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Longevity swaps reality improved by pensions funds

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UK - It may soon be possible for UK pension funds to purchase longevity swaps as protection against members living longer than anticipated, because pension funds have themselves improved pricing by making more cautious mortality assumptions.

An analysis of the defined benefit pensions market consducted by consultancy firm Watson Wyatt suggests "it's odds-on" that the UK pensions arena could see its first longevity swaps hit the market in the "coming months" as cost of swaps is now less of an obstacle to schemes thanks to their more realistic assumptions on liabilities.

Officials note the price of a longevity swap could be just as volatile as predicting the longevity of a single pension scheme member and as the financial markets, but the improved pricing means there are likely to be fewer bulk annuity - or buyout - deals this year because the bonds market is less attractive to suppliers.

More specifically, some buyout providers have already had to transfer some of their longevity risk to a reinsurer or to the capital markets in order to maintain a competitive position, so longevity swaps could eventually appeal to both sponsors, pension funds and suppliers.

With most defined benefit schemes now operating with a deficit, swaps could be attractive to sponsors in particular because there is no upfront funding requirement to tackling liability risk.

That said, any trustee board eyeing longevity swaps will have to act carefully, according to John Ball, head of defined benefit pensions consulting at Watson Wyatt, as there are complicated decisions to make over the terms to be set and the window of opportunity will mainly favour the early entrants to the market.

"Schemes which had not moved out of equities before the markets fell are still targeting settlement but expect it will take them longer to reach the finishing line. This increases the risk that changed longevity assumptions will make annuities more expensive by the time they are ready to buy."

He continued: "That could make longevity hedging an attractive solution but there are number of practical issues to consider. For example, the trustees and employer need to agree how any gap between the technical provisions and the fixed leg of the swap is to be funded. The long-term nature of the mortality swap contract also makes it essential that payments due from the counterparty are secured as new evidence affecting life expectancy emerges."

Officials at Watson Wyatt are still investigating the prospects for using longevity swaps within the rest of the European pensions market, though it is thought they are likely to be less attractive to the Dutch market, for example, as schemes are able to find more efficient funding solutions through risk-sharing.

If you have any comments you would like to add to this or any other story, contact Julie Henderson on + 44 (0)20 7261 4602 or email julie.henderson@ipe.com

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