Investment banks have been sitting up and taking notice of the pensions industry in recent years – an industry with global benefit liabilities of nearly $20,000bn. Edward Russell-Walling reports on how the banking industry’s big hitters are managing longevity risk.
Whoever accused big companies of not being entrepreneurial has obviously never seen a large investment bank beavering away at a business opportunity. One of their richer seams in recent years has been the pensions industry – and the capital markets’ most tantalising challenge right now is finding an affordable way to manage longevity risk.
Pension fund assets and liabilities are vast – $19,600bn in defined benefit liabilities worldwide, by some measures – so it is not surprising that investment banks want to be involved. An early way in was through so-called ‘transition management’ – helping pension funds to rebalance their investment portfolios away from the heavy equity bias that characterised the 1980s and much of the 1990s.
That business became less profitable as it grew more competitive and as the clients realised that ‘best execution’ was not always top of the agenda. So, the smarter banks turned to the next great pensions theme – derisking. New regulatory and accounting standards highlighted alarming deficits between what pension funds were going to have to pay their members over time – their liabilities – and how much they were likely to retain in the pot.
Wider impact
Pension fund status began to effect corporate valuations and even mergers and acquisitions strategy – first negatively and now, on occasion, positively. Edmund Truell’s Pension Corporation has bought UK companies such as Thresher, Thorn and Telent (the rump of GEC Marconi) purely to get its hands on their pension funds – which it believes it can run more efficiently.
So managing, reducing and even transferring pensions risk is now as important to the boardroom as it is to the trustees. The most popular approach that has evolved to deal with these concerns is ‘liability-driven investing’, which highlights the importance of minimising and managing risk. It identifies three main liability risks – inflation, interest rates and longevity.
“You ask yourself ‘am I adequately rewarded for assuming that risk?’,” says David Blake, director of the Pensions Institute at London’s Cass Business School. “If so, you retain it. If not, you insure it or sell it to someone else.”
Inflation and interest
Increasing numbers of pension schemes see no reward in retaining inflation or interest rate risk, and investment banks have been happy to take it off them with inflation and interest rate swaps. This was lucrative business to begin with, but it too has become commoditised and less profitable as more banks compete to offer it.
Longevity risk has been consistently underestimated and, on its own at least, is difficult to lay off. Professor Blake says that longevity improvements are a stochastic process rather than a deterministic one, and actuaries’ assertions that they ‘must tail off’ have always got it wrong.
He and two academic associates, Andrew Cairns and Kevin Dowd, developed a series of fan charts – much like the Bank of England’s inflation forecasting charts – to predict a range of possible longevity outcomes. They showed, for example, that while the best estimate of life expectancy for a 65-year-old male in 2050 (ie, someone born in 1985) was another 26 years, this could range from 21 to 32 years.
“Every additional year of life expectancy adds 3% or 4% to the present value of pension liabilities,” says Professor Blake. “So if this person has just entered the job market and joined a pension plan, the plan could end up between 18% and 24% short.”
That could represent an awful lot of money. The insurance market offers one way to offload this longevity risk, along with all other risk, through a bulk annuity. This is long-established practice, although new entrants to the market have given it an air of novelty. In the UK, for example, Legal & General and Prudential traditionally dominated the bulk annuity market for closed schemes.
Buyout competition
Competition is increasing here, in both full and partial buyouts. Paternoster, formed by a former Prudential executive with Deutsche Bank as a backer, has taken on mature pension assets worth £1.5bn ($2.94bn), it says. These buyout solutions are regulated by the insurance regime of the Financial Services Authority and must be fully funded. They are also expensive, costing between 20% and 30% more than the balance sheet value of the pension scheme
Only insurers can sell annuities. An alternative UK buyout route is to keep the scheme alive and regulated by the Pensions Regulator, which permits deficits under certain circumstances and allows a broader range of investments.
Citigroup opted for this approach when it proposed to acquire the $392m Thomson Regional Newspapers pension scheme. Its idea is to create value by managing the scheme more efficiently.
Many now believe that there is a better way to manage longevity risk. “Buyouts and bulk annuities are both costly and inflexible,” says Guy Coughlan, head of pension asset liability management, JPMorgan. “And an insurance-based solution will never get you to a liquid market. Capital markets products are more liquid and have lower transaction costs.”
JPMorgan has, with the help of the Pensions Institute and consultants Watson Wyatt, developed the LifeMetrics index to measure longevity and provide a tool for trading it. It has also created instruments to transfer longevity risk, called q-forwards (‘q’ is the actuarial symbol for mortality rates).
BNP Paribas, EIB and Partner Re tried to tackle the longevity problem with a 25-year longevity bond, announced in 2004. The coupon was adjusted in line with actual mortality rates. It never took off for various reasons, not least that it did not hedge the ‘toxic tail’ – the years after the age of 90 when longevity risk is highest – and there was a lack of capital efficiency. Given the up-front cost of the bond, there was very limited risk reduction.
Bad timing
“The timing was wrong,” says Mr Coughlan. “It was too early and the market wasn’t receptive enough.” There have been three historical barriers to a capital market solution for longevity risk, he says. The first was a lack of recognition and measurement of it as a problem – now largely addressed by regulatory and accounting changes.
Next was a lack of education. “The issue was obscured by jargon and actuarial complexity,” says Mr Coughlin. “Even for financial market professionals, longevity risk is unfamiliar – and most of the expertise lies with insurance actuaries, not pensions actuaries.” However, the subject is now raised more often in research papers and seminars, and is a more familiar sight in the press.
Need for standardisation
The third obstacle, says Mr Coughlan, has been a lack of standardisation – in risk measurement, language and concepts. “Actuaries, financial professionals, consultants, all need to talk to each other in the same vocabulary. We have been trying to promote a common way of looking at this, through our index and through use of language.”
Since all of these issues are being addressed, the time is right for a market in longevity risk to develop, he says. A portfolio of q-forwards swaps, with the LifeMetrics index as the fixed leg, can be used to provide an effective hedge of the longevity risk of a pension plan or annuity book, adds Mr Coughlan.
As such, it could be an alternative to a buyout, part of a do-it-yourself hedging of all risks. “Or it could act as the lubricant for a buyout, for those who can’t afford it but might be able to in five or 10 years’ time. They would use it to lock in the value of liabilities with respect to longevity changes at a future date – so it wouldn’t be a moving target.”
Measuring longevity
Mr Coughlin argues that measuring longevity risk is easier than most people think, and that you do not have to transfer 100% of it for a successful hedging strategy. “As long as the cost is commensurate with the risk reduction, you’re in a better position,” he says. The basis risk between a standardised hedge and a scheme’s actual longevity experience can be minimised, he adds, “by constructing the hedge appropriately”.
JPMorgan has yet to close any such contracts with a pension fund, although Mr Coughlin is confident that it will do so this year. Some consultants believe that these swaps do not yet offer value. “Longevity swaps are extremely expensive,” says Gavin Orpin, investment partner at consultants Lane Clark & Peacock. “We say they are not good value and that schemes should rather self-insure or do a buyout.”
Others are convinced that there will be a market, however. Secondary trading in life insurance policies – the life settlements market – has introduced investment banks to the idea of mortality and how to repackage and redistribute the risks. Credit Suisse, for one, is sure that this market will develop and has been staffing for structuring as well as trading this type of risk. “The market is in its infancy but interest is growing fast,” says head of insurance and pensions solutions at Credit Suisse, David Prieul. “Growing demand will drive prices down to levels where it becomes attractive for players – like pension funds – to consider offloading the risk.”
New entrants
Deutsche Bank agrees that longevity risk will become more important in 2008. Rather than using a swap approach, it is looking for new players to take on these risks via its trading and structuring arms. It already places some older-age longevity risk using structured notes, and believes it can also repackage longevity for the asset-backed securities market.
In December, Goldman Sachs launched the first index that will allow pension funds, insurance companies, hedge funds and money managers to trade exposure to longevity risk in a transparent and real-time manner. It is called QxX.LS, and the firm expects it to encourage a more liquid secondary market. Its competitors would like that too.
