Dealing with Longevity Risk

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.

TMI asked Matthew Bale, Director and co-Head of Client Solutions at PensionsFirst, how sponsors should assess the value-for-money offered by such solutions. 

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.  

And are longevity swaps an effective means of hedging this longevity risk?

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.

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