longevity risk
We usually think of dying early as the danger insurance protects against. But for someone living off savings, the opposite is just as frightening: living much longer than planned and running out of money. Longevity risk is exactly this — the risk that people, individually or in a group, live longer than assumed, so income or assets must stretch further than expected.
It comes in two flavours. For an individual, longevity risk is the personal danger of outliving your nest egg — you cannot know your own lifespan, so any drawdown plan might run dry. For an institution (a pension fund or annuity insurer), it is the aggregate risk that the whole group lives longer than the mortality table predicted, because life expectancy has risen steadily and unpredictably over the past century. Even a small underestimate matters: if pensioners on average live one year longer than assumed, a pension fund may owe several percent more than it reserved. Crucially, this is a systematic risk — it cannot be diversified away by pooling more people, because everyone tends to live longer together when medicine improves.
Longevity risk is one of the defining challenges of modern actuarial work in pensions and annuities, and it is why mortality-improvement projections are built into valuations and why a market exists for hedging it (longevity swaps, longevity bonds, and bulk annuity buy-ins where an insurer takes on the risk). The honest caveat: do not confuse longevity risk with ordinary mortality randomness. The chance any one person dies early is poolable and diversifiable; the chance that everyone collectively lives longer than the table assumed is not — and that trend risk is the harder, scarier one.
A pension fund prices its liabilities assuming members live to an average of 86. Thanks to medical advances, the cohort actually averages 89. Three extra years of payments per person, multiplied across thousands of members, can turn a fully funded plan into one with a sizeable deficit — and crucially, hiring more members would not have helped, because the whole group lived longer together.
The risk of living 'too long' — systematic, not diversifiable, and central to pensions and annuities.
Longevity (trend) risk is not the same as individual mortality risk. Pooling more lives diversifies the chance any one person dies early, but it cannot diversify away everyone living longer at once.