Socioeconomic differentials in mortality: implications on index-based longevity hedges

In this paper, we address the mortality modeling needs for pension plan sponsors who wish to use index-based solutions to mitigate their longevity risk exposures. Specifically, we propose the three-way Li-Lee (TWLL) model, which enforces a certain extent of coherence between the population to which the index-based hedging instrument is linked and the population of pension plan members, and at the same time incorporates the empirical fact that mortality improvement rates of different socioeconomic subgroups in the pension plan are persistently different. We further develop a delta longevity hedging strategy that is compatible with the TWLL model. With the aid of real mortality data, we demonstrate that if persistent socioeconomic differentials in mortality improvement rates exist but are not considered in an index-based longevity hedge, the performance of the hedge could be compromised, and the extent of underperformance would depend on the distributions of pension plan members and pension amounts across different socioeconomic subgroups. This problem can be alleviated if the longevity hedge is calibrated on the basis of the TWLL model.