A landmark hedge to spread

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Jaishree Kalia reports interest in hedging longevity risk of non-retired members could soar internationally following the news of the world's first such hedge being used in the UK

Last month, the trustees of the Pall (UK) Pension fund completed the first ever longevity hedge to mitigate increasing life expectancy of non-retired members. The move has spurred talk among UK providers that a similar solution could be exported to other parts of Europe and North America.


The global manufacturing firm's UK scheme - which has assets of about £120m and 1800 members in total, entered into a £70m ($113.5m) contract with JP Morgan using future values of JP Morgan's LifeMetrics Longevity Index. The hedge has a term of 10 years during which the scheme's trustees may choose to adjust the size and composition of the swap or decide on an alternative solution. Officials at the scheme said at the time the benefit entitlements of current and future pensioners of the fund were unaffected.


Chairman of the trustees Andrew Thomson said "Like other pension plans, our fund has been hit by significant life expectancy rises over the last decade. This flexible and innovative arrangement helps us manage the key risk of longevity."


The longevity index hedge aims to minimise the longevity risks for active members. In the deal with Pall, Mercer conducts the independent broking and the assessment of pricing; JP Morgan creates the mortality index based on the government's death dates for that year; and Schroders manages the contracts, ensuring the correct payments are being made at the right time.



A series of deals
It would seem the deal could be the first of many with members of The Life and Longevity Markets Association (LLMA), a group of banks and insurers who work together to make standard indices, also currently working on similar longevity deals, said a spokesperson. The members include investment banks like Deutsche Bank, Morgan Stanley, UBS and the Pension Corporation and insurers such as Swiss Re, Legal & General, AXA and Prudential.


JP Morgan's index-based hedge is different from previous longevity hedges in two ways: it aims to address the risks associated with non-retirees - in particular those aged around 40 years - and is the first longevity hedge to use an index for pension funds.


If life expectancy increases beyond previous estimates, occupational pension schemes will require additional funding. This transaction aims to help mitigate this risk by shifting it towards the investment bank.


JP Morgan head of longevity structuring David Epstein said: "There's a view today of how long people are going to live but it may be wrong. As a pension scheme, the risk is that people will live longer than expected, which drives up the liabilities and drives down the funding value. Mortality rates are expected to drop but the question is: how fast they will drop? Arguably in the pension space, actuaries have been playing catch-up for a long time expecting a slope which wasn't as steep as the slope we have actually seen."


Previous longevity solutions solely focused on pension plan retirees as hedging against higher life expectancy of active members was difficult.


Mercer risk consultant Gordon Fletcher agreed saying: "Hedging against active or deferred members has been difficult as the actual hedge is an abstract value placed by an actuary on the future pension payments."


He said the retirement options deferred members have such as early retirement, taking tax free cash or transferring out of the scheme, all add uncertainty to what is being hedged. With pensioners there is a constant stream of agreed payments which provides a tangible amount to hedge.


Previous longevity hedge deals covering retirees for pension funds include Swiss Re's transaction with UK's Royal County of Berkshire Pension Fund (RBPF) in December 2009 which provided protection against CHF1.7bn ($1.8bn) of pensioner liabilities which transferred the longevity risk from the scheme to the insurer. Under the contract, RBPF paid regular premiums to Swiss Re and Swiss Re insured the floating annuity benefits to members, so any future positive or negative deviation due to uncertain longevity was absorbed by Swiss Re.


In another longevity contract, JP Morgan traded its first longevity derivative contract with insurance company Lucida in February 2008. This hedge used a swap contract based on JP Morgan's LifeMetrics Longevity Index. The contract was the first to involve an insurer and was created as an alternative option to more traditional approaches which offload longevity through reinsurance. Lucida said it wanted to take advantage of the different market views to gain wider insights on life expectancy, without hedging the entire risk.

 

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