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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
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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.

Introduction

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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Further reading

Report:

  • Life & Longevity Markets Association. “Longevity pricing framework: A framework for pricing longevity exposures developed by the LLMA.” October 29, 2010. Online at: tinyurl.com/ln29zgn [PDF].

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