as demonstrated by the
fact that all the points are above the diagonal. Even if priced more attractively (which would
cause a shift downward in the scatter ‘cloud’), the slope of the scatter makes it difficult for the
q-forward to come out ahead in all but a few scenarios.
Source:AEGON
Without
With
Table 1: Comparison between indemnity and index swaps
Source:AEGON
Table 1 demonstrates the relative ineffectiveness of an index swap. The scatter represents the
outcomesofscenariosimulation,wherethex-axisvalueisthepresentvalueofcashflowswithout
theswapandthey-axisthepresentvalueofcashflowsoftheportfoliowiththeswap.Thescatter
showshowthedistributionalongthey-axisisnotaswideasalongthex-axis–theindexswaphashad
adampeningeffect.
15
However,itisalsoclearthatsignificantresidualbasisriskremains.11Theswapalsocomesataprice,
reflectedinthefactthatthescatterishigherthanthediagonal.Inthecaseoftheindexswap,the
two factors togetherdonotcreateagoodoutcome for the fund: forno single scenariodoes the
swapactuallycreateabetterresult.Thescatter isalwayshigherthanthediagonal.Evenifpriced
moreattractively(whichwouldcauseashiftdownwardinthescatter‘cloud’),theslopeofthescatter
makesitdifficultfortheq-forwardtocomeoutaheadinallbutafewscenarios.Thisisanexampleof
basisrisk.Intheend,althoughthebasisriskmaybemanageable,itisvitalthattheplanunderstands
thatithasassumedbasisriskbyenteringintothetrade.
Theindemnityswap,incontrast,performssignificantlybetter(figure10).Thereisnoresidualriskand
thescattersareallonastraightline.Andinthecaseofextremeevents,theindemnityswapprovides
theprotectionitwasdesignedtoprovide.Itisalsoclearthatanydownwardchangeinprice(vertical
shiftoftheline)directlymovesfurtherintoawinningoutcomefortheplan.
Finally,thepriceforthetwodifferenttypesofswapsispresentlysimilar.Whileindexswapsmaybe
thought tohave thepotential tobecomemore liquid, ifasecondarymarketwere todevelop,and
arguablyshouldtradeatalowerprice,thisisatheoreticalphenomenononly.Itisclearthatindex
swapshaveabetterchanceofdevelopingintoaliquidsecondarymarket,butcurrently,themarketfor
longevityswapsdoesnotexistandindexswapsaregenerallypricedatthesamelevelasindemnity
swaps.Inaddition,liquiditycanbeseenquitesimplyastheabilitytoexitthetransaction–andthis
possibilitycaneasilybestructuredintoanindemnityswap.
11Indexswapsalsocontainonemorerisk:re-investmentrisk.Theindexswapcoversthefactthattheindexhaschangedoveracertainperiod,butdoesnotcovertheriskofhavingtobuyanewindexswap,whichmaybemoreexpensiveduetothechangedindex.
Figure 10: Scatter diagram of scenarios showing the total sum of cash flows with and without
an indemnity hedge. With the indemnity hedge in place there is complete certainty over the
total sum of cash flows that the fund is going to have to pay, reflected in the straight line.
The hedge comes at a cost, but for the extremely negative scenarios, where the sum of cash
flows is high, using the hedge results in a more favourable result for the fund. The fund has
effectively locked in a sum of cash flows and bought protection against adverse scenarios.
Without
With
Source:AEGON
16
Remove investment risk
Rem
ove
lon
gev
ity
risk
Longevity Swap
Protectbalancesheet
Derisking solutions
Inflation overlayInterest overlayOpen DB Plan
Buyout
Buy-in
Controlling pension riskLongevityriskisoneofseveralrisksfacedbycompanypensionsand,assuch,shouldnotbeaddressed
inisolation.Thefirststeptocontrollingpensionriskistoidentifywhichpensionrisksarepresent.
And–asdifferentcompanieswillhavedifferenttoleranceforrisk–itisimportanttoaddressallthe
risksandidentifywhichneedtoberemovedorcontrolled.Somecompaniesmaywishtoremoveall
riskinordertobeabletoconcentrateontheircorebusiness.Othersmaywishtotakesomeriskbut
toremoveinflation,interestorlongevityrisks.Inmanagingpensionrisk,companiescanchoosefrom
arangeofde-riskingtoolsincluding:
• Liability-DrivenInvestment(LDI)–LDIallowsapensionfundtomanageunwantedinterest,inflation
andotherassetrisksbybettermatchingliabilitieswithassets.
• Longevityswaps–Asdiscussedabove,longevityswapsenablepensionfundstoprotectthemselves
againsttheriskthattheiremployeeswilllivelongerthanpreviouslyestimated.Longevityswaps
allowcompaniestoreducethevolatilityoftheirpensionplans.
• Pensionbuy-ins–Buy-insare insurancepolicies thatareregardedasaseparateassetclasson
thepensionfundbalancesheet.Theycanbeimplementedbycompanieswithpensionfundsthat
arenotfullyfundedandenablecompaniestousetheiravailableresourcesinthemosteffective
fashion.Theydifferfromlongevityswapsmainlyinthefactthataformofassetriskispartofthe
transaction.
• Pensionbuy-outs–Pensionbuy-outsremoveallpensionrisksbyenablingacompanytocompletely
transfertheaccruedpensionliabilitiesofadefinedbenefitplantoanotherproviderinreturnfora
premium.Anumberofsolutionshavebeendeveloped,includingphasedbuy-outs(whereliabilities
aretransferredinagreedstages).
Byusingacombinationofthedifferentsolutionsavailable,companiescande-risktheirpensionsin
stages,bycountryorbyplan,reducingriskovertime.Althougharelativelyrecentadditiontothe
de-riskingtoolkit,longevityswapsperformanimportantfunctioninreducingvolatilityandprotecting
againstextremeevents.
Figure 11: The spectrum of de-risking solutions
Source:AEGON
17
4 Hedging your longevity risk: one step at a timeThedecisionprocessinvolvedinhedgingthelongevityriskofyourpensionfundcanbelengthy,and
involvesmanydifferentpartiesandstakeholders.Itishelpfulthereforetoknowinadvancehowto
approachthedecision-makingprocessandwhattheimplementationoflongevityswapsmayentail.
Thefollowingguidelinesaredesignedtosupportthesponsoringcompanyinimplementingasuitable
decision-makingprocess.
GUIDELINE 1: START PREPAREDAlthough longevity risk is not new, only recently has the importance of this risk become fully
understood. Before the process of de-risking is started, the main team involved in driving the
de-riskingprocesswillneedtounderstandthemechanicsoflongevityriskandtheimpactithason
thepensionplan.
GUIDELINE 2: DETERMINE YOUR OBJECTIVEHedginglongevityriskcanbepartofawiderderiskingstrategy,orafirststeptoafullbuyout,or
both.Thelongevityswapcontractneedstobeflexibleenoughtosupportanyfutureplans.Yourlong-
termstrategy,andthepartthatthelongevityhedgewillplayinit,shouldthereforebeclearbefore
youstartdiscussinghedgingoptions.
GUIDELINE 3: REVIEW DATAExperienceshows that longevity swapsarevery sensitive todataaccuracy. Implementinga swap
requiresup-to-dateandaccuratedataonyourpensionplananditsparticipants.Reviewingyourplan
datamaybeofbenefittoyourplaninanycase.
GUIDELINE 4: ESTABLISH INTERNAL SUPPORT FOR A LONGEVITY SWAPIn order to be able to progress with a longevity swap, it is essential to have the support and
understandingofthekeystakeholders.
GUIDELINE 5: LOOK AGAIN AT THE VALUATION Beforeyourequestaquoteforalongevityswap,itisadvisabletoreviewthemortalityassumptions
underlyingyourcurrentvaluationofliabilitiesinthefund.Akeyelementinimplementinglongevity
swaps isreachingagreementonthebestestimateoffuturecashflows,which involvescomparing
respectiveviews.
GUIDELINE 6: THE LOWEST QUOTE IS NOT ALWAYS THE BESTPriceisoneofthemainpointsofnegotiationwhenagreeingonalongevityswap.However,asacontract
canlastfor50yearsormore,itisveryimportanttohaveatrustworthy,professionalcounterparty
thatcanallowfortheflexibility inthecontractthat isnecessarytomeetyourfuturegoals.So, in
additiontocomparingprices,comparingprovidersandunderlyingstructuresisanimportantpartof
theselectionprocess.
GUIDELINE 7: SPECIFY YOUR NEEDSOncethepriceisestablishedandyouhaveafoundaflexible,trustworthycounterparty,youwillneed
tocreateacontractthatsuitsyourneeds,nowandforthefuture.Dependingonyourstrategicgoals,
flexibilitymayberequiredsoastobeabletounwindthelongevityswaportransferitintoabuyout
contractatalaterdate.Exitclauses,valuationsandcollateralagreementswillallneedtobeagreed
uponbeforeacontractcanbesigned.
18
5 ConclusionPensionsystemsareunderstress.Eachpillarofthesesystems–public,companyandprivate–hasits
owncharacteristicsandchallenges,butthecurrentpressuresareone-directional.Theinabilityofany
onepillartoaddressthechallengesitfaceswillhaveanimpactontheotherpillars.Forcompanies,
therefore,itisimportanttoconsiderpublicandsocialtrendsevenastheyaddresstheirownpension
risks.
Longevitylookssettocontinuetoimproveinthesamewaythatithasfordecades.12Forthisreason,
pensionplansandtheircompanysponsorsneedtolookatprotectingthemselvesagainstlongevity
risk.Althoughlongevityriskmaybeviewedasarelativelynewphenomenon,therearenowanumber
ofde-riskingsolutionsavailable,andboththemarketandtechnologyhaveevolvedsufficientlyfor
companiesandpensionplanstobeabletoaddressthelongevityriskontheirbalancesheets.
Inaddressing longevity risk,companieswillfirstneed to revisit thebestestimatesof their future
pension liabilities and the risk around those estimates. This can be done through studying plan
mortality development relative to underlying actuarial assumptions and using a stochastic plan-
specificmodel.Thisexercisealonemayhelpthesponsortoidentifyapotentialliabilitygapthatneeds
tobefilled.Onlyonceacompanyorpensionplanhasagoodpictureofitsfuturepensionliabilities,
is it possible to address the costs and benefits of protecting the plan from further longevity risk
throughalongevityswap.Althoughthetrendforlongerlifeisstillheadingresolutelyupwards,there
isneverthelessuncertaintyaroundthetrend,andthepensionplanandthecompanysponsorhaveto
judgewhethertheyarewillingtopayariskpremiumofbetweenapproximately4%and7%toprotect
againstapossiblecostofbetween10%and30%oftheplanvalue.
Inorder toprotect themselves against longevity risk, companiesmayprefer to look at indemnity
hedgesratherthanindexhedges,asindexhedgesofferonlypartialprotectionandintroducebasis
risk.Inaddition,thepricingofthetwotypesofhedgesarecurrentlysimilar.Indemnityswapsprovide
betterprotectionand,althoughtheyarenottradable,theyarereversible.
Increasinglongevityisnotonlyanissueforcompanypensions.Intheend,allstakeholders(government,
companiesandindividuals)needtoaddressthechallengeofpeoplelivingforlonger.Preparationsare
alreadybeingmadetohelpkeepmorepeopleactiveandworkingforlonger,andwecanexpectto
seemanymoredevelopmentsonthisfrontoverthecomingyears.Therepercussionsofthisdramatic
successstorywillhaveanenormouseffectonoursocieties.Butthebenefitsoflongerlifealsopose
arisk,andthisiswherecompaniesneedtostarttakingactionnow.Thetimehascometolookagain
atlongevityriskandtoinvestigatehowbesttoprotectagainstit.
12Somepeopleareevensuggestingthatsciencewillenableustoextendourlifespanradicallyfurther.TheCambridge-basedSENS(StrategiesforEngineeredNegligibleSenescence)Foundationundertheleadershipof itsChiefScientificOfficer,AubreydeGreyaimstoachieve‘healthylifespanwithoutlimit.’
19
Additional bibliography
Further AEGON articles on longevity and longevity swaps
‘A Dutch Perspective on longevity swaps’:http://www.aegonglobalpensions.com/Documents/aegon-
global-pensions-com/Publications/Events/2010/2010-A-Dutch-Perspective-on-longevity-swaps-The-
indemnity-based-swap-and-other-solutions.pdf
‘Why longevity swaps should also be viewed as an investment’:http://www.aegonglobalpensions.
com/Documents/aegon-global-pensions-com/Publications/Newsletter-archive/2010-Q1/2010-Why-
longevity-swaps-should-also-be-viewed-as-an-investment.pdf
‘A Practical View on Longevity Swaps’: http://www.aegonglobalpensions.com/Documents/aegon-
global-pensions-com/Publications/Events/2009/A%20Practical%20View%20on%20Longevity%20
Swaps%20-%20Netspar%20Dec%202nd%202009.pdf
‘Longevity Modeling and Longevity Protection’: http://www.actuariaatcongres.nl/presentaties/
Sylvain%20de%20Crom.pdf
‘PP Show 2010 – Longevity swaps hedges risk while retaining asset flexibility’: http://www.
professionalpensions.com/professional-pensions/news/1898635/longevity-swaps-hedges-risk-
retaining-asset-flexibility
‘Longevity Risk – Source and Mitigation’:http://www.actuariaatcongres.nl/pdf/Artikel%20Chris%20
Madsen.pdf
‘Fresh approaches to longevity risks’: http://www.aegonglobalpensions.com/Documents/aegon-
global-pensions-com/Publications/Events/2010/2010-Presentation-Andrew-Ward-and-Chris-
Madsen.pdf
Acknowledgements
Theauthorswouldliketothankthefollowingpeoplefortheirvaluedinputandinsight:JeroenBogers;
SylvaindeCrom;UgoHofman;FransvanderHorst;ThurstanRobinson;andAndrewWood.
20
Contact details
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AEGON,April2011