Longevity: Beyond buyout and buy-in
The time seems right to develop an international secondary market for longevity risk that allows pension funds to deal with the downside of longer lives, writes Mariska van der Westen
Increases in life expectancy are a cause for celebration, but they also come with a price tag - longer pension payouts. The risk is not rewarded with returns, as investment risks are, so if there is a cost-effective way to do it, it makes sense to hand them off by insuring against or otherwise hedging them.
In the UK, a popular solution is ‘buyout' or ‘buy-in'. A buyout involves transferring liabilities, assets and all to an insurer or reinsurer which, in return, guarantees life-long benefits to be paid out to some or all scheme members. In the case of a buy-in, the pension fund does not transfer anything but, instead, buys an annuity policy covering scheme members.
Outside the UK, buyout/buy-in hasn't gained much traction. In the Dutch market, for instance, deals have been limited both in number and size, although some say it's only a matter of time: "Before the financial crisis hit, it was more or less assumed that investment returns would be sufficient to mitigate a whole range of risks," says Jacques van Dijken, Swiss Re's CEO for the Netherlands. "The crisis has turned that world view on its head and has brought home the need to analyse risks and determine which ones may be worthwhile to retain on the balance sheet and which ones it may be better to hedge." His colleague Costas Yiasoumi, head of longevity solutions, adds that the increase in liabilities resulting from the latest Dutch longevity data is likely to boost interest in buyout.
Demand for hedging solutions is likely to increase, concurs Carl Kool of BlackRock. "However, there are some differences between the markets that will have an impact. For one thing, demand in the UK is mainly driven by corporate pension funds, as corporate sponsors aim to remove this risk from both the pension fund and corporate balance sheets. And we have relatively fewer corporate schemes in the Netherlands."
Derick LeRoux of ING agrees. "In addition, there's a bit of a cultural difference in that corporate sponsors in the Netherlands don't have quite so much power in dictating which risks should be hedged," he says. "The objective is to please all stakeholders equally, rather than to serve the interests of the plan sponsor."
Another important factor is that UK DB schemes have largely closed to new members. The Dutch, on the other hand, kept their plans open to new accrual while lowering both the generosity and guarantees across the board.
"As a result, in the Netherlands there are relatively more active and deferred members as compared to the UK, which makes it a good deal more difficult to structure a hedging solution," says Kool. "In addition, there are some issues with regards to cost - the transparency of pricing leaves something to be desired."
Longevity swaps 1.0
An alternative hedging solution presently gaining more attention is longevity swaps. The first generation makes good use of the fact that insurance companies and reinsurers can more easily absorb longevity risk than can pension schemes, says Yiasoumi. "Insurers and reinsurers provide a natural home to longevity, as they have an insurance book that includes mortality that offsets longevity risk and earthquake and weather-related risks that diversify."
A swap allows pension funds to offload their longevity risk to an insurer at a relatively low cost, he explains. "If a pension fund already reserves capital against longevity then in a longevity swap these reserves are paid to the insurer as a premium, while the insurer, in return, commits to covering the financial impact of the pensioners living longer than expected."
Van Dijken adds: "Contracts like these remove any future impact of pensioner longevity for the pension fund, and as long as the fund has reserved prudently, the premium is relatively affordable."
There are some concerns to be aware of, though. These can be very long-term contract of 40 to as much as 60 years, which implies a considerable counterparty risk, and because the swap is custom-built to exactly match the pension fund's member population, it is not liquid.
In the UK, the first of these swaps have already been implemented - Swiss Re recently closed a deal with Royal County of Berkshire Pension Fund, for instance - but so far there have been no deals in the Dutch market.
"When funds are closed to new members, the longevity risk of the existing population can be estimated fairly easily to allow for this type of customised swap. But as the Dutch market as yet doesn't have a lot of closed funds and the percentage of active members is higher than in the UK, there really is no market," explains Gerard Roelofs of Towers Watson.
What the Dutch market really needs is a different kind of swap, he says: a derivative contract that isn't customised to an individual pension funds' members but is, instead, derived from a mortality or longevity index. In the UK market, too, calls for a secondary market are becoming louder - for the simple reason that potential demand for longevity protection far outstrips insurers and reinsurers' capacity to absorb this risk.
"For the time being, the insurance community can cater to pension funds who wish to transfer their longevity risk but, worldwide, the risk is such that we will eventually run out of capacity," says van Dijken. "It is important to develop other ways to diversify and absorb this risk, including capital market solutions."
For this next generation of swaps, the starting point is an index referencing the mortality characteristics of more generalised cohorts, say, 75-year-old males born in 1950, or women between the ages of 62 and 72. "Using actuarial data, a pension fund can analyse exactly where and when its longevity risk is greatest," says Geert Jan Troost at Towers Watson. "They then calculate how much a deviation from a mortality index for that cohort would cost them, and enter into a swap contract that will pay out (or receive) the difference should the deviation actually materialise."
These swaps behave more like ‘proper' derivatives such as interest rate or inflation swaps and are more easily tradable and manageable in terms of counterparty risk. Rather than 40-60 years, an index swap contract would be entered into for just five or 10 years. "So a pension fund can hedge longevity risk over a 40-year period with eight successive swaps, each of which is fully settled after five years," says Troost.
This new generation of swaps could go a long way to transfering longevity risk to capital markets. "Insurers and reinsurers would no longer be the only counterparties, as investment banks and hedge funds get involved as well," says Roelofs.
Before longevity swaps 2.0 can become reality, however, the market has to agree on a suitable benchmark. In effect, this means we need to agree on a mortality model for Europe, observes LeRoux. "Such a benchmark can't possibly match the longevity risk of each and every pension fund," he says. "The point is not to get a perfect fit, but to decide on a decent reference that can be used to design standard derivatives contracts."
In that sense, longevity risk resembles inflation risk, he adds. "No two funds have the same inflation risk, but some degree of basis risk is acceptable to them, knowing they can hedge away the bulk of their risk using a standardised swap contract."
Steps to facilitate a secondary longevity market are already getting under way, starting in the UK. The Life & Longevity Markets Association (LLMA) - comprised of Aviva, Axa, Deutsche Bank, JP Morgan, Legal & General, Morgan Stanley, Pension Corporation, Prudential PLC, RBS, Swiss Re and UBS - intends to develop templates for standardised longevity products, a longevity trading index and a standardised valuation model for longevity. Several public indices have already been launched: Credit Suisse's 2005 Longevity index focuses on the US, while JP Morgan's LifeMetrics index - launched in 2007 - covers England & Wales, the US, Netherlands and Germany, and Deutsche Börse's Xpect index, launched in 2008, applies to Germany, Netherlands and England & Wales.
The longevity market will not evolve overnight, but we may well see standardised solutions and ‘longevity buckets' develop over the next five years or so. Even then the problem of dealing with the downside of longevity will not be solved, though, experts warn. "This is a societal problem and cannot be resolved by capital markets alone," concludes LeRoux.