By Howard Kearns, Director, Insight Investment
In 2016, an average 65-year-old female could expect to live another 25 years; in 2023, this had fallen to below 24 years. Over the same period, the life expectancy for a 65-year-old male fell from about 23 years to below 22 years.
Such declines could have led to a reduction in pension scheme liabilities of c.5%, as pensions are paid out for less time overall, though the actual impact on a specific pension scheme will depend on a range of factors.
Life expectancy may not continue to fall: multiple factors could lead to increased life expectancy
There are many factors that could lead life expectancy to rise, including medical advances that increase the efficacy of treatments for cancer and other conditions; the development and adoption of technologies and lifestyles that could extend life expectancy; and changes to government policy, which can have a meaningful impact on life expectancy in many ways – including through healthcare funding.
Longevity is the biggest unhedged risk for most pension schemes
Defined benefit pension schemes have largely hedged their most significant liability risks, in the form of interest rates and inflation, and have generally reduced their allocations to risk assets in favour of bonds. With most risks hedged or greatly reduced, longevity risk is now one of the largest remaining risks for many pension schemes. A material rise in life expectancy could throw a pension scheme’s strategy off course.
Total longevity-hedging transaction volumes have surged to over £120bn in recent years
Longevity risk can be hedged by a pension scheme in different ways, but it is typically achieved by holding a buffer to mitigate the impact of rising life expectancy, by a longevity swap or through an insurance buy-in. There have been material longevity swap transactions announced in recent years – with over £50bn of transactions announced over 2020 to 2022, and transactions representing almost £9bn have been announced in 2023 so far.
The principles behind a longevity swap are simple in theory and practice
A longevity swap is an agreement under which a pension scheme pays pre-defined inflation-linked cashflows to a reinsurer (via an insurer) for a specified period of time. In return, the pension scheme receives cashflows to cover the pensions, payable for life, of a specific membership population. This means the scheme’s investment strategy does not have to contend with the possible impact of those members living longer than expected.
Longevity swaps are typically targeted to hedge the longevity risk of a specific population
Although there has been much talk of longevity indices over the years, only one longevity swap has been based on such a longevity index. Every other longevity swap has been based on the realised longevity experience of a specific population of pension scheme members.
Longevity hedges can be designed to cover deferred members as well as pensioners
Historically, longevity swaps focused only on pensioner members, as insurers could more easily project the probability of increased life expectancy of older lives. However, longevity swaps are now being designed to cover the longevity risk of deferred members as well as pensioners. For example, in 2021, the Axa UK Group Pension Scheme conducted a transaction to protect mostly deferred liabilities from improvements in life expectancy.
Multiple well-regarded reinsurers compete to take on pension schemes’ longevity risk
There are at least 10 global reinsurers with strong credit ratings willing and able to underwrite longevity risk for UK pension schemes. This means that pension schemes looking to hedge longevity risk can access a competitive market and secure attractive pricing.
Longevity hedge pricing has fallen due to increased competition and higher real discount rates
When a pension scheme conducts a longevity swap, the pre-defined cashflows it pays reflect two factors: a best estimate projection of the pensions it will need to pay to scheme members in the future, and a risk fee that reflects the longevity risk to which the reinsurer is exposing itself. According to our market contacts, as both the number of reinsurers competing in the market and bond yields have risen, the risk fee for longevity swaps has almost halved in recent years.
The additional investment returns required to fund a longevity hedge are typically small
Longevity swaps are unfunded, meaning that pension schemes do not have to make a significant one-off payment to their counterparty at the outset. They must, however, consider the additional return that is required to finance the risk fee. The additional investment returns required to do this are typically small. For example, for a pension scheme with a liability duration of 12 years, a longevity swap with a 3% risk fee would need to add 25bp to the annual required return from the scheme’s assets.
Longevity swaps can be collateralised with a wide range of eligible assets
Assets eligible to be held as collateral against longevity swaps can include cash, gilts, supranational and agency debt, and corporate bonds – meaning a pension scheme can retain flexibility in its investment strategy.
Longevity hedges provide future flexibility suitable for all endgame strategies
Most DB pension schemes are targeting an insurance buy-out or self-sufficiency. For schemes seeking to run-off over the long term, longevity swaps can be incorporated into their long-term strategy. They have also been successfully novated as pension schemes conduct a buy-out.
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