Very few schemes have protection in place against longevity risk in their scheme liabilities. Howard Kearns explains why and how to rectify this
Many UK defined benefit (DB) schemes have closed to new members and are now on a journey to their endgame. Typical target endgames would include a full buyout of the scheme's liabilities with an insurer or, alternatively, a self-sufficient run-off strategy in which risks in the scheme are hedged and the asset portfolio constructed such that liabilities can be paid as they fall due, with no or very low levels of sponsor dependency.
In the period before reaching this endgame many defined benefit schemes have already mitigated interest rate and inflation risk via liability driven investment strategies. However, very few have any protection in place against the longevity risk inherent in their liabilities and therefore remain exposed to the impact of changes in life expectancy. In our view, longevity risk is the next biggest liability risk.
One approach for those looking to hedge themselves against the potential impact of this risk, while retaining control over all of their assets, is to implement an unfunded longevity hedge, also known as a ‘longevity swap'. This transfers the risk of pension scheme members living longer than expected from the pension scheme to an insurer.
It typically involves the monthly exchange of cashflows, whereby the scheme pays an insurer a fixed rate in order to take the ‘risk' of paying a variable rate, with counterparty credit risk being mitigated through the regular exchange of collateral.
Although the concept of an unfunded longevity hedge is similar to an inflation swap (in that it exchanges fixed for floating payments), in practice their implementation and ongoing management are very different. For example, the payments under an unfunded longevity hedge are linked to the actual survival of a group of scheme members, rather than a quoted index.
The unfunded nature of a longevity hedge means that the scheme retains control over all of its assets, giving it the freedom to invest the full portfolio optimally with the aim of meeting benefit payments as they fall due and making up any funding shortfall.
This contrasts with an insurance buy-in, which can also be used to hedge longevity risk. Under an insurance buy-in a significant portion of the scheme assets must be passed to the insurer at the outset, meaning that only the residual scheme assets are available to make up any funding shortfall, potentially putting significant pressure on those assets.
The appetite for taking on pension schemes' longevity risk comes primarily from reinsurers, who view it as a natural offset to their mortality risk exposure. However, under current regulations, reinsurers can only transact with insurers, meaning any pension scheme wishing to hedge longevity risk must do so via an insurer.
Although the longevity market has been relatively quiet in recent years, there have been signs to suggest that activity is picking up and the expectation is that several large longevity swaps will be transacted early in 2020.
In order to support a longevity hedge on an ongoing basis, the scheme will need to appoint various agents. The line-up would typically include an agent who is responsible for calculating the payments to be exchanged during the life of the transaction (for example, net cashflows and collateral requirements).
The scheme will also need a valuation agent, to value the assets posted as collateral, and a manager, to move collateral assets as required on behalf of the scheme.
Liability-driven investment (LDI) managers often provide the collateral management service to clients who implement a longevity hedge. They can work closely with clients, supporting them through the implementation phase and then providing valuation and collateral management as required. LDI managers are typically well suited to this role in a longevity hedge because they already have the infrastructure, skill, and processes to manage the longevity collateral effectively.
We recently worked with a client to implement a longevity hedge. Insight's role in the transaction was to provide collateral management and valuation agent services to both the scheme and separately to the insurer. We worked closely with the scheme and their various advisers over a period of several months to ensure that the transaction could be successfully executed on time, and all of the complex operational aspects were set up ahead of the deadline.
Howard Kearns is director at Insight Investment
Just Group has completed a £74m pensioner buy-in with the UK pension scheme of a US-listed engineering business.
The Smiths Industries Pension Scheme has secured a £146m buy-in with Canada Life in its fourth bulk annuity and its sponsor’s tenth overall.
The Prudential Staff Pension Scheme has entered into a £3.7bn longevity swap with Pacific Life Re, insuring the longevity risk of over 20,000 pensioners.
The Baker Hughes (UK) Pension Plan has secured approximately £100m of liabilities through a buy-in with Just Group.
There have now been a total of 30 longevity swaps over £1bn publicly announced. The full list, provided by Willis Towers Watson and through PP research, is as follows...