It’s good to hedge*

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There has been a flurry of activity in the longevity swap market over the last 12 months culminating in the mammoth £16bn transaction announced in July 2014 between the BTPS and Prudential. We appear to be seeing a big increase in the size of individual deals, as well as the overall number of deals. Why is this?

–          Anecdotally there are more firms willing to supply longevity hedging cover into the market, meaning that it has become more feasible for large (£5bn+) schemes to contemplate a transaction. Once one transaction is completed, it demonstrates to others what is possible. Longevity transactions are generally more popular with larger schemes as having a very large amount of data on the specific membership of the scheme allows a longevity provider to get more comfortable with the risk they are pricing, and show an aggressive price.

–          With funding levels generally at their highest levels for 3 years (see Figure 2 below) it is likely that corporate sponsors may be more supportive than they would have been previously of hedging risk in the scheme, including longevity risk. Having said that, most of these deals will have likely taken years to bring to fruition, and so would have been started when funding levels were a lot lower.

–          Our analysis also suggests that when viewed in the context of other financial risk within a pension scheme (not a straightforward task) the biggest impact from hedging longevity risk occurs at funding levels above 80%, with low equity allocations and higher levels of interest rate hedging. Survey data from the PPF and KPMG indicate that there is a general trend in all 3 of these areas that makes longevity hedging more attractive (albeit most schemes are probably not yet at the levels indicated in our analysis)

–          Deals done to date have attracted positive publicity, and in general have been received favourably by the market.

–          There has been a general trend over the last 5 years or so of pension funds adopting longevity assumptions that build in an allowance for future improvements (my colleague Muqiu Liu discussed this in a blog in more detail here). This means that there is now less of a gap between the assumptions a longevity provider will make in determining their price, and those used by the scheme actuary, this makes a deal more palatable for the corporate sponsor.

One way to illustrate the last point is to look at the BTPS transaction.  BT show some information on their longevity assumptions in their annual report and accounts (see Figure 1 below) which shows that they have been making an allowance for future longevity improvements since 2008. It also shows that their longevity assumptions (which are driven by a scheme- specific base table, as you would expect for such a large scheme) have not actually changed much since 2008.

Figure 1: Excerpt from BT annual report 2013


Generally speaking the longevity assumptions in a swap deal are more conservative than those typically used by pension schemes for setting their technical provisions. It could be that in the case of BT, by recognising future improvements earlier than many other schemes and with the vast amount of data they must have on the longevity of their members, the gap between the pricing of the deal and their current assumption may have been less than for other schemes.

We estimate that the longevity improvements quoted in the BT annual report and accounts (of 1 extra year of life for a 60 year old per 10 years) are equivalent to a long term longevity improvement factor of 1.25% p.a. This is roughly in line with the average assumption used among UK pension funds in 2013 as shown by the KPMG survey. This blog illustrates the impact of different longevity assumptions. While the terms of the BT swap deal are not in the public domain, it is likely that the level of future improvements agreed in the deal was slightly higher than that currently assumed by the actuary. We estimate that the difference would increase the hedged portion of the liabilities by £250-£500m, although public statements on the deal state that no extra cash contributions from the sponsor are required, it’s difficult to interpret exactly what this means. It could be that the actuarial funding is based on a stronger longevity assumption than the annual report & accounts.

So, it’s been a bumper start to the year for longevity hedging and while it isn’t something that will be meaningful in an overall risk context for every scheme, we see a good chance that the trend for big deals will continue in the latter half of 2014.

Figure 2: PPF 7800 Funding Level to April 2014

PPF 7800 April 2014

* For non-UK readers of my blog (and others) I want to note that the title is a play on BT’s advertising slogan of the 1990’s “It’s good to talk” and is not intended to be expressing a view on the attractiveness of hedging or otherwise.

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