Buy-ins and longevity swaps are long-term contracts not to be entered into lightly. They are typically highly illiquid, i.e. surrendering them later is difficult, if not impossible. Before considering such a product for a DB pension scheme, it is vitally important for trustees, in collaboration with the sponsoring employer, to make a strategic decision on their “end game” and only to enter into such contracts if they are fit for purpose and likely to be what is required in 5 or 10 years’ time. Trustees should not be caught out by short-term fads. I worry that the current attitude toward longevity swaps could fall foul of this.
Before exploring this further, I want to show two examples that have led to this view.
Firstly, it is not uncommon to find schemes, especially smaller DB schemes, holding historic individual annuity policies. They typically go back to the days when those schemes insured scheme members as they retired. These policies often didn’t fully match the scheme benefits. For example, they might be single life, i.e. not provide a spouse’s benefit, or they might provide fixed rather than inflation linked pension increases. Schemes in this position who wish to buy out need to sort these historic policies out. This can be messy and is exacerbated by the fact that many of the insurers used are now not active in the bulk annuity market, and hence these policies are legacy business.
A second example is schemes that have purchased a buy-in but have excluded, or not matched exactly, a benefit. Not that long ago, some schemes chose to purchase insurance without a floor of 0% on inflation because buying inflation increases with a floor of 0% became quite expensive, primarily because of worries over a deflationary environment. This soon reverted to more normal pricing but those schemes that purchased without the floor are in a tricky position. Firstly, they are now tied to one insurer to purchase the inflation floor, which could lead to paying more than is necessary. Secondly, and worse still, the insurer may no longer be active in the market when the scheme wants to change the policy and its attitude to allowing such a change may now be different.
The market for longevity swaps, used by both pension schemes and bulk annuity insurers, has developed materially over the last decade. We have seen reinsurers’ attitudes to allowing schemes to novate swaps to insurers and insurers’ attitudes to accepting them both become more flexible. As such, this could lead schemes to consider more readily whether a longevity swap might be right for them. I would recommend pausing, learning from the past, and considering the future from two different angles:
Firstly, what’s the long-term plan and how confident are you in the timescales of that plan? A recent example is the £4.4bn British Airways buy-in. That involved passing across an existing £1.7bn longevity swap secured only a year before. I would question what possible value a longevity swap had over such a short timescale. I strongly suspect that a buy-in wasn’t seen as a near term option when the longevity swap was written. All too often, I find schemes are unaware just how quickly buy-out or buy-in can become affordable just from the maturing of the liabilities, i.e. deferred members retiring and taking tax free cash.
Secondly, will it continue to be easy to pass longevity swaps to an insurer? Currently, the UK bulk annuity insurance market has an elephant in the room; regulation has made it uneconomic for UK insurers to hold longevity risk. We therefore have a market where the insurers don’t take much actual insurance risk, and instead are effectively asset managers in an insurance wrapper. I don’t find that very satisfactory and I’m not convinced the insurers’ regulator, the Prudential Regulation Authority (PRA), does either. In 2018 the PRA commented:
“The current design of the risk margin is too sensitive to the level of interest rates, and it is therefore too high at current low levels of interest rates. This is particularly true for long-dated insurance contracts such as annuities.” and “[insurers] have responded… by reinsuring a substantial proportion of the longevity risk offshore. This is an unintended consequence and, if left unconstrained, would become a significant prudential concern…”
Therefore, it seems likely, maybe more so as we transition out of the EU, that the PRA will look to adjust regulation and encourage insurers to keep, at least some, longevity risk on their books.
If schemes are looking to purchase longevity protection and have comfort that insurers will be willing takers of such contracts on buy-out, I would argue that you should remember this might only be a short term feature of the market and make sure you contractually have a way out should you later want to buy-out.
Adam Davis, Managing Director at K3
