Andrew Stewart explains how longevity swaps could help manage the risk of running a pension fund
Over the last 50 years, it has been a real challenge to keep up to date with the pace of life expectancy improvements. Looking ahead, with the potential for further medical advances, it is safe to say that the art of accurately predicting life expectancies will remain a tricky business.
While the prospect of living longer is great news for individuals, it presents a significant financial challenge for Defined Benefit pension schemes.
Quite simply, if pensions need to be paid for longer than expected then extra cash will need to be found from somewhere.
This risk of underestimating the impact on liabilities of people living longer is known as longevity risk. It has the potential to seriously weaken a scheme's funding position. Roughly speaking, for the average scheme, for every additional year of life expectancy, liabilities will rise by on average 3-4%.
What can be done to manage this risk?
When we think of managing longevity risk we often think of buy-ins or buy-outs. This involves the passing of assets to an insurer to cover the liabilities of a specified portion of members. With a buy-out, the policy covers all of the members, whereas with a buy-in, the protection is limited to a section of the membership.
These transactions result in the transfer of longevity risk from the pension scheme to an insurer. If the members live longer than expected the insurance company will take the hit, rather than the pension fund.
Sounds like a great idea? However, buy-in and buy-out policies are not capital efficient, as schemes need to pay for protection up-front. This means they are really only suitable for very well-funded schemes who have the money to spend.
For pension schemes already in an underfunded position, going down the buy-in route would exacerbate the funding problem, as you are left with a proportionately smaller asset pool to meet the remaining liabilities, which is not an ideal situation.
The alternative approach – longevity swaps
Another option for schemes looking to mitigate longevity risks is to use longevity swaps. Longevity swaps are not a new idea however, until recently they were really only a feasible option for very large schemes.
More recently we have seen the market adapting to make this a feasible solution for a much broader range of schemes. Insurers have started to come to the market with solutions that basically strip out the inflation and interest rate elements of the "buy-out" contracts.
These are policies which make or receive cash payments depending on whether scheme-specific longevity is higher or lower than expected.
This means that more pension schemes can now gain longevity protection on a proportion of the liabilities (usually the pensioners and older deferred members), however little or no assets need to be handed over at the outset.
The risk management toolbox
For some, longevity hedging may not been so high on the agenda compared to some of the other risks being run, like inflation or interest rates, but it is definitely not something that is going to go away.
Capital efficient solutions like longevity swaps are great tool to add to the trustee toolkit to help in managing the risks of running a pension fund. We think the broadening of the market is a really welcome move.
Written by Andrew Stewart, Client Manager, Cardano
