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Special Report

Impact investing


Swaps are now an option

Gail Moss assesses approaches to longevity. Aside from raising the retirement age, pension funds now have a longevity swap market to add to their toolkit

In a climate of increasing pension fund risk on all fronts, one risk in particular has the potential to cause the most headaches. Longevity risk - the risk that a fund's pensioners will live longer than the scheme anticipates in actuarial assumptions - is likely to increase inexorably over time, thanks to medical and environmental advances.

And while no doubt happy for their members to enjoy lengthening life spans, defined benefit pension funds need to protect themselves against the burgeoning costs of their retired members.

For the moment, the bulk of interest in longevity hedging and other solutions has been in the UK. Here two principal areas have been developed - insurance-backed solutions, principally buy-outs and buy-ins, and capital market-based derivative products.

"Buy-ins and buy-outs were all the rage a couple of years ago, when scheme finances were a lot healthier and buy-in pricing was very competitive," notes Martin Bird, principal, Hewitt. "Now they are not happening at the same rate. Buy-in providers are now finding it difficult to price transactions because of market volatility, while the credit crunch has meant that capital from investors in buy-in firms has dried up. They are also not as affordable because schemes are running bigger deficits."

By contrast, the longevity swap market, having opened its account with the UK pension fund sector, looks set to thrive. Bird estimates that transaction volume could hit as much as £5-10bn (€5.7-11.4bn) over the next year.

For pension sponsors the attraction of longevity swaps is that they themselves retain control of their assets and liabilities. So losses on assets are not crystallised, giving schemes the opportunity to repair their deficits over time from investment returns.

Schemes also pay relatively little money upfront; any payment from the scheme to the swap provider or vice versa will be the difference between the agreed regular premium and the amount to be paid out in pensions each month to the group of individuals covered by the swap.

However, so far swaps have only been transacted to cover pension scheme members who have retired. One of the reasons is the greater uncertainty about the potential length of service or retirement age for employees yet to retire. But this aspect need not unduly restrict swap activity, as swaps can offer differing degrees of hedging.

For instance, schemes can use a bespoke swap which bases the payment from the counterparty on the scheme's actual mortality experience, or go for the broad brush (indexed) approach, where payments are in line with a national mortality index.

Indices are considered to be more liquid and more cost-efficient than other solutions, but as they do not exactly match the pension fund's experience - they can get rid of up to 80% of the risk eliminated by a bespoke product - they also introduce the potential for a difference between pay-off and risk within the scheme.

One solution would be to have a bespoke swap for retired members and an index for those who are active or deferred members, notes Bird, although he says all of the demand is currently for bespoke products.

Guy Coughlan, managing director and global head of pension asset liability management at JP Morgan, says insurance-based and derivatives-based contracts are complementary. JP Morgan's LifeMetrics index provides mortality rates and period life expectancy levels across various ages, by gender, for England and Wales, Germany, the Netherlands and the US. "Insurance-based contracts have a long history and are more familiar," says Coughlan. "But capital markets have more potential for liquidity and fungibility - they are easier to unwind and novate. They have a better mechanism for managing counterparty credit exposure through regular valuation and the posting of collateral." But he points out that capital market solutions typically have a finite maturity, say 50 years, whereas insurance contracts typically last till scheme run-off. The future success of capital markets products depends very much on their appeal to investors as well as pension funds that wish to derisk. "We are seeing more and more investors interested," says Coughlan. "They want to able to invest in an asset class with a low correlation to other kinds of risk products. Even now we are placing longevity risk from pension funds and insurers with investors in other countries, and I think we are going to see a rapid internationalisation of longevity risk transfer." Meanwhile, now could be the time for pension funds to buy a longevity swap, says Bird.

First, he says, a number of players are keen to market risk products but find it difficult to price them because of market volatility. Longevity, however, does not bounce around like other markets, so is easier to price.

"Secondly, they don't lead to additional cash contributions for the pension fund," Bird says. "They do not require the significant upfront cost of the buy-in, so are cash-neutral. And cash is king."

Furthermore, the longevity swap is a new product: providers are trying to kick-start the market by showing that these transactions can be done, which suggests that the first movers could benefit from downward pressure on prices.

But pension schemes opting for longevity hedging should be aware that due diligence is paramount. In particular, counterparty risk is becoming increasingly important.

"The scheme trustees will need to be comfortable with the strength of the counterparty over such a long period, so they may wish to negotiate specific security," says Bird. "In both insurance and derivative format, this can be done using collateral mechanics, much in the same way as interest and inflation swaps are collateralised. In insurance format, this means that the scheme has a collateralised insurance policy and - for UK schemes - FSCS cover."

Schemes transacting swaps should check the exit terms, ensuring they are carefully documented and the exit cost is defined. They should also check that it will be possible for them to go down a buy-in or buy-out route if the sponsor or counterparty goes bust. And UK schemes should also ensure that the swap can be unwound to give it admissibility to the Pension Protection Fund.

The priority in longevity hedging is to put the issue on the agenda for trustee meetings, says John Fitzpatrick, head of longevity risk management at Pension Insurance Corporation, which offers insurance-based longevity hedging products alongside other pension risk transfer solutions. "They should be asking themselves whether longevity is a risk they would like to keep or like to sell," he says. "If they keep it, are they being rewarded for it?"

Fitzpatrick says that if trustees conclude that longevity is the biggest long-term risk to the fund and is unrewarded, they should set up a sub-committee to study in detail prospective products and providers.

"A sub-committee is very useful as it can be difficult for trustees to devote time and attention to a transaction like this," he says. "They should be asking questions about flexibility and price. It goes without saying that they need proper legal advice."

Because longevity is a risk for DB rather than DC schemes, most of the activity in longevity hedging is in the UK at present.

The other major potential market for longevity hedging is the Netherlands. "All the major Dutch pension funds have problems with longevity and the attached cost," says Ronald Wuijster, head of strategic portfolio management at APG. "Now that volatility in the financial markets has abated, they are starting to look at longevity hedging again."

But Wuijster is sceptical about the efficacy of swaps or derivative-based solutions. He says that there are no effective products to hedge long-term exposure, as derivatives and swaps both demand a large safety premium. In the case of swaps, he says it is not always clear what is being swapped.

However, he says a conceivable option is to hedge mortality risk - the risk of members dying younger - setting it against longevity risk so they cancel each other out.

But Wuijster says: "Living longer is not the opposite of dying young, because there may be specific reasons for the latter, such as stress in the workplace. So it is an imperfect match. There is also a lot of demand for longevity hedging, but less supply of mortality risk."

Alternatively, he suggests an investment-based strategy. APG is actively looking at investing in companies - such as pharmaceutical companies providing medication for the elderly, and companies providing nursing or housing - which do well if people live longer.

A further strategy could be for the pension fund to earn a premium itself by extending its longevity exposure. And there is always the most drastic approach of all: increasing the retirement age or limiting the period over which people are entitled to pension payments.

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