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Home > Financial Risk Management Best Practice > Obstacles to the Further Development of the Longevity Swaps Market for Pension Funds

Financial Risk Management Best Practice

Obstacles to the Further Development of the Longevity Swaps Market for Pension Funds

by Martin Bird and Tim Gordon

This Chapter Covers

  • Why the United Kingdom is currently the most fertile locale for longevity swaps.

  • Why longevity risk protection can appear expensive to pension funds.

  • Why index-based longevity solutions are currently uncompetitive compared with bespoke longevity swaps and are likely to remain so for the foreseeable future.

  • Why lack of standardization remains a key obstacle to the wider use of longevity swaps.

  • Drivers pushing the continued expansion of the UK longevity swaps market.

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The combined liabilities of occupational pension plans in the United Kingdom are around £1 trillion. These liabilities are predominantly defined-benefit, consisting of immediate and deferred annuities, and therefore the majority of the benefit payments depend on the longevity of the beneficiaries. Given that these pension plans are materially exposed to longevity risk—i.e. the risk that their beneficiaries may live longer than expected—and the trend over the past decade has been to reduce asset–liability mismatching, it is reasonable to ask why UK pension plans have not done more to mitigate their longevity risk. There are, very broadly, only two means of removing longevity risk in a defined-benefit pension plan:

  • secure the liabilities completely with an insurance company (which may or may not involve the plan winding up);

  • take out a longevity swap with an insurance company or investment bank, i.e. receive cash flows that no longer depend on the longevity of the beneficiaries in return for the plan’s longevity-dependent cash flows plus a fee.

The question we address in this chapter is why longevity swap transactions are currently running at around only £3 billion to £5 billion per year in the context of total liabilities of around £1 trillion.

We should probably start by noting that in the United Kingdom a number of factors combine to explain why it is the most fertile locale for longevity swaps.

  • There is a large company-sponsored defined-benefit occupational pensions sector.

  • Pension plans are funded. Having to put real cash into pension plans focuses the mind remarkably compared with adding numbers to a balance sheet on what is typically an unrealistic basis. The UK regulatory regime also requires that pension plan assets are held in trust, meaning that pension plan funding is treated very seriously.

  • Companies bear the deficit risk. In many other countries, companies with large defined-benefit pension plan deficits can walk away from them, but in the United Kingdom this is not possible.

  • Index-linked pension increases. Quite simply, pension increases make longer-dated cash flows more valuable, and it is for these cash flows that longevity risk really bites. The legacy of high inflation in the 1970s has resulted in the United Kingdom having some of the strongest statutory inflation-proofing of pensions in payment and in deferment. By way of contrast, pension increases are almost unheard of in US pension plans.

Other countries that are prime candidates for future use of longevity swaps are Canada, the United States, and the Netherlands—with Canada being favorite. In the United States, pension increases (“cost of living allowances”) are uncommon and the law has been changed recently to allow members to surrender pensions in exchange for payment of a lump sum. This probably explains why the big US longevity deals, for example GM’s group annuity purchase in 2012, have been bulk annuities rather than pure longevity swaps—i.e. they are not primarily about longevity risk. In the Netherlands, it is not clear at the time of writing that pension plans fully bear longevity risk, so that market is in something of a state of flux.

It therefore seems sensible to focus on the UK market given that it is currently the trailblazer for longevity swaps. It is no coincidence that the UK actuarial profession has developed a sophisticated two-dimensional (i.e. depending on age and birth year) mortality projections model that is updated every year, while actuaries in many other countries are using one-dimensional (i.e. dependent only on age) projections that are sometimes a decade or more out of date. The reason is simple: in the UK the financial impact of longevity is material and therefore it is vital to get this right.

But—and it is a big but—it remains true that pension plan funding is treated very differently to insurance company reserving. Occupational pension plans started out providing what were essentially discretionary benefits and, despite the huge amount of legislation creep that has turned them into promises and foisted unforeseen levels of liability on companies, the regulation and culture of pension funding still reflects their origin. A defined-benefit pension plan in the United Kingdom, United States, or Canada is typically funded without risk reserves, or, if risk reserves are allowed for, they are typically much lower than the statutory reserves that insurance companies are required to hold. The notion that things will “work out in the long term” has been remarkably persistent in the pensions world, even though at the same time the insurance world in Europe has been ramping up its risk reserving requirements with the imminent introduction of Solvency II. It is still common practice for pension plans to invest in risky assets without corresponding risk reserves (other than an implicit reliance on sponsor covenant). In contrast, insurance companies are required to hold higher reserves the more mismatched the investment strategy is relative to the liabilities.

Until it becomes standard to maintain reserves explicitly for longevity risk in the pensions world, it will remain a struggle even to get longevity risk solutions on the agenda for many pension plans. And until pensions legislation changes, longevity swaps are likely to continue to appear expensive for nonpensioners.

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Longevity Index Solutions

An obvious solution is to provide a standard medium of exchange for longevity risk. This has received a lot of attention, initially being developed by JP Morgan through the LifeMetrics framework and then more recently through the Life & Longevity Markets Association (LLMA) based in London, whose stated aim is “to promote a liquid traded market in longevity and mortality-related risk.” The idea is that longevity indices can form the basis for a traded market in longevity risk which would, in turn, facilitate access to longevity risk protection and price discovery. This is a laudable objective, but the generic longevity index approach currently seems to be stalled.

In order to be suitable, a longevity index needs to be based on mortality experience data with strong assurances concerning:

  • stability of the definition of the population on which it is based;

  • sufficient past data to measure risk;

  • the availability of future data, along with their objectivity and reliability.

For UK pension schemes, the only population that meets these criteria is the national mortality data set as measured by the Office for National Statistics (ONS). However, the recent restatement1 of England and Wales mortality experience data (specifically, the population data) has illustrated that even nationally produced longevity indices are not 100% reliable.

The main problem is that longevity risk is not fungible—i.e. the future improvements in longevity for one group of individuals will not be the same as for another—and therefore one cannot reliably offset the longevity risk for one sector of the population against the longevity risk for a different one. This gives rise to basis risk, i.e. the risk that the mortality experience of the wider population on which the index is based will differ from the population at risk. Pension plan populations in particular differ from the national population because their members tend to be better off and, in addition, the liability impact is weighted toward the even better-off.

Even quantifying longevity basis risk is difficult. Not only do we not have good-quality data on past mortality experience by subpopulation, but even if we did we would still struggle. This is because it is almost impossible to determine whether a past difference between longevity improvements for different populations will:

  • continue into the future, i.e. the longevity of the different populations will continue to diverge forever;

  • fall to zero, i.e. the difference between the different populations will remain at its current level; or

  • reverse, i.e. the longevities of the different populations will reconverge.

We can find examples of each of the above by comparing different national mortality data sets. In particular, the difference between male and female mortality rates provides a striking example of mortality reconvergence in the United Kingdom and other Western World countries. If, in 1970, one had assumed that past differences between male and female longevity improvement would persist, the assumption would have led to a massive understatement of male longevity improvement. So basis risk is not only difficult to quantify, but given the wider possible range of outcomes it seems that it is necessarily quite large. And given that index solutions rely on leveraging to be effective, the basis risk is magnified still further.

There are other problems.

  • Although longevity index forwards are sometimes portrayed as being analogous to forwards in other markets, longevity has more dimensions because it is age-dependent. They are not simple to work with and introduce an additional step into the hedging process—i.e. the need to determine an optimal combination of various forward contracts, which is an ongoing process. By way of contrast, under a normal longevity swap structure, there is no need to calibrate, reconcile risk, and/or rebalance over time.

  • q- and S-forwards, the index contracts that have been suggested to date (LLMA, 2010), are zero-coupon structures and therefore are likely to be more expensive than a normal longevity swap. The underlying exits, i.e. capital markets and reinsurers, typically prefer a payout profile that pays an income. An investment bank therefore has to transform the forward starting q/S-forward structure into a coupon-paying structure for the exits. It would be cleaner (for example, there would be no queries or additional credit charges from the bank’s internal credit management) if the bank could simply pass on the swap cash flows without such manipulation.

  • q- and S-forwards are written in nominal sterling, whereas UK pension plan cash flows tend to be linked to inflation, requiring a further layer of intermediation.

What all this means is that, at present, using longevity index solutions is materially more expensive than a bespoke longevity swap, while at the same incurring a material but difficult-to-quantity basis risk. It should therefore come as no surprise that, at the time of writing, activity in index-based longevity swaps is somewhere between nil and small compared with bespoke swaps. It would be a hugely positive development if we had a large and liquid longevity index market, but we expect that the future will instead see quirky, one-off index-based trades.

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Expanding the Existing Longevity Swap Model

Having ruled out longevity index solutions as likely in the future, we are left with existing bespoke longevity swaps, i.e. swaps on the specific individuals in the population at risk. In the United Kingdom this market has grown from a standing start in 2009 to around £3 billion to £5 billion a year in 2011 and 2012. To put this in context, over the period 2000–12, UK plan sponsors settled liabilities in the bulk annuity market (buy-ins and buy-outs) to the tune of around £30 billion, whereas more than £19 billion of longevity liabilities have been hedged over the past three years. We think that this growth in longevity swaps is impressive and a testimony to the determination of pension plan trustees and sponsoring companies to address risk management seriously.

Table 1 provides details of the major longevity swaps to date. It is immediately obvious that the majority of these deals are large, typically over £1 billion—implying that at the moment the fixed element of implementation and monitoring costs makes longevity swaps financially viable only for large pension plans.

Table 1. UK pension fund longevity swap trades to date

Date Fund Provider Liabilities hedged1 (£ million) Deal type2
March 213 Bentley Motors Abbey Life, Deutsche Bank 400 Bespoke swap
February 2013 BAE L&G 3,200 Bespoke swap
December 2012 LV= Swiss Re 800 Bespoke swap (including nonpensioners)
May 2012 AkzoNobel Swiss Re 1,400 Bespoke swap
January 2012 Pilkington Legal & General 1,100 Bespoke swap
December 2011 British Airways Goldman Sachs, Rothesay Life 1,300 Bespoke swap
November 2011 Rolls-Royce Deutsche Bank 3,000 Bespoke swap
August 2011 ITV Credit Suisse 1,700 Bespoke swap
February 2011 Pall UK Pension Fund JP Morgan 70 Nonpensioner index-based hedge
July 2010 British Airways Goldman Sachs, Rothesay Life 1,300 Bespoke synthetic buy-in
February 2010 BMW Abbey Life, Deutsche Bank 3,000 Bespoke swap
November 2009 Royal County of Berkshire Pension Fund Swiss Re 1,000 Bespoke swap
July 2009 RSA Insurance Group Goldman Sachs, Rothesay Life 1,900 Bespoke synthetic buy-in
May 2009 Babcock Credit Suisse 1,500 Bespoke swap

1. Approximate figure based on publicly available information.

2. Solely pensioner-related unless otherwise specified.

Source: Aon Hewitt.

This is partly because the regulatory regime in the United Kingdom has resulted in pension plan benefit structures that are notoriously complex. Further, pension plan trustees are often reluctant to simplify reinsured risks because that entails retaining remote residual risks. This is not unreasonable—compared with professional investors with a portfolio of assets or liabilities, trustees are responsible for their pension plan in isolation, i.e. they do not have a portfolio of pension plans over which to diversify risk. Finally, pension plans need to have one eye on their ultimate exit strategy. Awkward residual differences between actual pension plan liabilities and those covered by the longevity swap may be expensive or impossible to buy out on eventual wind-up. This is less of an issue for very large pension plans, which realistically do not expect to wind up for the next 20 years, but it is a genuine concern for medium to large pension plans.

Possibly the greatest obstacle is lack of standardization. Longevity swaps are still relatively new, and each deal results in some form of innovation. And there is a bewildering array of options to choose from—for example, whether the contract is insurance- or derivative-based, the degree of precise replication of benefit indexation, the terms for exit options, whether collateral is provided via security interest or title transfer, and so on. So we are left in a chicken and egg situation. Very large pension schemes can afford to do things differently and therefore they do so, but the next rung down needs more standardization before longevity swaps can become cost-effective. Think Betamax vs VHS (or HD DVD vs Blu-ray)—once a standard was settled on, the market exploded. And the more standardized longevity swaps become, the more likely insurers are to treat them as plan assets and incorporate them as part of the purchase price at fair value if a pension plan winds up, removing one of the current obstacles to adoption. We think that progress is being made, but it will take a few years yet for the longevity swap to become a universal model.

In the meantime, there are plenty of drivers pushing the expansion of the longevity swaps market.

  • Awareness of longevity risk continues to increase. The large group annuity deals in the United States have raised awareness globally.

  • Although it might appear that the reduced number of intermediaries in the UK market is a negative, the reality is the opposite. Pricing is actually determined by the reinsurance market and the number of longevity reinsurers has increased, as have their capacity limits as they have become more comfortable with longevity risk as an insurance class.

  • Pension plans continue to mature, i.e. to have relatively more pensioner-to-nonpensioner liability. Longevity swap pricing tends to be more attractive to pension plans for pensioners.

  • The continued underfunding of pension plans makes longevity swaps relatively more attractive to pension plans compared with bulk annuities because it allows them to retain control over their assets, for example for outperformance.

  • There has been repeated interest from capital market investors, which suggests that there is additional capacity waiting to be tapped. Standardization would be particularly helpful in this context.

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We expect that the UK longevity swaps market will continue to grow as pension plans continue to bear down on risk generally and continue to mature. In most other defined benefit-oriented countries, the regulatory regime and/or no pension increases mean that pension plan longevity risk is typically not as financially material as in the United Kingdom. We therefore do not expect to see longevity swaps make as much inroad in these countries, although we do consider it reasonably likely that a major non-UK pension plan will implement a longevity swap within the next couple of years.

Index-based longevity solutions have failed to take off so far. Moreover, the problems associated with them, most notably basis risk, mean that we are skeptical about their future as a vehicle for pension plans to mitigate their longevity risk. Index-based solutions may, however, have a role to play as a means of exchanging longevity risk between insurers.

Finally, we expect implementation costs to reduce over time as longevity swap contracts gradually become more standardized.

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  1. Office for National Statistics. “Statistical bulletin: Population estimates for England and Wales, mid-2002 to mid-2010 revised (National).” December 13, 2012. Online at:

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Further reading


  • Life & Longevity Markets Association. “Longevity pricing framework: A framework for pricing longevity exposures developed by the LLMA.” October 29, 2010. Online at: [PDF].


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