Life expectancy has increased considerably over the past 50 years in the Western world. What is more, this trend shows little sign of stopping. In response, actuaries have adopted increasingly conservative assumptions around longevity; driving up pension scheme liability valuations as more members are expected to live into their 90s, or even to their centenary and beyond. And because the financial health of so many of the developed world’s large public companies is intrinsically linked to their defined benefit (DB) pension schemes, many treasurers and finance directors are rightly concerned that improvements in mortality rates spell a real threat to their company’s financial survival.
The much publicised deepening deficits of schemes has made it harder – that is, more expensive – to perform buy-ins and buyouts. Against this backdrop, it is clear why the management of longevity risk has now become an issue of good corporate governance and why schemes are interested in hedging the risk in the nascent longevity swap market. Indeed, last year was a record year for the longevity swap market, with over £7bn worth of swaps negotiated between pension schemes and banks, insurers and reinsurers in the UK alone. But given the long-term nature of the risk, how can treasurers evaluate, and then justify to board-level executives, the value of such a longevity swap?
How Treasurers Can Assess Value-for-money
Assessing the value of a longevity swap requires a comparison between the amount of risk being removed – that is the potential increase in benefit payments caused by members living longer – and the cost of removing that risk, which is effectively the price of the swap contract. But if treasurers are to establish how significant removing longevity risk may be to the overall level of risk they are running, they must also have a detailed understanding of how the scheme’s other exposures, namely inflation and interest rate risk, relate to each other.
However, a lack of transparency surrounding all risks and assumptions, as well as a lack of granular data describing the impact of a longevity swap on a scheme’s future cashflows, can muddy the waters as regards this judgement. This is especially pertinent if banks or insurers re-shape the cashflows underlying the swap. While this may make the transaction appear cheaper to pension schemes, it can also have unintended consequences, often increasing the scheme’s exposure to interest rate and inflation risks.
An understanding of these effects is therefore required in order to correctly appraise a swap in terms of cost versus overall risk reduction, and is perhaps best illustrated using a fictitious case study. This article looks at the case of a pension scheme with £2bn of pensioner liabilities (measured on an International Accounting Standard (IAS19) basis), which has undertaken substantive interest rate and inflation hedging, leaving longevity as its largest single risk in relation to its liabilities. As such, it wishes to reduce this risk, and hence its total risk position, by entering into a longevity swap. The fictitious illustrative study assesses the cost versus risk reduction calculation under two scenarios; firstly, a conventional longevity swap and, secondly, a longevity swap where the provider seeks to alter the underlying cashflows.
Scenario One: A Conventional Longevity Swap
Let’s assume that the example scheme has exposure to interest rates, inflation and longevity (values shown in Figure 1) which means that, including its positive diversification benefit, the scheme is running £174m of risk. This is measured in terms of 95% one-year value-at-risk (VaR), which is calculated by considering a large number of future outcomes for interest rates, inflation and longevity and their effect on scheme funding. Put simply, this means that there is a 5% chance that scheme funding reduces by more than £174m or more over a one-year period.
Figure 1: Conventional Longevity Swap Based on 95% VaR
Source: PensionsFirst Capital
If the pension scheme was to enter into a longevity swap to remove its £141m of longevity risk, it would be required to pay a fixed stream of cashflows to a bank or insurer, which will be based on the expected pension cashflow, under an expected initial rate of mortality and a set of longevity improvements agreed between the scheme and the provider. In return, the provider will pay a variable stream of payments based on actual levels of mortality. In this example, the insurer or bank’s best estimate of the longevity increases the cashflows by approximately 1%, and it then charges a 6% premium for taking on the risk (see Figure 2).
Figure 2: Longevity Swap Cashflows
Source: PensionsFirst Capital
The swap has the effect of increasing the liability by around 7%, as each and every pensioner cashflow is effectively uplifted by this amount. The present value of the estimated payments stands at around £2.14bn on an IAS19 basis. Were it to execute the hedge, the scheme would eliminate its longevity risk, but would conversely increase its exposure to interest rates and inflation (see Figure 3) as the uplift in cashflows will tend to exaggerate the mismatch between the scheme’s assets and liabilities. This means that, in effect, the scheme has paid £140m to remove £56m of risk.
Figure 3: After the Longevity Swap
Source: PensionsFirst Capital
Scenario Two: The Swap Provider Re-shapes the Cashflows
It is not uncommon for the longevity swap provider to seek to manipulate the cashflows underlying the swap to make the cost of hedging appear cheaper to pension schemes, and it is here where transparency is vital for treasurers.
The value to the swap provider or cost to the pension scheme of putting in place the swap will depend on their view of the world and hence the discount rate they use to present value the liabilities. In this case we assume that the swap provider assesses present value using the London Interbank Offered Rate (LIBOR) curve so they are happy to offer an alternative set of cashflows with the same present value but with a longer duration (see Figure 4 where the cashflows have been back-ended).
However, because pension schemes discount liabilities using different measures to banks, this has the effect of making the swap appear better value to them. In this example, our analysis estimates that the ‘cost’ would appear to drop by £4m if the pension scheme valued its liabilities on a technical provisions basis (where the discount rate is equal to gilt yields plus half a percentage point) and £34m on an IAS19 accounting basis (using a AA corporate discount rate).
Figure 4: Re-shaping the Longevity Swap
However, reshaping the cashflows in this way may have unintended consequences. In this case, the revised structure has increased the pension scheme’s interest rate and inflation exposure by £50m and £27m respectively (see Figure 5). This is because by reshaping the cashflows of the swap, the scheme has extended the duration of its liabilities, and hence its sensitivity to interest rates and inflation. If the scheme was to enter into this swap it would pay £106m to remove £31m of risk – an entirely different proposition.
Figure 5: Post-Longevity Swap with Reshaped Cashflows
Source: PensionsFirst Capital
Clearly such information puts pension schemes in a much stronger position to quickly and precisely value the worth of de-risking instruments such as longevity swaps – breaking down many of the barriers that have, to date, halted transactions in their tracks. Which means that the onus is not only on pension schemes to seek more sophistication in their risk valuation processes, but also on the swap providers to provide complete transparency around the potential transactions. Our own policy is to ensure transparency by conducting analysis of potential solutions on an open-book basis, with pricing and risk clearly presented and underpinned by leading technology, in the form of the PFaroe risk management platform.
Not only will such steps ensure that pension schemes reduce their overall risk exposure at a fair price, but it will also move them well on the way to an insurer’s best estimate of the liability, and reduce the extra cost of a buyout, which should be the ultimate aim.
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