As defined benefit schemes mature, trustees are increasingly turning their attention to the endgame and how their scheme will service its liabilities over the long term. In many cases, this involves targeting a particular funding level sometime in the future through a combination of asset returns and deficit repair contributions.
In order to maximise the certainty of reaching their target funding level, schemes must do three things well:
1. Protect themselves against the liability-related risks that could knock them off-course
2. Generate sufficient growth to reduce any deficit
3. Manage liquidity requirements to ensure they can cover outflows without being a forced-seller of assets
In relation to the first of these points, many schemes will already have in place Liability Driven Investment (LDI) strategies that mitigate their liability-related interest rate and inflation risks. However, few schemes will have in place any protection against the longevity risk inherent in their liabilities. As a result, many schemes are exposed to the impact of changes in life expectancy during the period before reaching their endgame.
Introducing unfunded longevity hedges
One approach for schemes looking to hedge themselves against the potential impact of longevity risk, while retaining control over all of their assets, is to implement an unfunded longevity hedge (commonly referred to as a longevity swap). An unfunded longevity hedge transfers the risk of pension scheme members living longer than expected from the pension scheme to an insurer. Figure 1 provides an overview of how an unfunded longevity hedge works
What happens to the unfunded longevity hedge when you achieve your endgame?
For any scheme considering an unfunded longevity hedge, an important question to ask is how might this affect my future plans? In particular, many schemes are targeting buy-out as their endgame, in which case there will inevitably come a time at which they wish to buy-out the members covered by the unfunded longevity hedge.
In this scenario, the two primary options are to either terminate or novate the unfunded longevity hedge. In the case of termination, the value of the unfunded longevity hedge would remain with the in-the-money party, but the scheme would almost certainly be required to pay a potentially significant termination fee. An increasingly viable alternative to termination is novation. In this scenario the unfunded longevity hedge insurer drops away, but the longevity reinsurer remains and instead contracts with the buy-out insurer. Under this approach, the portion of the buy-out relating to the unfunded longevity hedge is priced using the longevity assumptions underlying the original unfunded longevity hedge, meaning that the scheme has been able to lock into an element of buy-out pricing many years ahead of the actual buy-out, thereby reducing the risk associated with targeting buy-out as the endgame.
As novation of unfunded longevity hedges becomes more commonplace, we anticipate that they will increasingly be seen as a stepping stone towards a buy-out.
Given this, at Insight we believe longevity hedging can help pension schemes to evolve their LDI strategy, which will in turn increase the certainty of reaching their endgame.
Key steps in the implementation of an unfunded longevity hedge
There are a number of steps that schemes must carry out when implementing an unfunded longevity hedge, many of which are similar to those needed when considering an insurance buy-in.
1. Feasibility study
An initial feasibility study should be carried out in order to understand:
• Which liabilities should be covered by the unfunded longevity hedge
• The potential cost of the unfunded longevity hedge
• The impact of the unfunded longevity hedge in terms of the risk that it removes
2. Intermediation approach
The scheme must decide whether it will transact with the longevity reinsurer through either a UK-domiciled insurer or an off-shore insurer; both approaches have successfully been used by UK pension schemes.
3. Data preparation When the reinsurers are approached for a detailed quotation, they will want to receive member-level information for both in-force and historic scheme members. The preparation of this data could represent a significant amount of work and should therefore be started as early as possible.
4. Reinsurance brokerage
Pricing and key terms must be negotiated with potential reinsurers, with several rounds of bidding taking place before one or more reinsurers are selected for the transaction.
5. Transaction documentation
Once the reinsurer(s) has been selected, the transaction must be fully documented. This process will involve lawyers and advisors acting for all of the key stakeholders.
6. Ancillary services
In order to support the longevity transaction on an ongoing basis, the scheme will need to make the following appointments, all of which can be provided by a single third party:
• Calculation agent: Calculates the payments to be exchanged during the life of the transaction (i.e. net cashflows and collateral requirements).
• Valuation agent: Values the assets currently posted as collateral.
• Collateral manager: Moves collateral assets as required on behalf of the scheme.
investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations. Unless otherwise attributed the views and opinions expressed are those of Insight Investment at the time of publication and are subject to change. This document may not be used for the purposes of an offer or solicitation to anyone in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it is unlawful to make such offer or solicitation. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment
Longevity Pricing Director, Insight Investment