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More U.K. pension fund executives are hedging against the possibility that their members will live longer, with fund officials in other countries expected to follow suit.
In 2011, which was a record year in longevity swap transactions among U.K. pension funds, about £7 billion ($10.90 billion) in pension liabilities was offloaded to insurance companies and other financial institutions in the event that retired members live longer than the average life expectancy, according to data from Aon Hewitt.
In 2010, the total value for longevity swaps stood around £4.3 billion ($6.71 billion).
“There have been enough deals now that I think the market has reached critical mass,” said Martin Bird, managing principal and head of the risk settlement group at Aon Hewitt, London.
Pension funds in the Netherlands and, to a lesser extent, the U.S. also are considering similar longevity risk transfer solutions, but none has yet been implemented in those countries, several consultants and insurers said.
“Longevity concerns are not as acute in the U.S. compared to the U.K.,” said Phil Waldeck, senior vp for pensions and structured solutions at Prudential Financial Inc., Newark, N.J., which implemented the first insurance-based pension buy-in in the U.S. in May 2011 for Hickory Springs Manufacturing Co., Hickory, N.C.
“We are seeing developments similar to the U.K.,” Mr. Waldeck said. “They're slower but heading in the same direction.”
In a longevity swap, the pension fund typically makes a series of payments over a fixed period of time that's related to the average life expectancy of retired participants. In return, the insurer or financial institution covers the payments to the participants for as long as they live, Mr. Bird said.
The first longevity swap was executed in 2009, and the aggregate value of such deals for that year totaled about £4 billion ($6.47 billion), according to data from Aon Hewitt.
Stricter regulations toward mark-to-market valuations and increasing transparency of pension obligations coupled with a volatile market environment in the past few years have fueled longevity swap transactions in the U.K. Similar trends are happening in the Netherlands, where some the largest funds added billions to their pension liabilities in 2011 as a result of increased life expectancy among members, consultants said.
Longevity risk transfers are part of a broader set of pension risk transfer solutions that also include “buy-ins” and “buy-outs,” which typically involve insuring or transferring all or part of the defined benefit pension liabilities. In carving out the longevity risk, pension executives can offload that portion of the liability at a lower cost.
“Buy-ins and buy-outs require an upfront payment, and most (pension funds) can't afford to pay the premium to do that,” Mr. Bird said.
In addition, pension funds entering into a longevity swap don't need to sell assets at current depressed prices to pay for the transaction compared to buy-ins and buy-outs, said James Mullins, partner and senior liability management specialist at investment consultant Hymans Robertson L.L.P., Birmingham, England.
“The supply side is growing as well,” with new entrants into the market within the last couple of years also including financial institutions such as Goldman Sachs Group Inc., Deutsche Bank A.G., J.P. Morgan Chase & Co. and Credit Suisse Group A.G. Insurance companies have been at the forefront of offering pension risk transfers, with Swiss Re Ltd. and Prudential already offering longevity swaps, while Legal & General Group P.L.C. completed its first such transaction this year with the £1.3 billion ($2.03 billion) Pilkington Group Superannuation Scheme, Merseyside, England. The deal is valued at £1 billion ($1.56 billion) and accounts for about 60% of the fund's total pension liabilities.
“We're in the process of launching a (longevity risk reduction) product aimed at smaller pension funds,” said Tom Ground, head of business development within Legal & General Group P.L.C.'s pension insurance solutions division based in London. “Smaller funds have (relatively) larger longevity risk” because of an increasing chance that a few individuals within a smaller group of plan members will live much longer than the average plan participant.
“The credit crunch has shined the spotlight on managing pension risks, and one of those risks is longevity risk,” Mr. Bird said. Every additional year added to the average life expectancy could increase pension liabilities by 3% to 5%, according to estimates by consultants.
So far, longevity swaps have been implemented to offload the pension liabilities of retired members. There's still no efficient solution available to reduce longevity risk for younger members, consultants said. However, “there's more uncertainty” in life expectancy estimates for younger members, Mr. Mullins said. One potential solution is through a longevity swap transaction based on a longevity index rather than actual life expectancy of individual members.
“More and more work is being done in the index space,” Mr. Mullins said. The first longevity index hedge was completed in 2011, when the £120 million ($186.9 million) Pall Europe Ltd. (UK) Pension Fund, Portsmouth, England, offloaded longevity risks associated with about £70 million ($109.0 million) in pension liabilities using the future values of the J.P. Morgan LifeMetrics Index.
Other longevity swap transactions conducted in 2011 include British Airways P.L.C., which entered a longevity swap relating to about £1.3 billion ($2.03 billion) in pension liabilities; Rolls-Royce Holdings P.L.C., which offloaded the longevity risk for about £3 billion ($4.67 billion) of its pension liabilities; and ITV P.L.C., which transferred about £1.7 billion ($2.65 billion) in pension longevity risk. All three companies are based in London.
Mr. Bird of Aon Hewitt added: “We think this is the tip of the iceberg, with probably more (deals) to come in 2012.”
Thao Hua is a reporter for Pensions & Investments, a sister publication of Business Insurance.