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
JP Morgan’s second attempt to hedge longevity risk targeted pension funds as opposed to insurance companies. JP Morgan’s index, which observes mortality rates for England and Wales, is based on a forward rate contract.
Firstly, JP Morgan and the client will agree on a mortality rate which is taken from the index. At the maturity of the contract, JP Morgan will pay the client the fixed mortality rate and the client will pay JP Morgan the LifeMetrics Index mortality rate existing at that time – also known as the strike. JP Morgan will provide pricing for potential strikes to the pension fund.
If mortality rates fall faster than expected and finish below the fixed rate, the pension fund will receive a net payout to compensate for the associated increase in the value of its liabilities.
Pension funds will be able to take out these contracts from investment banks or re-insurers. There are no up front costs but transaction costs and security in the form of collateral is required in case any other parties default. If the outcome of the swap is zero cash flow, then any collateral being held is returned to the counterparty. None interviewed would provide details of pricing and costs.
Overseas interest
Mercer’s Fletcher said the hedge targets large plans holding several millions in liabilities, schemes which are closed to new members and those looking to de-risk their assets. He said there is current interest across Europe and the US.
“We are seeing interest from the larger plans. The Netherlands has been hit to make improvements to their actuarial tables and that’s certainly one area that has been receiving a lot attention. This deal looks to the non-pensioners rather than retirees. So I think a lot of plans are considering whether this is something they want to get in on.”
According to Fletcher, the bulk of interest had come from the UK, some from the Netherlands and Canada, with less from the US and Germany. JP Morgan has indices based on populations in the US, Germany and Netherlands while Canada’s is in the pipeline.
JP Morgan plans to transfer the indices to the LLMA.
“This will create an index where all the big players are buying into which helps the progress of this hedge nationally and globally,” Fletcher added.
Dutch pension fund PGGM managing director Erik Goris said he was very interested in the hedge but would need further information on pricing and the associated risks.
“Pricing would be my greatest concern. I would be interested to learn why they chose to do a hedge for active members and how this was favourable in terms of the pricing they received from JP Morgan. It would also be interesting to learn how they calculate the longevity risk for the active members,” Goris told GP.
Risks
However, the longevity market is still immature and pricing information is not readily available.
JP Morgan head of longevity structuring David Epstein said: “In other markets such as interest rates, people can get an idea of what strikes looks like because it is a liquid market and there are a lot of people trading in it. In longevity it’s not quite the case so it’s harder to get hold of pricing information easily because it has not reached the stage of sharing information, but we are trying to move the market towards this so it can become clearer what strikes look like.
“The key is to work out what the hedge notionals should be. Should it be $100 for 60 year olds or $50 for 70 year olds? This is the process we go through with schemes and their advisers on calibrating the risk in their scheme to the contract so we can hedge their sensitivity to changes in mortality rates. We are trying to create a hedge portfolio for pension funds so regardless of how the rate moves, it still works as a hedge.”
Schroders head of liability driven investment Andrew Connell said the associated risks are the same as in other future contracts. There is counter party risk as investment banks may not be around when the contract matures and there is a basis risk in which the underlying index of the contract could behave differently from the members of the pension scheme, he added.
On the other hand, PGGM’s Goris believes there are other risks that need to be considered.
He said: “Using a national index while the current interest in assessing the liabilities focuses on the particularities of the constituency of that fund can be a risk. You would have to take into account the experience, mortality and risk of the members under assessment.
“Funds are now more looking into the social economic composition of their participants and taking that into account when assessing the liabilities. Taking these factors into account could lead to a different outcome to the index.”
“The Netherlands is looking for a longevity solution but whether or not this hedge will break into the Netherlands depends on the pricing and risks.”
