Index-Based Longevity Risk Hedging Using the M7-M5 Model: Analysis on the Japanese Public Pension System

Abstract

Recent developments in health science and improvement in quality of life have rapidly increased human life expectancy. For pension funds, this gives rise to longevity risk—the risk that people live longer than expected. Especially, due to Japan’s aging demographics and pension system, its public pension faces significant longevity risk. As a potential capital markets solution to hedge this risk, I propose the us- age of index-based q-forwards which provides transparency and standardization to investors. To examine the validity of this hedge, first, I utilize the M7-M5 model proposed by Haberman (2014) and model the mortality dynamics of Japanese males by using US males as the reference population. Secondly, I evaluate the Hedge Effectiveness of static and dynamic delta hedge strategies and its sensitivities to different parameters. Next, I examine the model risks for the strategy. Despite the presence of longevity basis risk, the dynamic delta hedging strategy provides an effective hedge to short-term longevity risk and is fairly robust to model risks—and proves its theoretical effectiveness as a hedge. Finally, given these results, I provide next steps for practitioners in Japan.