Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

Could green investments help hedge longevity risk?

When it comes to ESG investing, a key question for investors is not only if it makes the world a better place, but whether it also improves risk-adjusted returns.

Analysis on the latter usually focusses on risk in an absolute sense. However, as part of the solutions team, I tend to be more interested in performance relative to liabilities. In some cases these are very explicit (e.g. in the case of defined benefit pension schemes) but in other cases they are more implicit (e.g. in the case of defined contribution schemes and retail investors).

A key component of liability risk is longevity risk i.e. the possibility of living longer than expected, so needing a larger fund to support retirement. Some very interesting research from Club Vita caught my eye, titled “How climate change might affect UK longevity”. They consider three broad scenarios, summarised in the table below:  

Scenario

Description

Typical impact on DB liabilities

Head in the sand

A range of disastrous outcomes result from a lack of response to resource and environmental risk. Amongst other consequences, there are food shortages and frequent flu epidemics due to more severe temperature fluctuations

-12%

Challenging times

There is some adaptation but it’s slow and not enough

-4%

Green revolution

A positive transformation occurs, including switches to greener energy sources

+5%

These scenarios can also be linked to investment returns. LGIM and Baringa have recently created a bespoke model that can construct energy scenarios.

An interesting observation arises from this. Plausibly, tilting towards green companies could help hedge longevity risk, given they are likely to perform well under positive transformation scenarios which are also those scenarios in which people are likely to live longer.

Of course any correlation to longevity will be far from perfect - assets might not have quite the sensitivity we expect. But they could act as a proxy longevity hedge to some degree, giving green investment an edge for consideration in portfolios even for investors sceptical of them from other perspectives.

We’re currently working on some ideas to incorporate the influence of climate change on asset class returns and longevity in a stochastic way (looking at thousands of scenarios rather than just three), which will give a more nuanced picture than our illustration and help us explore other interesting questions in this area. Watch this space for more on this, as well as work alongside our colleague Rob Pace on other strategies investors could adopt to help protect themselves against longevity risk.