Concerns that trustees may rush in to buy longevity swaps without careful consideration have been raised following Babcock International Group's decision to insure the longevity risk of their pension schemes' members.

Trustee GAAPS, a trustee search and selection firm, is concerned that trustees may neglect to consider the price they are paying for these swaps, and the covenant strength of the counterparty to that swap. "Trustees will need to scrutinise pricing of these swaps very carefully," explained David Johnson, consulting director at Trustee GAAPS. "The problem with longevity swaps is that there are very few natural end users that would want to take the other side of that swap.

"There are just a few big organisations that actually want to increase their exposure to longevity. If there are very few natural buyers for your risk then you are going to have to pay a lot to get that risk off your hands."

Johnson said a small market will not necessarily allow for a sense of "sensible price".
When it comes to the issue of covenant strength, Johnson warned that the financial strength of the counterparty that takes on the longevity risk must be a sound one.

"There is no point in swapping the respectable covenant of the pension scheme's corporate sponsor with the covenant of an investment bank's special purpose vehicle if that vehicle is not well capitalised." However, it is likely that longevity will move up trustees' agendas over the coming years, and so trustees should be open to new solutions. "As defined benefit pension funds cut off new membership and are left with an ever bigger rump of retirees they are going to find improved longevity a bigger drag," he added.

Financial consultants have voiced their belief that the longevity swap market will grow, with Hewitt Associates predicting that it will exceed £5bn. "We expect to see a surge of interest in completing longevity swap deals now that the "first mover" barrier has been taken down," commented Martin Bird, longevity solutions lead at Hewitt. "As a result, I would expect a minimum of six deals over the next year, initially focusing on the larger end of the market, leading to its expansion to a value of over £5bn."

Punter Southall's Matthew Furniss, senior consultant, added: "This is a welcome move in the journey for schemes looking to remove risk. However, most of the longevity risk within schemes relates to non-pensioners where few products are currently available and so each scheme must consider whether the cost is worth it for the risk reduction achieved."

- Pensions Age May 2009

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