> Pension Funds Insider> Longevity swaps: Field of dreams or minefield of complexity?
Longevity swaps are back in the spotlight following the first ever deal that hedges the risk of working contributors to a scheme. Some see the swap of £120 million worth of liabilities between JP Morgan and the Pall UK pension fund as indicating a new departure for a nascent market ready to take off, whereas others remain sceptical of their value to schemes. Pension Funds Insider investigates
"People always live for ever when there is an annuity to be paid them" could easily be a cynical aside of a depressed scheme trustee gawping at a chart showing mushrooming annuity liabilities in recent years. In fact it was uttered by Jane Austin's Mrs. Dashwood in Sense and Sensibility to bemoan the lasting power of one of her pensioned servants. A problem noticeable in the 19th century is now being offered a 21st century solution, but is the common-sense idea of longevity hedging really a sensible option for trustees?
Several pension industry figures have heralded the JP Morgan – Pall swap as an innovative moment that could well kick a potentially huge market into life. The "milestone" deal underlines "that there are starting to be a critical mass of transactions that provide confidence in the process," according to Martin Bird, Aon Hewitt's Head of Risk Settlement. The use of a customised longevity index was a novelty in the arrangement that is argued should lead to better value for trustees opting to hedge against unexpected ageing of their current, and for the first time, future retired members.
With this new innovation and the increasing awareness of the swaps, Bird estimates that £10-£15 billion worth will be completed by the end of 2011, overshadowing the £8 billion completed to date over the past five years. The Life & Longevity Market Association, composed of banks and insurers aiming to establish a longevity risk market, estimates that a massive £2 trillion of longevity risk remains exposed at UK pension funds.
Schroder's Head of Liability Driven Investment Andrew Connell is also confident of an impending swap boom. Having been a party to the JP Morgan – Pall UK swap Connell sees the deal as a model "That creates much lower governance costs for trustees and opens up longevity swaps to smaller schemes and those wishing to insure against the longevity of working contributors." He adds: "There is enough to suggest that this is a field of dreams moment – once you have built it they will come"
Worth the cost?
There remain trustees sceptical of the value of a longevity swap though, with the industry awash with rumours of planned longevity swaps having fallen through after cost calculations.
"Just because people have bought them, it doesn't mean they're right," says David Johnson, consulting director at Trustee GAAPS .
"Any providers would have to make a number of longevity assumptions and are going to build in margins that could be quite significant for schemes," he adds. Other trustee advisers cite the tricky exercises of calculating exactly how much risk is removed from a scheme via a swap and factoring in the administering of deals that could potentially last the best part of a century as deterrents, particularly for smaller schemes that may lack the capacity to easily do this.
Martin Scott and Edward Jewitt, pension partners at solicitors Mayer Brown say that the industry has got the message in the past three or four years about the need to be more prudent in mortality assumptions: "By being incredibly prudent there's a question as to whether they've got it right and there is really a need to enter into a longevity swap," says Jewitt.
A 2010 Lane Clark and Peacock survey showed UK pension funds expect that their retirees will live longer than funds in Germany, the US, the Netherlands and Germany assume. While Jerome Melcer, the consultancy firm's longevity hedging expert, admitted cautious longevity assumptions are an option for schemes preferring to retain risk, he told Pension Funds Insider that sponsors would find the need to back these assumptions up with reserves and capital injections unappealing compared to a fairly-priced longevity swap.
Melcer added: "More cautious assumptions can actually ease the transition to longevity hedging by moving estimates closer to those of the market where the impact of hedging longevity is then less of a step-up. Future longevity trends remain too difficult to call with any degree of accuracy and longevity swaps fit well within the broader appetite to de-risk schemes over time."
Trustee reluctance is a theme that Martin Bird, who advised on BMW's £3 billion longevity hedging deal in 2010, also emphasised, stating: "There remains a nervousness associated with this kind of new product that needs to be overcome." Simply understanding the nature of a longevity swap in the first place is also said to be an issue with Matthew de Ferrars, partner of pension solicitors Pinsent Masons claiming that trustees should not be taking investment decisions which they cannot understand, given that "consultants often struggle to explain derivatives and hedging techniques effectively to trustee boards."
Getting the message across
Advocates of the swaps concede that their complexity is a challenge that requires careful management, for instance due to the potential of margins to skew costs.
"There is no doubting that plenty of time and energy is needed to get to grips with longevity swaps. For instance the quality and robustness of process of pension scheme data is absolutely crucial for getting the fairest price, but that is not something that can be done overnight," says Bird.
The idea that index-based hedging, as completed between JP Morgan and Pall, offers a means to overcome the problem of complexity is contended by Melcer: "A major challenge is to make the swaps scale-down to smaller schemes, but index-based hedging could deter smaller schemes due to their complexity."
Scott and Jewitt also speak of a need for trusts to future-proof longevity swap contracts to ensure their complexity does not entail negative consequences, warning that funds need to make sure there are no nasty surprises in a contract that is likely to run for at least 30 or 40 years.
For all the extensive innovation in longevity swaps, no model has yet been formed that schemes are eager to follow, with the JP Morgan – Pall UK swap effectively adding to an established array of bespoke templates. "There is definitely a sense that a lack of uniformity is holding back the market," says Scott.
A lack of obvious counterparties willing to assume longevity risk has also proven a stumbling block, but Bird foresees "a significant opening up of capital market capacity" being engineered by banks to cater for demand. Some industry figures note that the long-term nature of the swaps also provides a negative in this regard, as schemes cannot be certain that counterparties would still be around to meet obligations in the distant future.
Buy-ins offer a more established path to removing longevity risk, although are also more limiting to trustees, as Paul Philips and Ian D'Costa of Sackers & Partners explain. Buy-ins and buy-outs can be expensive and difficult to achieve, but an approach that uses swaps can allow trustees to split counterparty risk, retain some control over the underlying investments, and deal separately with longevity risk and investment risk.
05 October 2011
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