19 May 2009

Published in: Longevity - mortality

Pensions ready for longevity solutions

Banks have been touting the virtues of longevity swaps to pension funds for years. Now that the first deal has appeared, John Ferry asks, Will the market burgeon?

On 13 May, Babcock International, the British engineering support services company, announced it had reached a deal to use longevity swaps to hedge the mortality risk on £500 million of its pensions liabilities. Although Babcock has not named the financial institution, or institutions, it struck the deal with - more details are expected in the next few days -- the transaction is groundbreaking. Banks have been trying for years to coax pension fund managers to use the capital markets to manage their longevity risk but with little success.

Insurers have been transferring longevity risk to the capital markets for some time - Norwich Union did a swap deal with Royal Bank of Scotland (RBS) in March, for example, in which it disposed of the longevity risk on a £475 million book of older UK annuitants until 2018. But convincing pension fund trustees and their various advisors and managers of the merits of pure longevity risk hedging has proven far more difficult. Could the Babcock deal be the first of many?

Buy-ins now second best

Jerome Melcer, a partner specializing in longevity hedging at actuaries Lane Clark & Peacock in London, believes this could be the start of a new trend. "The risk transfer market has changed significantly over the last six months. The position we're in now is one in which any scheme looking to de-risk is probably looking at longevity first and a buy-in second, rather than the other way around," he says.

Melcer says a number of fundamental factors started to change in the final quarter of last year, which today makes the use of longevity swaps far more compelling. Six months ago there was a lot of competition among insurers offering buy-in services, but a lot of that competition has drained away. "Over the second and third quarters of last year, insurers had capital to price keenly and we were at a point where they were able to price on the back of the higher corporate bond spreads," says Melcer.

A key pricing parameter in the buy-in market is the spread between government bonds and AA-rated corporate bonds, which is the typical benchmark insurers set for the assets they will invest in. An insurer will look at the difference between government bond yields and corporate bond spreads and allow for a portion of that when putting a price on a buy-in. The higher the portion the insurer allows for, the cheaper the pricing. Melcer says that last year "everything was pointing in the right direction" for insurers to use a relatively hefty portion of that spread when pricing buy-ins. But since then insurers have become more cautious. "I think there was a greater appetite for anticipating a larger chunk of the additional spread they could get from their capital on the investments by investing in corporate bonds," says Melcer.

The problem of inflation volatility

One of the reasons for insurers becoming more cautious is the rapid rise in inflation volatility. With some UK inflation indexes now registering deflation, and with some economists anticipating that future inflation could be significant as a result of the Bank of England's quantitative easing experiment, expectations for future inflation have become much more diffuse. "That uncertainty makes inflation swaps much more difficult to price and means banks can no longer offer to take on inflation risk at such competitive terms as they once did," says Melcer. The higher cost of hedging inflation risk today compared to last year ultimately leads to higher premiums for buy-ins.

As a buy-in involves the pension fund paying an insurer a premium in return for an annuity that replicates its pension benefits, the risks transferred cover investment, inflation, mortality and interest rate risks. Melcer says it is impossible to quantify in any general sense how much more a buy-in priced today would cost relative to what it would have cost late last year, but he says the difference will be significant enough to convince many pension funds looking to reduce their risk that a longevity-only solution is better than a buy-in.

Jerome Melcer of Lane Clark & Peacock: "The position we're in now is one in which any scheme looking to de-risk is probably looking at longevity first and a buy-in second, rather than the other way around."

That was certainly Babcock's thinking when, in a trading statement it put out at the end of March, it first announced it was in active negotiations with trustees to eliminate volatility on much of its pension liabilities through the use of annuities and longevity swaps. In a subsequent conference call with analysts, Bill Tame, the company's group finance director, said pricing in the annuity buy-in market was not favourable, and he added that Babcock therefore favoured de-risking purely using longevity swaps, with a view to looking at the buy-in market at some point in the future. Speaking at the end of March, Tame said the company had received quotes for both longevity swaps and for buy-ins from a number of interested counter-parties, but added the annuity buy-in market was difficult. "The market is not very good for those at the moment," he said at the time.

Three types of solutions

The capital markets could potentially offer three types of solutions to pension schemes looking purely to reduce their longevity risk. The bespoke longevity swap arrangement based on the actual pool of named lives within the pension scheme is the obvious choice. It is a simple solution. If the people in the pension pool live on average longer than expected such that the scheme has to pay out more than it had planned, then the swap counter-party makes up the difference.

Another method would be to buy a longevity bond. In 2005 BNP Paribas launched a bond that pays a coupon based on the value of an official UK government mortality index. However, the product did not sell well. One of the main problems was the fact that by necessity the bond had to be linked to a generic index that the whole market could look to. However, that introduced basis risk, which meant the bond would not exactly match the longevity liability profile of the pension scheme buying it. The bond did not have the impact BNP Paribas had hoped for and there have been no subsequent longevity bond issues.

Longevity indexes

The third solution has also suffered from basis risk issues. This involves investment banks putting together their own proprietary longevity indexes. The idea here is that, rather than enter a bespoke swap deal, a pension fund will instead do a swap transaction written on the proprietary index. The Credit Suisse Longevity Index, for example, which was launched in 2005, is designed to measure the average lifespan of the US population as a whole. When it launched the index, Credit Suisse said it would follow it up with longevity indexes covering Europe and Asia. However, it is yet to expand the range further. Meanwhile, in March 2008 JP Morgan launched its LifeMetrics suite of national mortality indexes. Its range now covers the US, Germany, the Netherlands and England and Wales.

To date, no pension fund has entered a swap deal written on these indexes. However, Guy Coughlan, JP Morgan's London-based head of pension asset-liability management, insists basis risk is not nearly as significant an issue as many pension fund managers believe it to be, and he says there are advantages to using his generic index. "People throw out the comment that basis risk is too large but rarely have they done analysis to back this up," he says, adding that his group is currently working on a paper that sets out how basis risk can be measured and gives examples of how big it is.

"Provided you address the basis risk in the right way then in most cases it can be managed and minimized by carefully choosing how you construct the hedge," observes Coughlan.

Coughlan adds that for a pension fund looking to hedge out its longevity risk now, with a view to doing a buy-out or buy-in sometime in the future, then a swap written on a LifeMetrics index could be an easy and relatively cheap solution. "It also gives you a fungible asset that you can unwind and that you can potentially unwind with a different counterpart," he says.

Getting that message across to trustees and advisors is not easy. Indeed, there appears to be scepticism across the industry. "That particular area of the market just hasn't got off the ground yet. The problem is the basis risk, understanding the implications of that and the complexity that brings," says Gordon Fletcher, an associate with pensions advisory company Mercer's Financial Strategy Group in Manchester.

Bespoke swaps most likely

Fletcher says bespoke longevity swap deals are the most likely types of solution we will see come to the market over the next year or two. "Because the contract takes away all of the longevity risk and doesn't leave any behind, it's easy for trustees to understand and be comfortable with. And they're also more likely to be comfortable with a swap arrangement rather than a derivative written on an [generic] index," he says.

So as long as buy-in prices remain unfavourable, more and more pension fund managers and trustees are likely to at least contemplate managing their longevity risk via a bespoke swap. Of course swap providers still face challenges in terms of convincing trustees and their advisors that it is worth actively managing their mortality risk. After all, traditional risk-adjusted investment performance metrics, such as the Sharpe ratio, are not affected by changes in mortality rates. Declining fund performance because of increasing longevity is not therefore as obvious as, say, declining performance caused by a fall in equity prices.

Guy Coughlan of JP Morgan on LifeMetrics' mortality indexes: "People throw out the comment that basis risk is too large but rarely have they done analysis to back this up,"

On the other side, investment banks say there is definitely demand among investors to acquire mortality risk, which the banks can sell on in various formats once they do a longevity swap. "One of the selling points is the very low correlation to virtually every other asset class in the market, be it inflation, foreign exchange, rates, commodities, equities or credit," says Gianfranco Simionato, a structurer in RBS's credit risk and insurance transformation group in London.

The next year will be crucial for the nascent longevity risk market. It should tell us whether the Babcock deal will give others the confidence to hedge their own longevity risk.

Back to top