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Longevity risk is a major threat to pension funds and sponsoring companies

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Longevity risk is being recognised as a major threat to UK pension funds and the companies who sponsor them. Many funds are now considering de-risking their liabilities over time and finding that it might be more cost efficient to de-risk by using more than one tool.

These are the latest conclusions from a Clear Path Analysis report ‘Pension De-Risking: Longevity Hedging and Buying Out’ published today.
 
There are many views on longevity: some think humans are going to live forever while others think longevity has already peaked.
 
Aubrey de Grey, author, theoretician and chief science officer for the SENS Foundation, believes it is very likely that the first person to live until 1,000 has already been born. He suggests there is at least a 50% chance of developing the technologies to enable this to happen within the next 25 years. He writes: “The first step is to demonstrate proof of concept in the laboratory. Once we have done this it will become generally attractive and it will only be a matter of time before we can do the same to humans. At which point, everyone’s priorities and decisions will change.”
 
Overpopulation, the structure of the new family unit, and how we will pay pensions are all fundamental problems that will result from increases in longevity.
 
Voicing caution he adds: “People are only going to get older one year per year, we’re not going to have any 1000 year old people for at least 900 years, whatever happens. I think we have at least a 10% chance of not getting there for 100 years if we happen to hit problems that we haven’t anticipated.”
 
Kelvin Wilson, Associate Director Pensions Advisory at Grant Thornton UK LLP states: “It is easier to predict how long retired pensioners will live for than it is to predict for younger deferred and active members. These younger members have a longer time horizon over which to benefit from any medical advancements. This increases uncertainty (and therefore risk) around their future longevity experience. While pensioner buy in and pensioner longevity swaps can address risks associated with retired members of the fund, significant residual risks with deferred and active pensioners remains.”
 
Andrew Reid, European Head of Pensions Origination within the Capital Markets and Treasury Solutions Group at Deutsche Bank notes: “What is clear is that life expectancy is uncertain. By hedging longevity risk, you gain certainty over that unknown. Pension scheme clients have been affected by longevity risk a number of times over recent years, increasing cash funding requirements and balance sheet liabilities. A life expectancy increase of say 3-4 years seen over the last 5-7 years, leading to a 10% plus increase in liabilities, is not uncommon”
 
In his contribution to the Clear Path Analysis report, Wilson states: An index-based solution is currently the most viable option for companies and pension fund trustees who are looking to hedge longevity exposure on deferred and active fund members; Indemnity-based swaps are not currently seen as a cost effective solution for pension funds with liabilities below GBP300 million, whereas an index-based swap is likely to be justifiable on a cost/benefit analysis for pension funds with more than GBP50 million liabilities, opening up this longevity risk management strategy to a much broader group of pension funds.
 
Wilson adds: “Unless capacity to absorb legacy employment benefits increases significantly, employers and trustees will be left in the unenviable position of running the risk and bearing the cost of managing these liabilities for well over the next 30 years. An index-based longevity swap structure might be the best mechanism through which de-risking market capacity increases sufficiently to absorb all defined benefit liabilities.
 
Reid remarks that intermediaries such as banks can take the clients risk and put it onto their own balance sheet, then distribute the risk to investors who want to invest in the type of risk that clients seek to remove. Talking about groups of risk takers he writes: “The capital markets route is in its infancy, but it’s a very exciting development because if we can crack it, it gives us scale that we won’t have through just using reinsurers. If you’re a fund investing in capital markets, longevity may appear to be quite an attractive asset class because it’s a diversifying risk and pretty much uncorrelated with anything else you might be holding. Somebody else is paying you a premium to transfer away their risk.  Add to those rates that are close to zero (implying high-yielding investment opportunities may not be as common as in the past) and it’s easy to see there could be broad appeal."
 
This sort of investment for diversification purposes will appeal to sovereign wealth funds, multi-asset hedge funds, mutual funds, possibly private equity, private wealth, banks, insurance companies and anybody who wants a diversified or uncorrelated investment. Reid adds: “The reinsurers between them might have capacity for the next few years of GBP10 – GBP15 billion annually, as measured in terms of value of liabilities. The potential for the capital markets is huge, it could easily be double that, probably a multiple of it.”
 
On the topic of contract standardisation Wilson comments: “Through contract standardisation and bringing greater transparency to longevity hedging, it is expected that index-based hedges will be more accessible for smaller pension funds and more amenable to capital market investors.”
 
Finally Wilson said: "It is possible to combine a pension buy-in, a deferred/active pensioner index-based longevity swap and an LDI strategy to achieve a de-risking position that is very close to a buy-out. The pension fund would, effectively, have done a DIY buy-out."
 

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