An increasing number of investment banks - and other providers - are launching products to tackle longevity risk, which loomed large over defined benefit pension funds in 2007. Elizabeth Pfeuti looks at what's out there
Instead of beating inflation and interest rate hikes, which could be hedged with the right information and calculations, longevity risk was found to be specific to each fund and a tougher nut to crack.
Not only the age of the scheme members had to be considered, but also the type of business, geographical location and even class of its workers all contributed to a pension scheme's longevity risk.
Never shy in offering new solutions to investors, insurers and investment banks have come up with new ways to capture a piece of the longevity risk hedging action, along with new players, like Amelia Fawcett's PensionsFirst, which straddle the remaining middle ground.
Their attentions have turned to issuing longevity products in order to muscle in on the global success of the liability driven investment (LDI) market and budding UK buyout industry.
Not that the attempt to target longevity issues is without precedent - for example, trustees might remember the failure of BNP Paribas' joint venture with the European Investment Bank in 2004. The partnership attempted to introduce an annuity bond with a longevity swap attached to it, but it failed to launch, in part because it did not cover pension scheme members over 90 years old.
David Blake, head of the Pensions Institute at Cass Business School, gave more clues to why the product had failed: "One of the reasons it never flew was that while trustees welcomed a longevity hedge, they did not want it attached to a bond."
Blake added: "Once that was realised, the investment banks stopped working on cash market (i.e. bondbased) solutions and moved over to designing longevity derivatives. These have been much more successful."
With this is mind, JPMorgan and Goldman Sachs have been the latest to step into the ring.
JPMorgan launched a longevity index in March 2007, initially in the US, UK and Wales. The index has since been rolled out to the Dutch market and is intended to be spread further afield in coming months.
Named LifeMetrics, the index was created to help pension funds measure, manage and look at ways to tackle mortality and longevity exposure.
In autumn 2007, Guy Coughlan, global head of pension asset liability management, JPMorgan, told Global Pensions the take-up of this product had varied from one country to another, despite each index being specifically designed to account for the differences of each market.
Goldman Sachs' QxX.L.S. was launched in December 2007. It was the first - and currently only - tradable index to give secondary market exposure to holders of both longevity and mortality risk, such as pension funds and insurance companies.
Hedge funds could also potentially use the index as a trading tool to express trading views.
QxX.L.S. has been marketed to pension funds worldwide, with Europe a definite target for Goldman Sachs.
David Cule, principal, Punter Southall, said the conditions had to be right for this market to eventually take off: "Investment banks will play a part in pension funds de-risking longevity in their scheme and due to the strong relationships already established between the two, discussions may have already taken place."
Too many cooks?
However, are investment banks in danger of overcrowding an increasingly busy marketplace?
Over the past few years, many UK pension funds have been getting back into the black. This has caused a flurry of buyout activity with companies wanting to avoid the deficits they have suffered in recent years by transferring either some or all of their liabilities to a third party.
However, even with this increase in activity, the number of players in the market still far exceeds demand. With investment banks and others now stepping on the toes of these specialist insurance companies, surely the market will be saturated?
Cule considered investment banks had more flexibility than buyout companies, which were obliged to follow insurance industry guidelines, and said this freer regulatory status could help them to deliver different, more bespoke products.
In fact, the various parties selling de-risking products have been quick to confirm the marketplace is big enough for everyone and each is targeting a different sector.
Mark Wood is the chief executive of Paternoster, the pension fund buyout company which took on the liabilities of the P&O, Emap and LASMO schemes in 2007.
He seemed unconcerned at the move by investment banks to enter the longevity space. Wood said: "Investment bank solutions are primarily appropriate for the pension funds of large companies."
He continued: "To create a bespoke solution requires a largescale approach, therefore it would only be worth working with a scheme with assets of a significant amount."
Wood explained Deutsche Bank had invested in Paternoster, as the German investment giant could see the benefit of exposure to the small and medium sized pension funds interested in removing longevity risk.
How longevity solutions work
PensionsFirst, according to its executive, was created to fill the gap between a full pension fund buyout and the products offered by investment banks.
Timothy Lyons, partner, PensionsFirst, explained how the company aimed to create schemespecific longevity solutions. "We are able to analyse a scheme using membership data, scheme rules and postcode analysis. This enables us to create bonds or derivates which will pay out a mirror of the actual cash flow liabilities which the scheme is exposed to."
Kevin Carter, head of JPMorgan's Pension Advisory Group, explained the process behind the bank's LifeMetrics product: "The idea here is to try and create standardised building blocks of mortality risk - which is of course the flipside of longevity - that can become a traded market in the same way that credit derivatives is a traded market of credit."
He added: "By its nature, it's going to be an evolving process - it's not going to happen overnight - but we believe from the conversations we've had with both people who want to sell longevity risk and people who want to buy it, that there is the makings of a two-way market."
So why is this market taking so long to get off the ground?
As is often the case with new products, the speed of pension fund trustees' exploration, understanding and adoption of what is offered sits way behind the providers, be they asset managers or investment banks pushing their wares.
The other major issue which can make or break the fortunes of a product is its cost.
Pension fund buyouts hit UK headlines in 2007, not just for the amount of business the companies were taking, but the reduction in price the increased competition in the market had dictated.
Lyons at PensionsFirst claimed many investment banks now had the resources in place to deliver capital market solutions such as PensionsFirst is offering to the DB pensions market.
He also said within the next three to five years they would be major players in the longevity de-risking market.
However, the feeling for the moment is one of treading softly.
Carter at JPMorgan clarified: "What's going on at the moment is a price discovery phase, where the buyers and sellers want to transact but they're just not quite sure what price [to transact at]."
Cule agreed: "People would like a trade to be made available to examine and gauge a price. They know the expertise is out there, they just want to how much they should be prepared to pay for it."
By creating a tradable index and encouraging a secondary market, Goldman Sachs said it intended to open up the process and make it more inviting for potentially apprehensive pension funds.
Alex Dubitsky, head of Goldman Sachs' Longevity Markets Group, said: "This will result in more transparent pricing of longevity risk, should reduce transaction friction, and will likely lead to improved economics for market participants."
But, cutting through the industry spin and marketing, have pension funds taken these new offerings seriously?
Paternoster's Wood said the P&O pension fund trustees had investigated the various products offered by investment banks, but had opted for a partial buyout in the end.
The UK's Pension Protection Fund (PPF), which acts as the safety net for stricken companysponsored defined benefit pension schemes, acknowledged the emergence of this market.
A PPF spokesman said the firm's investment team carefully analysed any risk mitigation strategy against cost.
He added: "At the present time, we are not hedging longevity risk as the market is still in its infancy. However, we will continue to monitor the market."
Cule at Punter Southall concluded it would only be a matter of time before investment banks were major players in this arena.
He said: "Longevity risk is the hardest to address as you can never get uniformity.
"Once trustees learn more about the concept and there is a benchmark established, this industry should take off."
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