Longevity solutions for pension funds

Christopher Andrews looks at what longevity solutions are available to pension schemes today

In his speech at the Annual Club of Rome conference last year, Rodrigo de Rato, managing director of the International Mon-etary Fund (IMF), said there were three main problems facing society: climate change; financial instability; and demographic transition. While these are all of obvious concern, it is this third point which arguably represents the greatest threat to funded pension schemes in the developed world. Italy's Risk Institute, in fact, has described the lengthening of the life-cycle as a “revolutionary feature of contemporary society”, and for many schemes it also represents a potentially ruinous one.

The question is why longevity, or mortality, risk is such a problem for pension schemes, and why they haven’t had mechanisms in place to deal with it for years. According to David Blake, director of the Pensions Institute at London’s Cass Business School, it is the result of a “systematic underestimation of longevity”.

Blake focuses on the UK, Holland, Ireland and Scandinavia, as most other European countries had not set up funded pensions until very recently, he says. Concerning those countries and the funded schemes they provide, though, he says: “What has only just become clear over the last ten or so years is that the actuarial assumptions underlying the cost of these schemes were grossly underestimated.

“There's $23 trillion in private sector pension plans worldwide. These pension plans have un-hedged exposures to cures for cancer, cures for Alzheimer’s disease, and they’ve got nothing to manage it. They didn’t even know that they had these exposures. Their actuaries didn’t tell them. Their actuaries didn’t know.”

And this leads to two obvious problems according to Jane Beverley, principal and head of research at Punter Southall. One is that longevity continues to be underestimated and a scheme doesn’t have the funds to pay its pensions. The other, and this doesn’t usually happen, is that it is overestimated and excess capital remains tied up in the fund.

Getting assumptions right, therefore, is key, but it isn’t the simplest task. The ‘easy’ bit is a factual analysis of current rates of mortality examining published death statistics, ensuring that up-to-date longevity tables are used which accurately reflect the constitution of scheme members (white collar workers in affluent areas often live longer than blue collar workers in less affluent for example).

Then there is estimating how those rates will change in future, “And that’s the bit that is hard to manage because – who knows?” Beverley asks: “If you talk to two longevity experts you’ll get two different answers, and when the experts don’t agree where do you take a stand?”

It is in response to this that the investment community has been getting creative, seeking means to hedge against longevity risk, and provide some peace of mind to schemes. And trustees are crying out for some form of protection, says Brian Nimmo, partner and senior actuary at Hymans Robertson. “Every time they come round to an actuarial valuation they’re told that life expectancy has increased and is still increasing and that needs to be reflected in their liability figures. So to come up with some sort of protection that helps them and the sponsors to cap that risk will be pretty essential. But it is difficult to speculate where that market will go.”

A whole new investment class
Blake says that what is essential are capital market solutions which help to transfer this risk out of pension plans, and this effectively means creating a new investment class dealing solely with longevity risk trading; he has dubbed this the “life market”. It will trade longevity linked assets and liabilities. “And that is what the investment banks are desperately trying to do as well, to get that market started,” he says.

And this life market may in fact come to fruition. The seeds of it began with buyouts a couple of years ago and it is now starting to also move in the direction of longevity focused solutions.

Buyouts
The buyout solution is a pretty all-encompassing one, with a pension scheme’s liabilities transferred to an insurance company, which includes investment and inflation risks as well as longevity. Up until two years ago, transactions of this nature didn’t exist, says Paul Kitson, senior consultant at Watson Wyatt, and transfer to an insurance company was a last resort option if a company went bust. “Those existed but this is a relatively new market in solvent employers actually choosing to transfer their DB pension liability to a counter-party.”

And the buyout approach is becoming a pretty viable option, says Nimmo. He says that some of the buyout prices being quoted are now cheaper than “do it yourself solutions” for closing down investment risks and “if you do it as a buyout option, in essence you get your longevity protection thrown in for free,” he says. “So in current market conditions that’s pretty attractive. Longer-term, who knows, but I guess the consensus is that prices will move out a bit and while you wouldn’t get your longevity protection for free, you need to start giving more thought as to what the cost of that is.”

Beyond buyouts there are a variety of longevity solutions coming to the fore which could fit the mould for Blake’s life market. These include longevity specific insurance and swap products, among others.

Insuring the scheme
While most pension funds have done very little historically to manage their longevity risks, says John Fitzpatrick, partner at the Pensions Corporation, that is starting to change. “Schemes have done partial insurance of their pensioners in payment which has resulted in them eliminating the risk of life extension,” he says. “The next phase is one that we think pension funds will take up, and that is to purchase longevity insurance.”

This involves a fixed line of payments representing expected payments to pensioners, and the insurance company pays the actual costs, thereby fixing the liability. This solution is now becoming available. “We put out a product which we believe was the first one where you could sell or buy protection against your longevity risk in its pure form,” says Fitzpatrick.

Swapping around
While longevity insurance may not count as a new investment class, longevity derivative contracts, which are now being developed, do. These, says Kitson, use a similar framework to inflation and interest rate swaps in which many pension schemes are currently invested.

In terms of longevity swaps, there are two main areas being developed. The first is a cash-flow swap, which is primarily used for pensioners in payment. In simple terms this involves paying a counter-party, whether this is an investment bank or insurance company, for a fixed term. If you lock into, say, ten years and the scheme member dies after seven, you continue to pay for ten. Likewise if the member lives for 12 years, the counter-party picks up the tab for those additional two years.

The second type of transaction is based on a value hedge, and this is of use for deferred members. So, for example, there is 100 million worth of liability today for people who are going to be paid pensions in ten years. If at the end of that time life expectancy has increased and so the liability has increased, the counter-party pays that extra liability. Likewise if the liability is reduced, the scheme pays the counter-party. “So what you’re doing is swapping a fixed cash flow for a floating one,” says Kitson.

It is very early days for this market and there’s no telling if it will take off. In fact there have only been two swaps of note thus far; in 2007 between Norwich Union and Swiss Re and JPMorgan and Lucida. In saying that, the buyout market had a similar slow start two years ago but now represents huge amounts of money. “It will be interesting to see whether in two years time a similar thing happens with mortality swaps,” says Kitson.

It is also worth noting that a form of longevity trading has existed in the US and parts of Europe for some time in insurance linked securities, which in the US involves buying the risk of longevity in US traded life policies. This market represents large amounts of money, and could be the pre-cursor to a successful longevity swap market.

There are other ideas being put forward as well such as longevity bonds, but thus far European governments have not made any moves on issuance. As Nimmo says: “If I was a betting man I’d say we’ll see more products coming through, and we’ll see more market development. Over what time frame though is anyone’s guess.”

Written by Christopher Andrews, a freelance journalist