PensionsFirst is set to offer UK pension funds a set of bonds aimed at immunising them from longevity as well as market and inflation risk. It claims it can do all of this cheaper than the bulk annuity buyout firms currently hunting the same schemes. Alex Beveridge talks to Timothy Lyons
Timothy Lyons: We started looking at this about two years ago and looked at the changes which had occurred in the defined benefit (DB) market over recent years, prompted by the changes in regulation and accounting standards. We wondered why there was no capital markets solution for the management of DB risk. On the one hand, you have bulk annuity and insurance products which provide full economic and legal solutions for the risk, and on the other, you have a variety of products under the heading of liability driven investment (LDI), which cover interest rates and inflation and to some extent match duration, but leave longevity uncovered. Longevity is a risk class which has been managed in the insurance sector for many generations and there is no logical reason why the capital markets could not manage similar types of risk. We started to look at this and look at some of the solutions which had been investigated before in terms of creating longevity solutions. It seemed to me nobody had done the hard graft and investigated a methodology which could provide a robust basis around which markets could become comfortable with securitising longevity. This is essentially what we set out to do; to create a methodology for analysing the risk in longevity and to create a methodology which we believe will enable a broad range of capital market investors to participate in this asset class. It is not only a very large asset class, but it is one which has two characteristics which we believe will appeal to investors. Firstly, it is essentially uncorrelated and secondly, it is based on trend, as changes in longevity occur over long time periods.
Alex Beveridge: Could longevity experience a spike if there was a dramatic breakthrough in medical science, if someone found a cure for cancer for example?
Timothy Lyons: That would not change mortality statistics suddenly. It would take a long time to filter through. If some of the drugs being tested at the moment come on stream between now and 2020 then you would not see a significant impact until the middle of the century. Our model factors in the impact of significant medical advances and the key point for investors is that longevity is nevertheless a trend exposure rather than a spike, or event risk as is the case with mortality - and yet mortality bonds have nevertheless found a fairly broad marketplace. Also, insurance linked securities as a class have been left relatively unscathed by recent events in the credit markets. This reflects the lack of correlation between insurance and pensions risk and the other risk classes.
Alex Beveridge: There have been a number of attempts to create longevity bonds, none of which have gained market traction of any note. What is so different about your proposal?
Timothy Lyons: Well, we take a very different approach. If you look at the first attempt, the EIB bond in 2004, it was flawed because it was limited in the risk it covered. They based the payments on that bond to a single cohort of 65-year-old males in England and Wales as of the date the bond was issued. This meant that you were only tracking one cohort of males over time - this would have provided a very limited hedge for scheme specific longevity exposure. A pension scheme has a very specific community or exposure and the basis risk that is left if you just hedge it against a very crude cohort is considerable. Since then, we have seen solutions driven by a sense that the only way to get a market for longevity is to create a big liquid instrument around which everyone can trade. There are two errors in that approach, one is that it supposes there is really a natural market for buying longevity risk, which we don't think exists at the moment. Also, what people like JPMorgan and BNP Paribas and Credit Suisse, who have created indices, have done is to focus on whole population indices. So they are measuring risk on a whole population and are saying that is a good proxy for people who are managing specific scheme risk. We don't think that is true. We want to bring debt capital to support the development of the longevity product we have produced. We are going to offer scheme specific solutions, and we are going to do that by creating a system platform which analyses longevity risk. We are going to be able to analyse a scheme using membership data and postcode analysis. We will create a complete analysis of the specific exposure that scheme has and then create bonds or derivates which will pay out a mirror of the actual cash flow liabilities which the scheme is exposed to. So we can offer bonds which will cover everything from market risk, inflation risk and longevity risk. Or we can split them out and offer schemes cover for individual components of risk.
Alex Beveridge: What size of scheme are you targeting with this?
Timothy Lyons: We are definitely geared towards the mid-sized to larger schemes in the sense that we believe this is a very scaleable solution. So for extremely large schemes we think we could propose a full solution.
Alex Beveridge: Who will be the counterparty to this risk?
Timothy Lyons: PensionsFirst will be the counterparty, putting its capital at risk to manage the longevity exposure acquired by offering scheme specific investment solutions, using a combination of real equity and debt capital. The point here is that our methodology, which is a statistical methodology effectively projecting likely outcomes in the development of longevity over time, is one around which you can create a variety of subsets of asset class and by doing so we can access cost efficient and scaleable sources of capital, which will make our products highly competitive. Our methodology enables us to tranche risk and sell down components of risk to investors who may have no natural bias in longevity. Many investors in securitisation are used to buying asset classes which are based on statistical projections - infrastructure finance and catalogues of music for example.
Alex Beveridge: So you are ultimately reliant on selling on the risk once you have acquired it?
Timothy Lyons: Yes, we will initially sell on parts of the risk by selling short-dated longevity capital notes, butwe are not expecting to sell on all the risk in the near term. We do expect that over time the market in longevity will develop to enable total transfer to the capital markets, but we don't think that this is a prerequisite for starting to develop the market. That is where we think other people have perhaps taken the wrong path.
Alex Beveridge: How do you go about hedging the longevity aspect of the bond?
Timothy Lyons: We are providing the capital to support our own model. We believe the model is very robust and we have done a great deal of back testing in terms of how a model would perform throughout various periods of time. It is a very stable projection of longevity. Because it is statistical, it is not like the typical methodology which is used by the insurance industry or the pensions industry, which is based around short, medium or long term cohorts, all of which suffer from the problem that after a time, the cohort models start to assume that longevity will not continue to improve. The statistical model is one which effectively re-calibrates as it goes forward.
Alex Beveridge: But ultimately, if a pension fund buys one of your bonds, then it is completely dependent on you not going bust.
Timothy Lyons: As you are with an insurance company or anybody else that provides a solution. That is why we expect to be able to offer these solutions to a capitalised AAA standard. We will be capitalised accordingly, in other words there will be sufficient capital supporting the offering.
Alex Beveridge: Presumably not all this capital is coming from yourselves. What sort of institutions have you got backing you?
Timothy Lyons: The initial backing came from a Japanese bank and from a high net worth individual. At the moment we are in the process of going through round two financing, where we are looking to raise the first tranche of capital devoted to the management of longevity risk. We are expecting to announce a capital raising of £250m and then we will build out from that. In addition, we are hoping to bring in between two and four strategic partners who will come from major financial institutions. Basically, people who can give us a combination of deal flow and distribution for products which effectively have a horizon far beyond the UK. We developed the methodology around the specifics of the UK market, but this is really a global market opportunity.
Alex Beveridge: Will this be cheaper than buyouts?
Timothy Lyons: Currently the bulk annuity market has too much capital chasing too little business with a consequent impact upon pricing. As a result, if we were offering the equivalent of a full buyout we might only be marginally cheaper than an insurance solution. However, rather than competing for the relatively small market for buyouts, which is around £5bn p.a., we see our place in the market as filling the gap between bulk annuity and LDI, by providing investment solutions which enable scheme sponsors and trustees to manage all the risks within their DB schemes - that market in total is close to £1.5trn.
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