Longevity swaps: new way to offload risk in pension schemes

News that Babcock International's pension schemes have entered into a longevity swaps deal in order to reduce their exposure to the risk of life expectancy increasing further has put the spotlight on this new form of hedging. Longevity swaps may now take over from buyouts as the preferred means of handling longevity risk.

On this page:
What are longevity swaps?
First longevity swap deals
Babcock International: longevity swap deal
More longevity swap deals planned
Longevity swaps: some definitions.

Key points

  • Defined-benefit schemes operated by Babcock International have recently agreed in principle to enter into a longevity swaps deal covering pensions-in-payment liabilities of around £500 million. It is believed to be the first such deal completed by an occupational pension scheme.
  • Longevity swaps are a means of transferring the risk of members living longer than expected to a third party, while retaining direct control of the assets.
  • Bespoke longevity swaps relate to the longevity experience of the actual pension plan membership. Index-based swaps only protect schemes against general trends in mortality and not against their own adverse experience.
  • More longevity swaps deals are expected to be concluded, particularly as the cost of buyouts is making them less attractive and because no upfront capital payment is required.
  • It is estimated that there is market capacity for only about 5% of DB liabilities to be hedged in this way.

It is widely recognised that rapidly increasing longevity is placing an enormous financial strain on defined-benefit (DB) occupational pension schemes. Actuarial assumptions are being strengthened to reflect increasing life expectancy and some schemes have bought out benefits with an insurance company (that takes over responsibility for paying the pensions) to avoid costs increasing if their own members live longer than expected. Now Babcock International's DB schemes have become the first occupational pension schemes to make use of a new arrangement - longevity swaps - as a means of managing its risk of increasing life expectancy. Experts believe longevity swaps may become popular because buyouts (and buy-ins) are becoming more expensive.

What are longevity swaps?

A longevity swap (see below for definitions) is a means of transferring the risk to a scheme of members living longer than expected to a counterparty, the hedge provider.

Under a bespoke longevity swap, the provider meets the pension payments as they fall due for however long the scheme's pensioners survive. In return, the scheme makes a series of fixed payments to the provider over an agreed period. Consequently, if, on average, members survive longer than expected, the counterparty will have to pay out more than it forecast but the scheme's costs will be unchanged. If mortality is worse than anticipated, the counterparty will pay out less than expected and the scheme's payments will still be unchanged. In either case, the scheme will have reduced the volatility of its funding requirement, a key consideration for companies in the light of the current accounting standards governing corporate reporting.

Bespoke longevity swaps are the most attractive, but are generally available only for liabilities of over £100 million, according to actuarial consultancy Lane Clark & Peacock. Providers will be unable to price smaller schemes sufficiently well. Index-based longevity swaps are the alternative for smaller schemes. Under these arrangements the provider's obligation to pay out is based on a recognised index. If the index changes to reflect longer life expectancy generally, the scheme will be protected. However, if the scheme's membership lives longer than the index, the scheme will not be protected. The process of developing indices was begun by the JPMorgan LifeMetrics Index, according to Hewitt Associates. This index reflects population statistics for the whole of England and Wales. Credit Suisse is another organisation that is putting its toe in the water.

One key difference between a buyout and a longevity swap deal is that no payment is made (or assets transferred) to the provider at the outset, which may be attractive in itself, especially for the many underfunded schemes. Consequently, the scheme retains the investment risk. Another difference is that the counterparty risk is more modest under swaps as there is no upfront payment.

First longevity swap deals

Longevity swaps are not entirely new. Law firm Slaughter and May has disclosed that it has advised on a large longevity swap transaction in which a vehicle formed by a global investment bank assumed longevity risk in relation to a large number of annuities.

Lucida, a specialist insurance company focused on the annuity and longevity risk business, maintains that a "small handful" of longevity swap transactions were completed at the end of 2008 and the beginning of 2009. The first to "go public" was its own deal with JPMorgan, worth in the region of £100 million. It was linked to the JPMorgan LifeMetrics Index. The deal saw Lucida reinsure more than €100 million (£85 million) of the Bank of Ireland's annuity business. If people covered by the index (ie not the annuitants concerned) start to die sooner than expected, then Lucida will have to pay JPMorgan. If longevity improves faster than expected, then JPMorgan will pay Lucida.

Babcock International: longevity swap deal

Babcock International's pension scheme has agreed what is thought to be the first longevity swap deal by an occupational pension scheme. The company reached agreement in principle with the trustees of two of its DB schemes for them to enter into contracts with an unnamed provider to cap their exposure to increasing life expectancy, using longevity swaps. The swaps will apply to current pensions in payment and are on a bespoke basis. As part of the agreement between Babcock and the trustees, the company has agreed to "fund the excess of the swap payment over the funding assumptions adopted by the trustees over a 20-year period" - in other words, the company has agreed to pay the additional amount that will need to be paid to the provider above the funding that would have been required for the scheme.

The company states: "This arrangement is designed to ensure for both the group and the pension schemes that any further financial risk related to improved longevity is eliminated." It also maintains that the arrangement will have no material direct impact on the group's income statement, balance sheet or cash flow.

The Babcock DB scheme liabilities are currently valued at about £1.7 billion, with a small surplus of roughly £50 million. Around £800 million of the liabilities relate to pensions in payment and the swaps deal covers about £500 million of these liabilities. A further deal is expected to cover another £250 million of pensions-in-payment liabilities in the near future. According to the company, existing inflation and interest rate risk hedging is under review to ensure that a "fully effective hedge is established for all pensions-in-payment liabilities".

Babcock was advised by Watson Wyatt on the longevity swaps deal.

More longevity swap deals planned

According to Lane Clark & Peacock's recent report on buyouts, two of the leading longevity hedge providers have quoted for hedges on £30 billion of pension liabilities in 50 pension schemes over the past 12 months. It says that several individual quotes have been for more than £1 billion. However, consultancy Mercer estimates that the UK market's capacity for taking on longevity risk from DB schemes in the form of swaps or bulk annuities over the next five years is at most £50 billion, or around 5% of liabilities. Hewitt Associates estimates that possibly only £5 billion of longevity swaps may be written in 2009. This lack of capacity is likely to cause prices to rise and Mercer believes that those "who push early for longevity swaps deals will be the envy of the majority".

Lane Clark & Peacock considers one of the main factors against using longevity swaps is the possible impact if a scheme subsequently wished to arrange a buyout. Buyouts providers might regard a longevity swap as unattractive. Other factors acting against using swaps is the difficulty of quantifying the benefit of the longevity risk removed (although the report mentions methods that can be adopted) and the ongoing management costs involved.

The more cautious life expectancy assumptions being used in schemes' actuarial valuations is helping to make swaps more attractive, while the increase in buyout costs is making that option less appealing.   

Longevity swaps: some definitions

"Swap:

An agreement with a counterparty (often an investment bank) to 'swap' types of liability exposure. For example, under an inflation swap a pension plan pays the bank if inflation falls compared to expectations, but the bank pays the pension plan money if inflation rises. This hedges the pension plan's inflation risk.

Longevity swap: A tool to enable pension plans to transfer the risk of members living longer than expected to a third party (the counterparty), whilst retaining direct control of the assets. The two main types of longevity swap are a bespoke longevity swap or an index-based longevity swap.

Bespoke longevity swap: A swap that is linked to the longevity experience of the actual pension plan membership. The counterparty will pay the additional pension payroll if the underlying members live longer than expected; the pension plan will pay the additional pension payroll if the underlying members die sooner than expected.

Index-based longevity swap: A swap where the actual payout is linked to a standard population. For example, the counterparty may pay out to the pension plan if the longevity of the standard population improves faster than anticipated. Index-based swaps are flexible, but provide only partial longevity protect­ion against actual pension plan experience.

Counterparty risk: The risk for a given party that the other party (eg an insurance company or bank) defaults on its obligation. Mechanisms such as posting collateral can sometimes be negotiated to reduce the potential impact of this risk."

Source: Lane Clark & Peacock.