MMC UK Pension Fund's Frank Oldham tells Stephanie Baxter how its £3.4bn longevity swap came about and why it chose a captive structure
Given longevity risk is one of the major challenges for pension schemes, it was no surprise to see a healthy £6.4bn worth of longevity swap deals in 2017.
The largest of the year was the Marsh & McLennan Companies (MMC) UK Pension Fund, which transferred longevity risk to the global reinsurance market through an innovative £3.4bn deal.
Covering liabilities for all 7,500 pensioner members, it used a captive approach to structure a contract with Guernsey-based insurer cells managed by Marsh Capital Solutions Guernsey.
The starting point
The MMC scheme is a large, complex defined benefit (DB) fund with circa £7bn worth of total liabilities, of which around 50% relate to pensioners.
Closed to future accrual like many other DB schemes, it is getting mature and is on a journey to de-risk over time, slowly switching return-seeking assets into maturing assets, and increasing hedging against inflation.
"That meant longevity rapidly moved up the list as being completely unhedged," says trustee director Frank Oldham.
"Adding to that, most pension schemes have concentration risk among the pensioners; it's not untypical to find the top 20% of pensioners represents around 50%, 60% or even 70% of all liabilities.
"We have a strategy to reduce risk over time in the asset space, but we also wanted to retain control of the assets, so in essence we wanted to manage both longevity and investment risks but at our pace."
Oldham says, back in December 2016, it was difficult for the fund to see great value-for-money opportunities to further reduce investment risk and inflation risk.
"A lot of people were saying at the time, ‘where are yields going to go, do we really want to lock in at this level?'", explains Oldham.
"Did we want to lock our assets in at this particular point in time - maybe we don't - so let's look at another way of de-risking, and one way is tackling longevity risk."
Oldham explains that, as pension increases within schemes compound over time, which results in longer duration and compounds the cost of increases in life expectancy, this was yet another driver for hedging longevity risk.
As such, the fund conducted some analysis to see what might happen to longevity under different circumstances.
"For example, we could see that if the government allocated some additional resources to health sector etc, or if general attitudes to health changed, that could easily add several years onto existing life expectancy. Putting all of this together, we had a pretty clear picture of what we needed to do and what we could do to get good deal for the fund. So it moved from being on the agenda to being on top of the agenda."
Choosing the structure
After deciding to buy a longevity swap, the scheme had to choose which structure suited it best. There are four ways to structure these deals: traditional, streamlined, pass-through, and captive.
The traditional structure is where a pension scheme contracts with a UK-regulated insurer or bank, which then reinsures the majority of longevity risk with the reinsurance market.
However, the fund was more interested in the other types of structure.
Oldham says: "We've seen emerging recently a pass-through structure, which involves sub-contracting with a UK-regulated insurer - but the insurer doesn't take the credit risk in relation to the reinsurer. So you start to create a direct relationship with the reinsurer as the end taker of the risk."
Of even more interest, he says, was a captive structure, which instead of using a third-party intermediary, involves entering into a contract with a scheme-owned captive. It effectively gives the fund a more direct relationship with the underlying reinsurer via the scheme-owned captive, which has its own board of directors.
"You do 'lose' the protection afforded to a UK-regulated insurer, but as all these contracts are typically fully collateralised, you have the collateral as protection in the event of reinsurer default," says Oldham.
The key reasons why the pension fund opted for the captive route fall under the following headings: flexibility in terms of the contract (e.g. novation/transfer to a bulk annuity provider) managing contagion risk, efficiency and cost.
As this is potentially anywhere between a 10- and 50-year contract the scheme is entering into, explains Oldham, "you have at the back of your mind the potential need to novate swaps if you want to subsequently go into the bulk annuity market".
Although this is possible following the precedent set by the Phoenix Life / PGL scheme transaction last year, he points out schemes still have to rely on many parties in a traditional form of contract - the reinsurers plus the fronting insurer - to reach mutual agreement.
The next decision was what type of captive structure it should choose. One is a segregated captive account operated by a third-party; the other is a wholly-owned incorporated cell, which is what MMC opted for.
The captive cell belongs to the pension fund, and can sit under an umbrella organisation.
"From a security point of view, it was important to have our own entirely financially separate captive cell that removes the risk of contagion with other schemes or between reinsurers," according to Oldham.
In the structure chosen by the MMC UK Pension Fund, there are two captive cells, one for each of the reinsurers - Canada Life and PICA - to avoid contagion risk. Each reinsurer took 50% of the pensioner liabilities.
Every month, the scheme provides data to the captive to work out what the pensioner cashflows should be, and then pays each captive a fixed leg portion of the swap. The fund then makes payments based on the predicted life expectancy in the contract, and the captive pays back an amount based on actual emerging experience, according to the number of pensioners still alive. The cashflows go directly through to reinsurers; the captive is just the pass-through structure and it retains no risk.
The process of selecting reinsurers firstly involved going out to all players to get indicative pricing to see whether or not there was an acceptable deal on the table," explains Oldham.
"Using scenario analysis we were able to compare our highest criteria and all the signs were good. We were in the middle of an actuarial valuation at the time, and were able to make a specific reserve for this contract so there were no nasty surprises."
However, the amount of work involved in choosing an innovative structure should not be underestimated.
As Oldham says, "It was a big step for the fund; it took a lot of effort, time and expense in setting up this structure and going through this particular process. But it was absolutely worth it - you only need to save a few basis points on cashflows every month for the next 50 years to justify setting up this kind of structure."
If he could have done anything differently, he would have set aside more time in his 2017 diary.
The whole process took around 12 months from start to implementation. It took around three months to find potential for a good deal, and another three to go through the process of thinking about the structure. After going back to the reinsurers and negotiating a price, it took an extra six months to go through the broking process, get a shortlist and move on to implementation.
Good governance was another important factor in finalising the deal.
"We were fortunate to have a good relationship with the sponsor," he says. This was underpinned by the joint working group which has representation from the trustee, the sponsor in the UK and US, and the advisers.
"That really enabled full and transparent communication through this process. One of the key challenges for any contract of this nature is bringing all the stakeholders with you. That was one of the keys to success."
The trustee board's strategic investment and risk management committee, whose role is to oversee some of the key financial strategic risks, came up with a suitable longevity contract proposal to a joint working group of trustee and sponsor representatives.
The group delegated implementation to the fund's joint implementation sub-group, which did most of the hard work, meeting on a bi-weekly and then weekly basis by the end of the contract. Its job was to work through the details of the contract, and formulate the proposition to come back to the full board to seek full approval.
Advisers also played a key role, he says: "You need to ensure you work with people who know the market, know the reinsurers, and can not only get you the best price but also the right contract terms."
Current Frank Oldham is an independent trustee and a trustee director of the MMC UK Pension Fund.
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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...
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