Published: November 01, 2010
Despite treasurers and finance directors becoming more and more concerned about the impact that increasing life expectancy may have on the financial viability of their defined benefit (DB) pension scheme, few to date have transacted on a longevity risk-transfer deal.
Longevity risk has fast risen to the top of many corporate treasurers’ agendas. Why is this?Life expectancy has increased considerably over the past 50 years in the western world. What is more, this trend shows little sign of stopping. In response, actuaries have adopted increasingly conservative assumptions around longevity – driving up pension scheme liability valuations as more members are expected to live further and further into their 90s and beyond. Indeed, FTSE 100 pension schemes increased their assumptions on how long their members will live by an average of five months last year – the fourth consecutive year that they have made such an increase in their longevity estimates.
And because the financial health of so many of the UK’s large public companies is intrinsically linked to their DB pension schemes, many treasurers and finance directors are rightly convinced that improvements in mortality rates spell a real threat to their company’s financial survival. Against this backdrop, it is clear why the management of longevity risk has now become an issue of good corporate governance and why schemes are interested in hedging the risk in the nascent longevity swap market.
Yes, they can be effective. In a longevity swap the counterparty (usually an insurance company or a bank) agrees to meet the actual benefits payments made to the pension scheme members, regardless of how long they live (the floating leg of the swap). And in exchange, the pension scheme meets a fixed schedule of payments to the counterparty (the fixed leg of the swap). With such a hedge in place, a scheme is no longer exposed to the risk that members live longer than expected and can, as such, fix its liabilities with respect to longevity risk.
One of the key attractions of a longevity swap is that, unlike a buy-out or buy-in arrangement (where all pension risks are transferred), there is a limited initial payment to a counterparty.
I would suggest that many pension schemes have found that the solutions on offer in the longevity risk-transfer market fail to offer value-for-money in terms of the level of risk that is actually being transferred. In many cases pension schemes spend considerable time and money with their advisors assessing the finer details of longevity swaps – such as the collateral used to mitigate counterparty risk – before fully considering this issue.
Adding to this is the worry that a longevity hedge may not be an attractive asset for buy-out providers to take on as part of a buy-out in the future. Given these issues, value-for-money should always be the first consideration when analysing whether to enter into a longevity swap.
To determine whether a longevity swap offers value-for-money, pension schemes need to be able to compare how much risk is being removed – that is to say the potentially higher payments that the scheme may need to make in the future due to increasing life expectancy – to the cost of removing that risk, i.e., the price of the swap contract. For a transaction to take place, pension schemes must be convinced that the risk reduction justifies the cost of the longevity hedge.
To understand the true nature of their risk component, pension schemes must consider their pension liabilities over a wide range of longevity scenarios – from a flu pandemic, which would dramatically reduce their liabilities, to a cure for cancer, which would have the opposite effect. Only by assessing the spectrum of longevity outcomes can sponsors work out the risk they are faced with.
Yet under the status quo, this type of scenario testing requires actuaries to update their models and repeat numerous valuations, which is not only expensive for sponsors but, more importantly, time consuming. By the time this process is concluded market prices can often swing, hampering schemes’ attempts to transact effectively.[[[PAGE]]]
It is important that schemes assess how their individual risks in the portfolio are correlated to each other.
Before getting into the complexities of longevity swaps, it is important that schemes establish how significant removing longevity risk may be to the overall level of risk that the pension scheme is running. Indeed, inflation risk and interest rate risk present more significant dangers to scheme funding levels yet are, at the same time, far easier to remove effectively.
A good way for schemes to gain a better understanding of the whole spectrum of risks that they face is by conducting a value-at-risk [VaR] analysis on a risk platform. VaR analysis can be used to determine the breakdown of a pension scheme’s risk exposures in order to identify precisely how much each risk factor contributes to the overall VaR.
Furthermore, it is also important that schemes assess how their individual risks in the portfolio are correlated to each other. Pension schemes benefit from having risks that are diversified (or un-correlated) and many schemes have been seeking more diversified risk exposure in recent years.
Yet longevity risk is largely un-correlated with other financial risks to which a pension scheme is exposed. Indeed, when assessed in light of a scheme’s total risk position, longevity is likely to provide significant diversification benefit and removing it, therefore, may have little impact on the scheme’s overall risk position.
Yes, but significant barriers remain to the creation of a liquid longevity market. Finding counterparties is one key barrier.Currently, there are few natural investors that would benefit from an unexpected rise in life expectancy – even life insurers, despite having some appetite for longevity risk, are not an ideal hedge for a longevity swap. People that are paid pensions and people that buy life insurance products tend to be of very different ages, which can create significant basis risk for an insurer. As such, the life insurance industry does not offer a deep opportunity to provide a hedge for the ‘tail’ in longevity risk – the 65-and-over age bracket. What is more, clearly there is a substantial cost to counterparties holding capital against longevity risk and, given the long-term nature of the risk, they have to hold onto this capital for some time before seeing a return.
This has put many of them off entering the market, or alternatively forced them into high pricing levels.But treasurers and finance directors can only decide whether these prices are too high after first understanding the true nature of the risks that their DB pension scheme faces. For some, the benefits of a longevity swap will be worth the cost; others will be more comfortable retaining longevity risk.
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