Longevity risk higher on TLP derivatives - MPL
GLOBAL - Pensions funds are being advised to invest traded life policy funds as part of a strategy to hedge longevity rather than buy direct or opt for TLP derivatives, as a supplier to European pension funds argues only half of the risk is being hedged in some circumstances.
Officials at Managing Partners Ltd, a UK-based provider of trade life policy (TLP) funds, believe there is the potential for the growth of TLP -based derivatives to help support pension funds' need to hedge longevity risk but argue investors are still exposed to greater mortality risk than through funds because the indices used in such products may not sufficiently correlate with the lives of those people they are measured against.
Jeremy Leach, managing director at MPL, told IPE traded life policies while there could be significant growth of the TLP market over the coming years, many of the policies investments banks are buying and holding to back such derivatives only represent a small portion of the market they are benchmarking to.
More importantly, investors could find their returns from TLP derivatives, were they to be created, may not match their benchmarks and could therefore see higher volatility risk than intended as the assets held may not be benchmarked against the mortality rates of today.
As a result, he believes pension funds seeking to hedge longevity risk would be better suited to investing in TLP funds where assets are regularly rebalanced to smooth the potential returns.
"For LDI, [pension funds] are looking for a benchmark level of return which is a smooth predictable return whatever their liabilities and what most of the derivatives are doing is providing a sample of lives and comparing it to a mortality scale, most of which tend to use the US Valuation Basic Tables (VBT)," said Leach.
"What they are doing is comparing their sample against VBT so if they have a different correlation it will move up or down. If the sample of remaining lives is of 45,000 lives from 2001, what it doesn't include is the mortality today on the VBT and what you are left with is a sample of the data, and incomplete data at that," he added.
The subject is a somewhat complex one as TLP derivatives are a relatively new product but experts, such as Professor David Blake from the Pensions Institute have recently argued their development could help pension funds to manage longevity risk. (See earlier IPE story: TLPs could be foundation for wider mortality market)
The TLPs purchased for such derivatives tend to be bought in batches designed to represent the required timeline of mortality risk for a pension fund, so should span the spectrum of potential deaths the fund experiences.
That said, they are made up of largely US-based life insurance policies of individuals who have chosen to sell their plan so they no longer have to pay the insurance premium and gain a payout based on medical predictions as to how long they will survive before the policy ‘matures'.
The risk, as Leach suggests, is there is no definite maturity date to those policies, so a pension fund buying a derivative on the back of it, or investing directly in TLPs, is potentially taking a higher risk compared with investing in TLP funds which can be open-ended investments and, as is the case at MPL, are regularly rebalanced through policy maturities and acquisitions to smooth returns and rebalance the portfolio against the chosen benchmark.
"A larger number of Italian, as well as German and Swiss pension funds" have been buying into MPL's TLP fund, according to Leach, in their search for assets uncorrelated to other classes as part of an LDI strategy, and have seen returns over 9.5% per annum as a result.
But some investors, such as the Netherlands' PME pension fund, has bought direct and seen equally strong gains, albeit paying a higher administrative price in the process.
Roland van den Brink, former director of investments at PME pension fund and now a member of the executive board at Mn Services, keeps a watching eye over its clients' investments in trade-life policies.
In contrast to Leach's opinion, he believes they are a good direct investment for pension funds as they deliver a net return of 9.5% per annum, and have an attractive risk profile because of the low correlation to other assets. Some clients, such as PME, have therefore allocated 2% last year and are still interested in the market.
While they are a good investment for pension funds, he does not believe they should be used in an LDI strategy, because it does not minimise the funds' interest rate exposure.
"When we started investing, we first did one and a half years of research and we were one of the first movers. But one issue is life policies carry a heavy administrative burden and in the past there have been some governance issues," said van den Brink.
"One has to do a medical check, and solicitors have to verify the policy is correct. There is quite a process to complete and a lot of paperwork because you are changing the ownership. You buy a policy from someone and have to pay the premium until the moment that person dies. The policy does not change, only the beneficial owner. Nowadays because interest rates are moving up and credit spreads are tightening there is an opportunity because policy owners have more difficulty in financing the premiums."
He continued: "It is an attractive way of getting higher yield from sound investments. It is just a niche in the market, which requires knowledge and experience. Without adequate selection criteria you could run reputational risks.
"Credit has gone up, so everything with a risk has risen in value giving you a higher yield than before. But this market is maturing and prices have become more transparent as most policies are sold via auction," added van den Brink.
His expectation is the TLP market will continue to grow as more American citizens may find it appealing to cash in their life insurance policies.
"People may have housing problems or job insecurities, so they can get rid of these annual payments. Ageing and current circumstances are in our favour as people over the age of 70 as well as returning soldiers may sell their policies tax-free."
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