Marek Handzel asks whether hedging longevity is a beneficial process for pension schemes

If the number crunchers at the Office for National Statistics have got their maths right, then UK life expectancy has risen by about 10 years over a 40-year period, a trend that looks set to continue its upward trajectory, given continued medical advances and state-driven lifestyle improvement.

This may be good news for retirement homes and manufacturers of beige coloured clothing, but it leaves defined benefit (DB) schemes staring at a potential ticking time bomb.

Consequently, a number of schemes have washed their hands of their longevity risk with a variety of high profile longevity swap deals.

At first glance, a longevity swap looks like a sensible contract. A pension fund pays a fixed stream of cashflows to an insurer or investment bank, based on agreed mortality rates for its membership profile. In return, the insurer or bank makes payments based on actual mortality levels, protecting the scheme from any unanticipated increases in longevity.

The problem that UK pension schemes face when it comes to addressing rising long-term benefit costs, is not so much how to do so, but whether or not the effort and cost of doing so is worth it. Contracts can be cumbersome to execute, and expensive. Premiums for longevity deals can run as high as 7 per cent of a scheme’s liabilities. With trustees facing other, more immediate risks, longevity can take a backseat.

Rothesay Life co-head of the business development team Guy Freeman suggests that pension scheme trustees should consider four areas when looking at hedging longevity risk through a swap arrangement.

To start with, they need to decide on how much of a priority it is. Then they need to make sure that the longevity swap provides sufficiently comprehensive cover; followed by making sure that they and the sponsor are fully aware of what risk removal they are paying for. Finally, trustees need to know that they can still fully buyout and wind-up the scheme in the future.

In many cases, examining the first point negates the following three, says Freeman.

“Pension schemes tend to address longevity risk after they have removed other risks, by moving out of equities into fixed income and matching cash flows. It tends not to make sense for schemes to insure longevity risk when they’re still running a lot of equity, interest rate or inflation risk.”

As Quantum Advisory partner Rhidian Williams points out, these other risks can have a much more immediate impact on funding positions.

“If you get a 1 per cent reduction in interest rates and everything else is unchanged, then the scheme could see a 25 per cent increase in their liabilities, a hugely painful position,” he says. In contrast, an increase of one year in life expectancy would not have the same damaging effect on liabilities, perhaps forcing a 3 per cent rise in value.

But some schemes have taken a longer-term view – and they don’t like what they see.

“Some sponsors and trustees will say ‘we want to look at the big picture’. We want to make sure we have enough money in the kitty to pay all the benefits,” says Aon Hewitt managing principal Martin Bird.

“So in that context, although longevity is not going to hit overnight, over the term of the liabilities, it could have the most scope for causing a problem.”

In that context says Bird, entering into a longevity swap may well prove to be a de-risking deal that gives a scheme the “most bang for its buck”.

Growing recognition of the security that longevity swaps offer has led to some recent deals, following a quiet period for the market. Most recently, it was announced in late May that the Akzo Nobel (CPS) Pension Scheme had agreed a £1.4bn transaction with the insurance company Swiss Re to hedge the longevity risk for 17,000 pensioner members.

However, the number of schemes that have carried out such longevity swaps has barely reached double figures. And they all share a common characteristic – they are very large.

A small problem
This is hardly surprising. Larger schemes are better able to hedge longevity, since they can afford products that are designed to fit their own membership profile. The only avenue available to smaller schemes, says J.P. Morgan Asset Management European head of strategy Paul Sweeting, is to rely on generic index products, which may not be suitable anyway, as smaller schemes are more likely to have additional volatility in their mortality experience.

Pension Corporation co-head of business origination Jay Shah says that the complexity of longevity swaps can also be off-putting for smaller schemes.

“We do longevity swaps on our own business and we have a team of people who just spend their time managing that relationship. For a small scheme with no in-house longevity expertise it’s an overhead,” he says.

The various elements that need to be considered can also result in a deal becoming a long drawn-out process. These include concerns about the strength of counterparties, and data risk.

“There is a risk that the schedule describing the benefits covered by the contract does not match the benefits which the trustees actually have to provide under the scheme,” says law firm DLA Piper partner Matthew Swynnerton.

“This risk is likely to be borne by the trustees. There is likely to be a data cleanse exercise following completion, however it will be important for the trustees to ensure that the benefit specification is accurate,” he adds.

Although swaps are beyond the reach of many schemes at present, Swynnerton sees this changing, particularly as documentation becomes more standardised.
“It could be similar to what has happened to LDI. That used to be just for larger schemes but is now available to smaller ones too.”

Index-based solutions are likely to improve as well, for those who cannot afford bespoke deals. It is currently possible to buy some general insurance against rising longevity based on average life expectancy rates, but Williams sees that going further.

“There is the possibility of the market offering a more bespoke index, so rather than a general UK index, one that is more geographical or industry based,” he says.

Further risks
Nevertheless, barriers to entry remain, for schemes of all shapes and sizes. For example, longevity swaps typically only cover pensioners, leading Freeman to ask how comprehensive they really are.

“The longevity risk associated with deferreds is largely unhedged and that can be risky as there is more time and therefore opportunity for life expectancy to change for deferreds in the future,” he says.

Concerns also remain as to whether a longevity deal will fit in with a buy-in or buyout.

“There are all the practical issues of whether an insurer would accept taking a longevity swap over in a deal on the same terms that the scheme has signed up to,” says Shah. “Is it with a bank rather than another insurance company? Does the insurer have exposure to that bank in terms of other swaps, which would hit its counterparty limit?”

Bird, however, argues that at some point most schemes are going to annuitise and dismisses such concerns.

“There’s no trustee that will sign up to a contract on a 50-year longevity swap that doesn’t allow them to annuitise in, say, 15 years. Every offering has provisions for transferring a swap to a provider,” he says.

Just annuitise…
To achieve real peace of mind, however, and remove all risk, including longevity, trustees have to buyout, claims Freeman, saying that there is no combination of instruments that can provide a scheme with cover that is as comprehensive.

“The annuity brings protections not available through combining other instruments. All risks are taken away when a pension scheme passes its obligations to an insurance company,” he says.

Trustees, he adds, should consider what risks they are removing in a longevity swap and the cost of that risk removal when compared with the overall cost of an annuity.

Written by Marek Handzel, a freelance journalist

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