The focus of liability driven strategies has so far largely been on interest rate and inflation risk. Solutions to longevity risk have been slow both in creation and take-up, finds Nina Röhrbein
With life expectancy constantly improving throughout the world, defined benefit (DB) pension funds increasingly find themselves struggling to forecast their member’s life expectancy and calculate that risk to be able to fulfil the future payments.
But although this is a global phenomenon, the large majority of solutions to longevity risk are currently only available in the UK. However, they are set to gradually move beyond the existing borders. At the moment, in terms of products, the market in Britain is split in two directions.
“On the one hand, we have the traditional insurance products like buy-outs and buy-ins,” says Guy Coughlan, managing director and global head of pension asset liability management at JP Morgan. “On the other hand there are the newer capital markets products which look purely at the longevity risk. They can be either customised to the particular mortality profile of pension fund members or be index-based.”
“Buy-outs take all the longevity risk off the table as far as trustees or companies are concerned,” says Jerome Melcer, (pictured right) partner at Lane, Clark & Peacock (LCP). “But in doing this they bundle their longevity risk together with financial risks & hand it over to the insurer, together with a large chunk of pension assets.”
One form of longevity hedge is the customised longevity swap. For this, the pension scheme enters an agreement with another party, such as an insurance company or an investment bank. The pension scheme pays an agreed set of payments to the provider while the provider pays the actual pension payments due.
“If a scheme enters into such a longevity swap it effectively is completely protected against the longevity risk of its members,” says Melcer. “But customised swaps are normally only available for pensioner members.”
The index-based swap takes the view that if the general population of the UK lives another year longer than expected then the pension fund members will on average also live a year longer than expected.
“The gamble is that the scheme members reflect the longevity of the general population, which may or may not turn out to be the case,” explains Melcer. “It is not a complete hedge but may be of interest to schemes that either cannot afford a customised swap or for smaller schemes where a customised swap may not be available.”
But despite these solutions the current longevity market in the UK is still nowhere near a liquid market. And as the transactional part of the market is still very small, a preference for one or the other solution has yet to emerge.
“The examples that we have done in the public domain indicate that hedgers are willing to do each of these alternatives, depending on their situation,” says Coughlan.
Recent market developments have taken place in both areas. JP Morgan launched its tradable longevity index - called the LifeMetrics index - in spring 2007. It was designed to enable pension funds to measure and hedge the risk associated with their beneficiaries by incorporating statistics on mortality rates and life expectancy across genders, ages and nationalities. So far, indices have been created for the US, England and Wales, Germany and the Netherlands.
Second, UBS Global Asset Management has just entered the UK market with a phased buy-out product with the insurer Aegon. This product is designed to allow pension plans to split their plan membership into various elements and then buy them out in the future as and when the moment is right.
But capital market solutions can have advantages over insurance solutions. “They offer a broader set of potential counterparties, as the counterparties are no longer restricted to the insurance industry,” says Coughlan. “There is a lot more liquidity and pricing transparency. And all derivatives that are transacted are fully collateralised, which means their credit counter-party risk is minimised.”
So far all the longevity products that have transacted have been derivatives, not securities or bonds, according to Coughlan. “Longevity risk does not emerge until after quite a long period, which makes the amount of return on an initial capital investment in a bond quite low,” he says. “Taking a derivative format gives typical longevity investors such as hedge funds an expected return that is more in line with their objectives.”
One key advantage of a longevity swap, compared with a buy-in, is that trustees retain control over scheme assets. “In an environment where trustees are increasingly focussing on counterparty risks, a swap is therefore a new tool that allows them to deal with longevity risk, but still diversify scheme assets,” says Melcer.
However, the figures for 2008 show a different direction in the longevity market. “We estimate that the buy-out market for 2008 as a whole was around the £8bn (€8.9bn) mark,” says Melcer. “In terms of the market for longevity hedging, although there have been trades between investment banks and insurers, we are not aware of a longevity trade by a pension scheme.”
But the buy-out market has now stalled to some degree, according to Coughlan. “Asset values have fallen and insurers that do the buy-outs have access to less capital than they would have had in the past,” he explains. “In turn that has increased the pricing that is needed to cover the buy-out liability.”
“As few people are willing to take longevity risk in its pure form, capacity is limited,” adds John Fitzpatrick, partner at the Pension Corporation, a UK insurer specialised in acquiring pension obligations. “And with more pension funds using longevity insurance, prices will rise.” Pension Corporation offers full and partial buy-outs as well as longevity insurance to pension funds.
Both partial and full buy-outs took place in quite significant numbers in 2008, according to Fitzpatrick. But in the current climate many pension fund trustees will focus on partial buy-outs of pensioners as something they can afford, he believes. “However, the buy-out market will continue to benefit from sponsors looking to de-risk their balance sheets,” he adds. “Trustees will look to longevity insurance to protect themselves while they invest their assets to achieve their targeted funding level. When pension funds get their funding up to a full buy-out level I believe they will execute a full buy-out.”
“If they have got members’ security in mind trustees may still be looking at it but the final approach adopted really depends on the individual case requirements,” adds Ritesh Bamania, (pictured left) head of asset liability investment solutions UK at UBS.
“In our phased buy-out product Aegon guarantees the longevity basis it would use on pricing for seven years, which effectively removes longevity risk over this period. If pension schemes carry out a buyout within those seven years they can apply this locked basis. In other words, pension funds set in place a process where they buy out pre-determined elements of their plan as and when the funding ratio improves using the locked-in mortality basis.”
“We have already witnessed a significant increase in interest for this offering, which we did not see in early 2009,” he says.
“Once there has been proof of product and one pension fund has actually gone through the process this market becomes much more attractive and other deals should follow. One of the hurdles is that a longevity trade may face is the need to manage collateral arrangements - the first trade may therefore be carried out by a larger scheme, which would have the resources to work through and resolve such issues.”
Buy-ins and buy-outs
In both buy-ins and buy-outs, UK pension fund trustees pay a premium to a Financial Services Authority (FSA)-regulated insurance company in exchange for bulk annuity contracts that guarantee to pay a set of defined benefits to the pensioners. In a buy-out, the trustees fully discharge their liabilities, while the pension scheme ultimately winds up and individual members receive an annuity policy from the insurer. Apart from undertaking a full buy-out, pension funds can also agree a partial buy-out, for example for the pensioner members only. In the event of insurer insolvency following a buy-out the members are protected by the Financial Services Compensation Scheme (FSCS). A buy-in is an asset of the scheme, with the trustees owning the bulk annuity policy and the beneficiaries remaining members of the pension scheme. The number of buy-out providers in the UK has grown sharply over the past couple of years. It has moved from the initial two big insurers Legal & General and Prudential to include players such as Aegon, AIG, Lucida, Met Life, Norwich Union, Paternoster, Pension Insurance Corporation, Rothesay Life (owned by Goldman Sachs) and Swiss Re.
Capital market products
Capital market products, as opposed to insurance solutions such as buy-ins or buy-outs, look at longevity risk only. They can either be customised to the particular mortality profile of pension fund members or be index-based. For a customised longevity swap, the pension scheme enters an agreement with another party, such as an insurance company or an investment bank. It pays an agreed set of payments to the provider, while the provider pays the actual future pension payments due. The index-based swap is based on a generic index. It assumes that if the life expectancy of a country’s general population increases by a number of years, the life expectancy by the members of the pension fund will increase accordingly.
Transactions and trades
The first public announcement of a transaction on the LifeMetrics index in the UK was the one by UK insurer and pensions buyout company Lucida in February 2008. So far a handful of transactions have taken place on the index. In terms of longevity hedging, trades have taken place between insurers and investment banks. However, the first longevity swap trade by a pension scheme has yet to emerge.