Longevity swaps now part of the risk tool set

Engineering firm, Babcock International, is the first UK firm to use a longevity swap to hedge against life expectancy risk in its pension scheme. Amanda White looks at the use of longevity swaps as a risk management tool.

Longevity risk remains a key long-term risk to pension funds, and has a major effect on funding levels and investment programs.

A number of life insurers have transferred longevity risk either to a reinsurer or to investors via the capital markets, but until now there have been no transactions taking mortality risk directly off the hands of a UK corporate pension scheme other than through annuity contracts.

Now, a UK engineering firm, Babcock International has announced it will use a swap to hedge ₤500 million
($759 million) in longevity risk for its retired workers, becoming the first UK pension fund to do so. And with this first move some industry observers are claiming the market could exceed £5 billion this year, with rumours the UK Government may issue a longevity bond to hedge its own state-related pension risks.

The swap used by Babcock will see the corporate defined benefit pension schemes agree to make fixed payments
in exchange for receiving the actual value of pensions due to members – irrespective of how long the members and their dependents live, with the firm funding the excess of the swap payment over the funding assumptions adopted by
the trustees over a 20-year period. It is believed Credit Suisse was counterparty to the deal and Watson Wyatt was the fund’s adviser.

Babcock said it was also reviewing its existing inflation and interest rate risk hedging to ensure a fully effective hedge was established for all pensions in payment liabilities.

John Ball, head of defined benefit pension consulting at Watson Wyatt says until recently, the market price anticipated much higher life expectancy than schemes were allowing for in their funding reserves.

“That made swaps look like an insurance policy with a high excess charge. But the gap has narrowed as pension
schemes are starting to set more cautious assumptions and greater competition is developing among the providers, so cost will be less of an obstacle for many pension funds.”

He says in the long term, swap prices are as unpredictable as longevity itself but current prices could reflect competitive pressure, but there is an early mover advantage.

“We saw with pension buyouts that providers are very keen to plant their flags in the ground when a market
appears to have significant growth potential. The same forces are at work here, so the pension schemes which move early may get the best deals.”

According to Watson Wyatt, stock market falls have left most defined benefit schemes with substantial deficits,
while few employers are able to inject the cash needed to transfer all pension risks to an insurer. Longevity swaps need not require upfront payments and may appeal to cash-constrained employers looking to hedge some of their risk as a
first step on a long journey towards settling their pension liabilities.

“Schemes which had not moved out of equities before the markets fell are still targeting settlement but expect it will take them longer to reach the finishing line. This increases the risk that changed longevity expectations will make annuities more expensive by the time they are ready to buy. That could make longevity hedging an attractive
solution but there are a number of practical issues to consider. For example, the trustees and employer need to agree how any gap between the technical provisions and the fixed leg of the swap is to be funded. The long-term nature
of a mortality swap contract also makes it essential that payments due from the counterparty are secured as new evidence affecting life expectancy emerges.” Ball says.

Mercer has also been consulting to funds on the use of longevity swaps and according to consultant in Mercer’s financial strategy group, Gordon Fletcher, a method of passing some of the pension risk to another party, without surrendering the assets, is a desirable outcome.

“While a longevity swap may increase liabilities, it can often be transacted with a nil cash payment on day one – often an important consideration at a time when cash flow is critical.”

“The announcement by Babcock that it has secured a deal to hedge its liabilities may send other finance directors rushing to their actuaries to also sign up,” he said. “It’s particularly likely if they believe the jump in Babcock’s share price to be partly attributable to this innovative approach to dealing with the pensions issue.”

According to Mercer, the inclusion of longevity swaps in the risk management tool box does add a great deal of flexibility for schemes and sponsors looking for ways to manage their pension risks.

“It looks likely that this first deal with a pension scheme will spur others to look at what could be a growth area,” Fletcher said. :It’s a significant development. For many companies, it will be a step towards the end game. However, companies must ensure that the contract leaves them well positioned if their ultimate aim is to exit completely through a total buyout.”