With the closure of DB schemes, what is the future of longevity swaps?

The question over where to turn to hedge pension scheme risk, and
specifically longevity risk, is something that is rousing the curiosity of many
employers including the UK government, which is currently reviewing public
sector pension schemes and the management of creeping longevity risk ­ not just
for scheme members who have already retired but for existing members and future
employees.

Questions remain as to whether the government will reduce its final salary
schemes, sell them off, or close them. Meanwhile, the “slice-and-dice” option
for managing pensions risk and the option to bundle it up into one contract and
hand it to one manager, which may be cheaper, is a fixture of corporate scheme
trustee conversations.

The stats prove that wholesale change in the approach to these challenges
can’t be avoided. In a 2009 survey of finance directors among UK companies,
pensions advisory MetLife revealed that more than one in five companies saw a
rise in complaints from staff about their pension scheme in the 12 months
previous, following market volatility. It also found that 22% of responding FDs
saw a rise in complaints about defined contribution (DC) schemes outstripping
those about defined benefit (DB) schemes, despite the trend of moving away from
DB schemes that appeared to give DB schemes a growth opportunity ­ but this has
not been the case. With the typical FTSE-250 company reporting liabilities in
its DB schemes equalling more than one quarter of their market capitalisation,
there has to be other routes to managing this risk and stopping it from
seriously eroding profitability.

Investment strategy risk
Finance directors should be working ever more closely with their pension scheme
trustees to manage the risks in the pension investment strategy. Most UK private
sector schemes are relatively mature with shrinking numbers of active members,
so the risk of dwindling contributions is dwarfed by the risk of managing the
assets and liabilities already built up against the level of market volatility.
According to pensions advisory Hymans Robertson, it is this that poses among the
biggest risk to shareholder value creation. If FDs can work more closely with
trustees to mitigate these risks from their schemes at the right price, whether
that involves buy-in, longevity swaps or more traditional asset de-risking
strategies, time is of the essence.

Standard Life’s head of pensions policy John Lawson says that most employers
with DB schemes would prefer to undertake a full buyout of all their
liabilities. “But as that is unaffordable for most of them, the next best
alternative is to insure longevity risks while also de-risking assets.”

That is the window of opportunity for longevity swaps, but their success will
depend on how assets within DB schemes perform. Lawson explains: “If asset
values climb without an accompanying increase in liabilities, employers might
prefer full buyout. If not, more employers are likely to consider removing or
reducing longevity risk with hedges.”

At any rate, it is predicted that there will be a continued trend of full
buyouts and increasing uses of longevity hedging. Many commentators are urging
the government to issue longevity bonds, which would effectively transfer
longevity risk to the taxpayer. However, Lawson does not think this likely to
happen, at least not in the short term.

But Martin Bird, principal consultant at pensions advisory Hewitt Associates,
thinks something urgently needs to be done about government pensions. “Longevity
improvements have been a key contributor to increasing the cost of public sector
pension provision and also to the increasing difference in value between public
sector and private sector pension provision,” he said after the 2009 pre-Budget
report. “Effective cost-sharing would limit both the cost to the public purse
and further growth of that differential.”

The corporate reaction to the realisation of a long-term adjustment in the
health of the UK economy has been, for many, the knee-jerk decision to close DB
schemes. Lawson says that many companies can no longer afford to keep staff in
DB schemes and, while most have already chosen to close schemes to new members,
there are plenty going a step further and closing them to existing members too.
Alliance Boots took the decision to close its DB scheme to active members this
January and consulted staff about launching a DC scheme in its place.

Indeed, the reality for some is that DB schemes are simply unaffordable to
many companies which have little choice but to close them to avoid the balance
sheet impact and volatility, according to Robert Gardner, founder of risk
management advisory Redington. While this may be the case, it is not necessarily
the best option for all businesses and opinion is divided over the best course
of action. For some companies, there are ways of managing the risks properly
should a company want to keep the scheme open.

Who wants to live forever?
Despite an increasing array of ailments, people in the UK are living longer than
ever before ­ putting an untenable strain on pensions provision.

But those in the later stages of life are living in a poorer state of health
today, despite leaps in healthcare provision. According to the Office for
National Statistics (ONS), 30 years ago, a 65-year old man had a one in 1,000
chance of living to the age of 100, while today that figure has increased to one
in 100. There are already 10,000 people in the UK who have reached the 100-year
milestone.
There are three basic factors that are attributable to people living longer:
diet, health and lifestyle.

There is more dietary advice available to people today (sometimes provided by
employers) and better education on how to become fit and stay fit and there is a
greater awareness of the need to maintain a healthy lifestyle. There is also the
influence of the smoking ban in the UK, which has a notable effect on mortality
assumptions even though the ban has not been in place for very long.

As a result of the increased life expectancy among the pensionable
population, actuaries have to alter the way they measure life expectancy, or
mortality, which means a wholesale change for the pensions industry and a
greater, longer-lasting burden for businesses.

Postcode lottery
There is evidence to suggest that where a person lives can play a determining
role in how long they live. The ONS says it is possible to see how longevity
compares between different areas. Actuaries working on new mortality assumptions
would not use that data specifically, but rather the determining factors of the
data: to understand the characteristics of the people that live in an area with
either high life expectancy, or low. According to Hewitt Associates, larger
pension schemes have typically carried out this analysis based on their own
membership data to determine a base table, which can be tweaked to allow for
future life expectancy improvements.

New mortality data
It is common for actuaries to look at tables based on a huge amount of data,
indicating mortality rates from lots of occupational pension schemes. Actuaries
also look at insurance company data. This has been the case for a few years now
and the UK is considered to be ahead of the curve, since in other European
countries, these tables are only just coming in to use. Hewitt Associates
believes that continued innovations in modelling mortality rates are helping to
provide a better understanding of the factors that affect member life
expectancy and provide reassurance to schemes assessing the merits of investing
in longevity swap products. Now, with the development of the Life and Longevity
Markets Association it will create standardised contracts, a trading index
valuation model for mortality.