27 July 2009

Published in: Longevity - mortality

Allure of longevity swaps grows for pension plans

Competition between insurance and capital market providers of longevity solutions for pension plans will drive further innovation and possibly pricing, explains Jerome Melcer.

A longevity hedge allows a pension plan to remove the risk that members live longer than expected but, unlike a buyout or buy-in, there is no transfer of the underlying assets and the associated investment risks.

There is an established UK and overseas market for the transfer of longevity risk between financial institutions. Interest from UK pension plans has lagged behind the institutional market, but has been building up steadily over the last 12 months, culminating in May 2009 when Babcock International announced that an agreement had been reached in principle for two of the group's pension plans to enter into a bespoke longevity hedge - the first UK pension plans to do so. With "proof of concept" established, the market is now showing signs of developing strongly - for example, the £1.9bn pension risk transfer recently struck by RSA Insurance Group with Goldman Sachs for two of its own pension schemes included a longevity hedge.

When is longevity hedging most attractive? While many pension plans have considered pensioner buy-ins, longevity hedging can be an attractive alternative de-risking option for larger plans where:

• there is an appetite to retain investment control and gain exposure to future return on the underlying assets;
• there is a desire to reduce counter-party risk, for example with a single insurance company;
• a buy-in or buy-out is difficult to execute, for example due to a shortfall in pension plan funding, difficult investment market conditions, or where pension liabilities are very large; or
• there is a preference to deal separately with longevity and investment risk within the pension plan.

Longevity pricing: are we there yet?

As with the buy-out market, pricing is likely to be the main driver of growth. Pension plans typically evaluate longevity pricing compared to:

• the expected longevity of plan members built into the trustees' funding reserve; and
• the cost of a buy-in -- the main alternative for a pension plan seeking to transfer longevity risk.

We have seen longevity pricing become more competitive on both measures, in recent months, as providers seek to kick-start the market. The analysis below explores this in more detail.

Expected longevity of plan members

The last decade has seen pension plans move toward ever-higher longevity allowances, driven by unfolding experience and new research. The chart below shows the impact for a typical pension plan over the last three valuation cycles, compared with actual longevity swap pricing today.

Any increase to a pension plan's funding reserve from taking out a longevity swap can generally be spread over a number of years, so the actual cash cost is usually modest.

DIY buy-out: longevity hedging versus pensioner buy-in

Pension plans can now create their own "DIY buy-out" strategies by hedging individual risks separately within the pension plan - but how do you compare this with a pensioner buy-in? One of the best comparisons is to calculate the "break-even" investment return that needs to be achieved on the asset portfolio underlying the longevity hedge in order to "beat" the pensioner buy-in price.

The following chart shows how this breakeven investment return has fallen significantly since autumn 2008. In this case, the underlying assets would have needed to earn 5.5% pa in autumn 2008, but this had reduced to 3.7% pa by spring 2009. In practice the actual break-even investment return will vary according to financial conditions and plan specific factors.

Many pension plans back their pensioner liabilities with a mixture of gilts and corporate bonds. So, another way of looking at a DIY buy-out is to consider the proportion of corporate bonds that would be needed to achieve the break-even investment return. As can be seen, this proportion has also fallen significantly in recent months and is now much more in line with typical pension plan investment strategies for backing pensioner liabilities.

For larger pension plans willing to accept a limited amount of investment risk for the assets backing the pensioner liabilities, there is now a strong case for establishing the price of a longevity hedge.

Longevity hedging mechanisms - an overview

Longevity hedging solutions have developed along two distinct paths: bespoke and index-based hedging.

A bespoke longevity hedge transfers longevity risk for the members covered to the hedge provider. The provider agrees to meet the actual payments to pension plan members regardless of how long they live - this is called the "floating leg" of the hedge. In exchange, the pension plan meets a fixed schedule of payments to the provider - this called the "fixed leg" of the hedge.

With a bespoke longevity hedge in place, a pension plan is no longer exposed to the risk that members live longer than projected.

While highly effective, bespoke longevity hedges are normally only available for relatively large pension plan populations, as the hedge provider will look for enough member data to price the hedge efficiently. Competitive hedge pricing is available to pension plans with pensioner liabilities over £100 million - this is significantly above the entry level for buy-out. Also, providers will typically offer bespoke hedging for pensioners only, or "pensioner-rich" memberships.

An index-based longevity hedge provides protection against future increases in longevity, but only based on the general population and not the specific pension plan membership. This allows the provider to assess an efficient price for the hedge, regardless of the size of the pension plan.

However, index-based hedges have two main disadvantages:

• The pension plan is left holding an uncertain and indeterminable risk: that movements in pension plan member longevity are not in line with those of the index population; and
• Such hedges typically only offer protection for a relatively limited period (usually between 10 and 30 years) whereas pension plans are often more concerned about longer-term risks.

These uncertainties present a substantial challenge to providers seeking to develop a market for index-based hedging instruments with pension plans. As a result, bespoke hedging is often seen as the more attractive option by pension plans seeking to transfer longevity risk. By contrast, financial institutions generally view index-based hedging more favourably as a means of trading longevity risk between institutions. The flexibility of an index-based hedge is attractive to them and, with large pools of lives on their books, they expect their pensioner longevity experience to closely match that of the index population.

Regulation of longevity hedges

Longevity hedging for pension plans is presently available from a range of providers, primarily investment banks and insurance companies. Consequently, regulation of these products can fall under the insurance regime or the capital markets regime.

Unlike the buy-out market, where the focus has been on FSA-regulated insurance vehicles, some of the key providers of longevity hedging do so through a capital market solution - typically a swap. The key difference between the two competing frameworks is the management of counter-party risk:

• Capital market providers put collateral arrangements in place, whereby the two parties (i.e. pension plan and provider) stake assets to protect the other against any financial loss expected to arise from a default.
• Insurance companies are not required to put collateral arrangements in place. Instead they have the stronger capital reserving requirements of the FSA insurance regime, with the option of putting collateral arrangements in place where desired.

Regulation in the longevity market may develop differently from the buy-out market, with room for both capital market and insurance solutions to prove successful. As a precedent for this, interest-rate swaps and inflation swaps are in widespread use by pension plans under the capital market route.

One reason why capital market solutions may succeed here is the level of counter-party exposure under a longevity hedge compared to a buy-out. The following chart shows the maximum potential loss a pension plan would face (on £1 billion of pensioner liabilities) were a provider to default on its contractual obligations under a longevity swap and a buy-in respectively. In practice, any compensation from the Financial Services Compensation Scheme would significantly reduce the counter-party exposure under a buy-in.

As can be seen, there is only limited counter-party exposure under a longevity hedge, compared with buy-in. Further, a longevity hedge is symmetric with either party potentially exposed to counter-party risk, depending on whether members live longer or shorter than expected.

We see strong benefits from the development in parallel of longevity solutions from both insurance and capital market providers. We expect competition between the two frameworks to drive further innovation and possibly pricing, as providers seek to neutralize any disadvantages (perceived or real) arising from the particular framework in which they operate.

What are the challenges facing longevity hedging?

The challenges facing longevity hedging include:

• Whether a longevity hedge would complicate an eventual buy-out and wind-up. Pension plans should consider whether a longevity hedge will be an attractive asset for buy-out providers to take on as part of a buy-out. Trustees should negotiate terms to ensure they ultimately get value for money for any longevity hedge they take out.
• How to quantify the benefit of the longevity risk removed. Pension plans will want to be convinced that the risk reduction justifies the cost of the longevity hedge.
• On-going management costs including regular valuations, posting of collateral, and additional administration.

Of these challenges, the impact on a future buy-out is in our view the most material, and we expect this issue to come to the fore in the coming months.

The future for longevity swaps

In our view the development of the longevity swaps market is a welcome additional option for pension plans looking to de-risk.

• We see conditions today as especially fertile for this fledgling market. With buy-out prices trending up, and pension plans adopting more cautious longevity allowances, longevity-hedge pricing is now more attractive than ever before.
• With an increasing number of plan sponsors focussing on the removal of pension risks from the corporate balance sheet, a key challenge for the longevity market is to persuade pension plans that a longevity hedge is viable as a "stepping stone" to buy-out in the longer term. 
• The first trade by Babcock International is a milestone, providing "proof of concept" and the subsequent deal by RSA Insurance Group has shown how longevity hedging can form part of a wider de-risking process. However, it is not yet clear whether these deals signal a rapid growth in activity (akin to the insured buy-out market of 2007/2008) or an exceptional event (similar to the short-lived success of the non-insured buy-out market in 2007).

Jerome Melcer is a Partner at Lane Clark & Peacock LLP

Note: This document and the information it contains should not be construed as being advice from LCP and should not be relied upon as such. Specific professional de-risking advice should be sought to reflect individual circumstances. The views expressed in this article are those of the author and not necessarily those of LCP as a firm. The firm is regulated by the Institute of Actuaries in respect of a range of investment business activities.

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