Longevity swap to buy-in
How easy is it to transition from a longevity swap to a buy-in?
• A longevity swap can represent a good first stage in a derisking process.
• Interest rate, inflation and investment risk are not covered.
• Transitioning from longevity risk transfer to buy-in may not be straightforward.
• It may be beneficial to use the same provider.
Underperforming markets, poor investment returns and increased longevity have resulted in higher deficits for many UK pension schemes, pushing risk management to the top of the agenda for trustees. UK pension schemes unable to make the leap to a buy-in due to funding constraints have been exploring other risk-reduction methods to protect against further losses.
The longevity swap market has provided the ideal solution for some schemes as a step towards the ultimate goal of full risk reduction. And some schemes have already successfully completed the switch from longevity swap to buy-in. But how easy is it and what issues need to be considered when making such a transformation?
A longevity swap enables pension schemes to transfer the risk of having to pay pensions to members for longer than expected to another counterparty, usually an insurance company. Trustees will typically make payments to the insurance company based on the best estimate of the pension scheme’s longevity and the insurer will make payments to the trustees representing the actual pension payments that fall due.
However, unlike bulk annuities, a longevity swap does not provide trustees with full protection – interest rates, inflation and/or investment risks still need to be actively managed after a longevity swap has been put in place.
There has been a significant reduction in bulk annuity pricing recently, which has made it affordable for a more pension schemes to offload risk in full, whether in respect of a tranche of members or moving to a full scheme buy-in or buyout.
As a longevity swap has already removed mortality risk from the scheme, it might seem that other risks would then be relatively straightforward to remove.
However, this is not necessarily the case – longevity swaps are typically intricate, bespoke transactions involving numerous counterparties (often cross-jurisdictional) and hundreds of pages of documentation setting out complex collateral arrangements.
The move to buy-in may result in new counterparties with different risk allocations, and will probably mean that an insurer’s standard bulk annuity terms will not be fit for purpose. New, bespoke documentation will therefore need to be negotiated.
Perhaps the first thing to consider is who the buy-in provider will be. If the buy-in provider is the same as the existing longevity swap provider, negotiations ought to be easier – assuming, of course, that the existing longevity provider wants to enter into a buy-in.
It is more complicated if the longevity swap provider and proposed buy-in provider are different. There will probably be termination fees associated with bringing the longevity swap to an end, so these will need to be factored in to the overall cost/benefit analysis for the transaction.
Once the transition is under way, attention needs to be paid to the following:
• Single premium rather than a swap. Longevity swaps are designed to facilitate the steady cash flow over a substantial number of years – the trustees pay a fixed amount in return for a ‘floating’ payment from their counterparty, reflecting the scheme’s mortality experience. In practice, the two payments are netted-off against each other, leading to one counterparty being ‘in’ or ‘out’ of the money.
Contrast this with a buy-in, which is usually a single-premium bulk annuity transaction involving the transfer of an agreed set of assets relative to the market value of the premium. To make the move to a buy-in, the scheme will need to have sufficient assets to pay the premium – or seek a contribution from the sponsor where relevant – rather than using the assets as a return-seeking investment.
• Counterparty relationships. A number of established relationships are part of a longevity swap. Taking the example of an insurance-based transaction, the trustees will have developed a relationship with an insurer (who may potentially also be a buy-in provider), and will inevitably be aware of some of the commercial terms agreed with the reinsurer(s) and custodian.
If the insurer/reinsurer(s) are ‘in’ the money, there is no great incentive for them to assist the trustees with moving to a buy-in. This is particularly so if the longevity insurer does not act as a buy-in provider, as the transition would result in the insurer dropping out of the transaction.
On such occasions, there may be general agreement that the relevant longevity reinsurances should be novated to offer protection to the new buy-in provider. However, the risk assumed by the buy-in provider under the buy-in policy will differ from that originally assumed by the longevity insurer, even in instances where the insurance counterparty has not changed.
Although there may be general agreement for the reinsurer(s) to transition to the buy-in arrangement, this will, in itself, include negotiation of deal-specific terms with each reinsurer, which is likely to be a complex and time-consuming exercise.
• Data. Data is often a key concern for trustees when entering into a buy-in. Insurers will price based on an agreed set of assumptions; data verification takes place once the transaction has been entered into, although the insurer reserves the right (subject to certain limitations) to reprice the transaction if the threshold for data errors is breached due to data errors. Trustees who have entered into a longevity swap will already have undertaken a significant amount of data verification.
In addition, if the longevity swap provider is also in the bulk annuity market, it will have the advantage of knowing the scheme data and any historic data issues. This will give the provider the ability to price on a more accurate basis, reducing the trustees’ repricing risk following verification.
• Conversion to buy-in/buyout. As mentioned above, the ultimate goal for trustees is generally to secure a full buyout for the scheme. Longevity insurance providers are aware that trustees will want to transition to a buy-in or buyout, and the longevity agreement will usually include an option for the trustees to terminate the swap in such circumstances.
However, longevity agreements do not generally include a mechanism enabling trustees to switch easily from a longevity swap to a buy-in, perhaps because most longevity insurance providers are not part of the bulk annuity market.
Bulk annuity providers will, as part of their standard contracts, cover conversion to a buyout. However, they also tend to reinsure their transactions on a bulk basis, meaning reinsurers are not always party to negotiations on individual transactions. In the event that the longevity reinsurer(s) are maintained throughout the transition from a longevity swap to buyout, they are likely to have more input into the negotiations.
These are just some of the issues that will need to be considered when moving from a longevity swap to a buy-in. We might see more streamlined approaches develop more trustees seek to capitalise on bulk annuities while pricing is favourable, but even then the complexity of these arrangements means that negotiations and implementation will be time-consuming.
Although a longevity swap can be the first step along the road to a buyout, it is a journey that needs some careful thought and planning.
Amanda Wallbank is an associate in the pensions team at the law firm CMS