30 June 2010
Published in: Longevity - mortality
The pros and cons of longevity hedging
Removing, or at least reducing, risk is now a priority for pension schemes. But mitigating longevity risk doesn't always have to involve hedging or swaps, explains Steve Hood.
A pension scheme will "pay a pension to each member until their death." If a scheme member lives longer than expected, the scheme will pay out more pension payments than expected. As such, the scheme is exposed to longevity risk (the risk that individuals will live longer than expected).
A longevity swap is a financial arrangement which allows the scheme to pass its longevity risk to a third party (see figure below).
In summary, the swap provider makes payments to the pension scheme during the actual (but currently uncertain) lifetimes of a defined group of members. The scheme is effectively "swapping" the uncertain payments to pensioners for a fixed schedule of payments to the swap provider. In return, the pension scheme makes a fixed and known series of payments to the swap provider.
Features of a longevity swap
The following table summarizes the key features of a longevity hedge agreement:
| Feature | Options available |
|---|---|
| Members covered | Typically pensioners in payment, buy can extend to non-pensioners.
Coverage can be on a "pensioners only" or a "pensioner plus dependant" basis. |
| Reference longevity | Under a customized swap (as described above) the scheme receives payments based on the actual longevity of the scheme membership. An index-based longevity swap uses population based longevity experience (for example, national longevity statistics) to determine the payments that the scheme receives. |
| Contract structure and collateral | A longevity swap can be constructed as an insurance contract (and so FSA-regulated) or as a capital market solution (as for a typical swap contract).
Under a capital market solution, collateral tends to be required, that is, both the scheme and the longevity swap provider post assets to protect the other party against financial loss in the case of a default. Under an insurance contract, collateral is not required, as the insurer must separately hold appropriate capital reserves - but collateral can be adopted if requested. |
| Contract term | Whole-of-life or fixed-term arrangements available; however, by adopting a fixed-term contract the risk associated with the very old is likely to be retained. |
Downside and upside
Of course, scheme members do not always live longer than expected. As with any hedge, by entering an arrangement that protects against the downside, the potential benefit of any upside (that life-spans are actually shorter than expected) is sacrificed. But looking at a hedge in terms of an ultimate "winner" and "loser" perhaps misses the point. The real benefit is that schemes are able to reduce a risk which they do not wish to take, irrespective of the eventual outcome.
Hedging and swaps are complicated. There will be significant advice and training requirements to ensure that decisions can be made effectively.
The drivers of hedging
Sponsors and trustees of defined benefit pension schemes have, over the last few years, become more risk-averse. Many people involved with pension schemes will be familiar with actuaries delivering "more bad news" on longevity, with longevity assumptions being strengthened as a result. Considered alongside the financial shocks that pension schemes have faced recently, it is no surprise that removing risk is now seen as a priority.
A broad rule of thumb is that every one year increase in life expectancy from age 65 equates to approximately a 3% increase in the value of a pension scheme's liabilities.
Longevity has typically been the largest risk that pension schemes have been unable to manage effectively, so it is no surprise that there is a great deal of interest in arrangements that will allow pension schemes to remove longevity risk.
One of the other attractions of longevity swaps is that, unlike a buy-out/buy-in arrangement (where all risks are transferred), there is a limited initial cashflow requirement.
So, why isn't everyone doing it? Until a month ago only the agreed transactions had been publicized. It has been interesting to see, recently, two cases of longevity swap transactions that have not progressed to completion, namely Premier Foods and The Co-operative. The Premier Foods transaction appears to have stalled on the issue of value: the Premier Food's finance director commented that such contracts did not represent value for money.
Of course, it is all about how much value the sponsor and trustees of a pension scheme place on removing longevity risk. For some, the benefits of a longevity swap will be well worth the cost; others will be more comfortable retaining longevity risk.
Longevity swap providers price their products in order that, ultimately, a profit is expected to be made. The arrangements are structured so that the provider anticipates making payments that are lower than the fixed payments it will receive from the pension scheme. But longevity does not seem to have "behaved" itself for long in the past. Whether longevity swaps are indeed profitable is an interesting question, but not one where the answer will be clear for some time.
Key considerations for longevity hedging
A longevity hedge cannot be put in place overnight. If a sponsor or trustee of a pension scheme is of the view that longevity hedging may be an appropriate part of their medium- to long-term strategy, preparatory work should include:
- Considering your risk profile. Before getting into the nitty-gritty of longevity, it is important to establish how significant removing longevity risk might be to the overall level of risk that the pension scheme is running. For many schemes there are other areas, for example investment or inflation risks, that present much more significant risks and that can be removed or reduced more efficiently and effectively.
- Considering your longevity profile. It is of critical importance that there is a clear understanding of what factors are driving the longevity experience of the pension scheme. Club Vita has identified that affluence, lifestyle and retirement health are all significant factors in how long pensioners live and these factors must be understood if an informed decision is to be made. Also, it is important to consider whether your industry and workforce has changed in nature over time; if so, your current pensioners may be very different to those of the past.
Other areas that should be investigated include the trends in longevity improvements and, again, if your scheme can be considered to be typical. - Cleaning your data. Longevity swap providers like certainty. If something is a "known", it can be priced appropriately: unknowns (blanks in your data) will require assumptions to be made. As you would expect, when pricing a longevity swap, any assumptions will tend to err on the side of prudence and generally lead to an increase in the cost to the pension scheme.
- Training your trustees. Longevity hedging and longevity swaps are complicated. The sooner that all relevant parties become familiar with the products, the smoother any decision-making process will be.
Alternatives to longevity hedging
It is by no means a given that longevity hedging is the most appropriate approach to reducing longevity risk for each and every pension scheme. There are a number of other routes that can achieve similar results, including:
- Tackling idiosyncratic risk. Often, a disproportionately high amount of a pension scheme's liabilities rest with a small proportion of the scheme's members, typically those with very the highest earnings and long service. Managing the benefits of these individuals effectively can materially reduce the longevity risk of the pension scheme.
- Encouraging member options. The exercise of any member option that leads to pension being exchanged for a lump sum payment on reasonable terms (such as commutation) will help to reduce longevity risk.
- Reviewing benefit design. Many schemes are closed to future accrual but, for those that are not, future benefits can be amended to reduce the longevity risk that builds up in the future
The future
While there are few certainties in life, I'll offer up a few thoughts for what the future may hold.
- Sponsors and trustees have become more risk-averse. We will see increasing numbers of schemes seeking to both understand and transfer risk. In order for the risk transfer market to develop, the providers and consultants will continue to develop tools that help pension schemes understand risk and the available solutions.
- Longevity swaps will become commonplace with off-the-shelf products available. Providers will offer these as part of a "route to de-risking" suite of products that the majority of pension schemes will ultimately make use of.
- As risk becomes easier to identify and analyze, the solutions available will become more bespoke, possibly leading to idiosyncratic risks and general risks being tackled differently
Steve Hood is a longevity consultant at Club Vita. Club Vita is the first ever longevity comparison club for occupational pension schemes, providing longevity analytics to help trustees and sponsors manage longevity risk.
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