Longevity: Time to get the tradesmen in
With buyout deals and pipelines buoyant as more DB schemes close to future accrual and sponsors bite the cost bullet, Pádraig Floyd asks whether the short trend for ‘DIY’ has already run its course
The de-risking market has been relatively stable over the past few years, with between £8bn (€14bn) and £12bn of liabilities being transferred or hedged through buy-ins, buyouts or longevity swaps each year since 2008. Traditional buy-in and buyout remained stable in 2012, ticking over at £4bn (see figure 1 for the 2012 top 10) against £5bn in 2011.
However, longevity swaps, a more recent feature of the market and a key to the ‘DIY buyout’ trend, were few and far between (figure 2). Compared with a total of £7bn across five swaps in 2011, only two deals were brokered in 2012: the LV= deal worth £800m (innovative for being the first bespoke longevity contract to include defined benefit (DB) scheme members who have yet to retire) and AkzoNobel’s for £1.4bn, both written by Swiss Re.
It is early to be reading much into the reduced volume, says Emma Watkins, a principal with Lane Clark & Peacock. But for timing, that figure might have been closer to £4bn as Legal & General has already sealed a £2.7bn deal in 2013 with the BAE Systems 2000 Pension Plan.
“Given their complex nature and the size of the liabilities being hedged, longevity swap transactions will inevitably be ‘lumpy’,” Watkins says. “Each year will see a small number of very large deals, with only one extra (or fewer) having a significant impact on the overall de-risking market volumes reported.”
The number of longevity deals has only just hit double figures, over a four-year period, although those deals represent many billions in de-risked liabilities. However, trying to identify trends in a market where it is likely that there will only be a handful of deals in any one year is a difficult task, says Martyn Phillips, a director at JLT Employee Benefits.
“Given that synthetic buy-ins – DIY – and longevity swaps remain the domain of large pension schemes, generally involving a minimum of £500m of pensioner liabilities, there are fewer than 200 schemes that could consider such transactions,” he says.
One reason for their appeal is the sensitivity in pricing for bulk annuities. This market has seen consistent volumes since around 2005, but in 2009-10, traditional providers of buy-ins and buyouts were forced to review how much capital to hold for credit risk as a result of the potential impact of Solvency II.
“Any pension scheme seeking a quotation saw quite a lot of variability in pricing and that tends to lead to hesitation to transact,” says Myles Pink, co-head of business development at Rothesay Life.
Consultants suggested to clients that if they couldn’t remove this risk in the form of an annuity because of the implied cost, why shouldn’t they keep the assets, instead, and just hedge longevity risk? With that, the longevity swap and ‘DIY’ markets were born.
For Martin Bird, partner & head of risk settlement at Aon Hewitt, a DIY solution remains a viable proposition for those schemes with the infrastructure and appetite to run relatively complex asset portfolios. The main barriers to broking these deals are their complexity and the scheme’s decision-making process, rather than the pricing, he says.
“The ease and simplicity of the traditional buyout or buy-in still carries significant appeal, particularly for schemes with liabilities under £1bn,” he says. “For very large deals, purchasing an annuity with an inflation floor has looked expensive – there isn’t much of a market for 0% inflation floors to match the type of pension increases that most schemes provide – so this has often pushed larger deals towards the unfunded longevity solution, leaving the inflation to be dealt with later on, if and when that market looks more attractively priced.”
There is plenty of scope for the longevity market to develop. Capacity is considerable as reinsurers seek longevity risk to counteract their mortality books. The withdrawal of players – Credit Suisse and UBS withdrew from the market due to concerns about reserving for
Basel III – has not harmed its development, says Watkins. If anything, the market has “significantly improved” since 2011. “Fewer primary providers means a more orderly market with each provider having a distinct offering,” she says. “And a greater number of reinsurers provides more depth of capacity and potentially pricing.”
The lack of transactions is demand-side driven, she says, and any consideration of a de-risking exercise will always be based on an affordability assessment. With scheme funding depressed, transactions are more challenging to complete, particularly for larger deals, where trustees may require additional funding from the sponsor.
However, the notion that DIY approaches are ‘losing out’ to ‘traditional’ buyout and buy-in strategies is, at best, unhelpful and could be misleading.
“Buyout, buy-in and longevity are complimentary and all appropriate in different circumstances,” says Daniel Harrison, global head of longevity solutions at Swiss Re. “A longevity swap is more suitable for a scheme wishing to maintain its own investment strategy, whereas a buy-in goes that step further still and passes the investments and inflation risks to the insurer. Buyout goes a step further still in fully discharging the trustees of their obligations, but they are solutions that fulfill different objectives and we are seeing a lot of demand for longevity risk transactions.”
DIY or bodged job?
In the current climate, the traditional buy-in/buyout market has remained fairly solid. Many of the deals completed in the past 12 months have been due to schemes holding considerable – and currently highly valuable – Gilt portfolios, which they have looked to exchange for a buy-in/buyout when possible.
And there is sound reasoning behind such a choice, says Jay Shah, co-head of business origination at Pension Insurance Corporation, as DIY solutions are neither cheaper than a buy-in, nor simple enough for most schemes to be able to manage themselves. They might not even cover all the risks.
“Generally, they do not hedge against deflation, so if we have negative inflation, the DIY solution pays out less than a buy-in,” says Shah. “Equally, during periods of high inflation combined with increasing life expectancy, the DIY solution doesn’t match the liabilities.
“So DIY solutions are better than nothing but are an imperfect match and have sometimes wrongly been promoted as a perfect match.”
However, Shah is seeing an increase in interest in longevity swaps for larger schemes as the first step in the road towards the endgame: “A new area of much interest is hybrid longevity swap/buy-in, whereby schemes look at structures that convert a longevity swap to a buy-in over a period of time.”
In effect, adds Shah, a DIY solution asks a pension scheme to operate like an insurance company, but without the infrastructure at the disposal of the insurer.
When it comes to a counterparty for these longevity deals, an insurance company is also better placed to write the business, says Myles Pink, co-head of business development at Rothesay Life. With Basel III on the horizon, the banks are not well-disposed to holding long-dated liabilities and pension schemes favour the bespoke longevity swap solution – the full-term, full-risk transfer of longevity risk without stop loss or other limitations.
“Historically, some of the banking solutions have truncated these products – offering terms of 10, 15 or 20 years, after which a bullet payment is made,” he says. “The insurance product can be expected to be in place for over 50 years.”
However, don’t be fooled into thinking that Solvency II or Basel III continue to hang over these markets. Providers and consultants agree that any potential issues on pricing have been incorporated into any future quotes on bulk annuities or, for that matter, longevity swaps.
“If there is a ‘battle’ between banks and insurance companies, then insurance companies are currently winning because this is the sort of risk they are used to assuming – often with the help of the reinsurance market,” Pink explains. “If a natural other side appears in a traded market, then the banks could intermediate as they do in other markets. The question is, therefore, who is the natural other side of longevity risk?”
In reality, both insurers and banks operate as intermediaries as they will both reinsure these risks. And for Bird, there is little difference in the mechanics of swap, whether it is insurance or derivative-wrapped, as nearly all the risk is being distributed to the global reinsurance markets.
The concept of a traded market for longevity has vexed this sector for a number of years. There would appear to be demand for it, and there are willing distributors but, ultimately, there is a more fundamental obstacle.
Some argue that the long-term nature of pension funds means they are well placed – and should be well disposed – to invest in longevity products. This is one of those conceptual hand grenades that when tossed into a conference room will divide the assembled crowd.
Although the idea might have some merit, detractors point out that schemes will already have more longevity risk than they can comfortably live with and taking on more – and other people’s to boot – is a potential recipe for disaster.
Developing an index-based approach may offer the economies of scale to allow smaller schemes to hedge a degree of longevity risk more easily, but the law of diminishing returns will apply. It returns to Shah’s concept of an “imperfect match”.
“Longevity swaps taken out with an insurance company have, to date, tended to provide scheme-specific hedges and therefore bring no basis risk for the pension scheme,” says Pink. “A pension scheme may choose deliberately not to hedge perfectly – by, for example, insuring simplified benefits or first lives only – and therefore introduce basis risk.
However, the longevity swap would still be based on a group of pre-identified members. Index solutions tend to bring substantially more basis risk.”
So, for his money, the traditional annuity is the product with the least basis risk.
In terms of de-risking strategies, the development of the longevity swap market does not make it a competitor for traditional buyouts or even buy-ins. As Harrison says, each different approach may be suitable at different times and are utterly dependent upon what an individual scheme requires and trustees should not be deflected from that focus.
“There are a number of things people want from any transaction and pricing is one. Security will be the second and then elements around flexibility will be the third,” he says.
“These are the areas people will inevitably be concentrating on and I don’t think that’s changed.”
The market is more than big enough for banks and insurers to write annuities and longevity swaps, agrees Bird, adding: “It’s more a question of what is the right solution for a particular pension scheme, depending on its funding position and the longer-term strategic plans of the trustees and sponsor.”
Due to this, longevity swaps are likely to remain a specialised tool for larger schemes or those that do not wish to pursue a buyout.
“Those who take out longevity swaps are happy to hold asset risk and seek to be rewarded for it and do not think it is good value to pass it on to insurers in the form of an annuity,” says Pink. “But if they do want to remove longevity risk they can do so using longevity swaps and take a more ‘DIY approach’ to de-risking.”
Longevity swaps are becoming better understood, and the fact that insurers also use them
to hedge the risk they take off their clients is likely to calm any lingering fears when considering anything other than physical assets. They will continue to be used as one of the numerous tools that schemes now have at their disposal in the range of options between LDI, delegated management and annuity purchase.