Longevity swaps and the derisking dilemmaLongevity swaps can help pension plans – and their corporate sponsors – to protec...
Figure 2: Breakdown of longevity swap pricing (source: AEGON Global Pensions)                                             ...
AEGON and deriskingAEGON Global Pensions offers a broad range derisking capabilities (including buyouts and buy-ins, liabi...
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What is the Right Price for Removing Longevity Risk


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What is the right price for removing longevity risk? (From 2011)

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What is the Right Price for Removing Longevity Risk

  1. 1. PAYING THE PRICE FOR LIVING LONGER – WHAT IS THE RIGHT PRICE FOR REMOVING LONGEVITY RISK? Life expectancy around the world is rising and there is no sign that this trend is about to stop anytime soon. For companies that sponsor either active or closed Defined Benefit pension plans increased longevity requires careful attention. Longevity swaps are increasingly seen as a solution to reduce longevity risk in pension plans. But what is the right price for removing longevity risk? Over the past several decades, life expectancy has continued to rise. Recent UK research indicates that more than 2 million people presently aged over 50 in the UK will live to be older than 100 (17% of the present population), and 33% of female babies born today can expect to live 100 years or more.1 Estimates vary, but life expectancy now appears to be increasing at a rate of 1 to 3 months every year. While the impact that this has on pension liabilities varies according to plan demographics and the levels of interest rates, every year of additional life expectancy is generally thought to add about 3-4% to the present value of pension obligations for a typical pension fund.2 Once again, it is not clear whether life expectancy will continue to rise at present rates but the risk is clearly visible. For example, if, as a result of increasing public smoking bans, the number of smokers were to fall, average life expectancy from birth could increase by between one and two years. This in turn would require an increase of between 8 and 10% in pension reserves.3 Figure 1: Longevity swaps to date (source: AEGON Global Pensions) £ 500 Mln £ 1500 Mln £ 1900 Mln £ 3000 Mln Indemnity swap Indemnity swap for RSA by for BMW by for Canada Life for Abbey life by Goldman Sachs & Deutsche Bank & by JP Morgan Deutsche Bank Rothesay Life Abbey Life £ 550 Mln £ 70 Mln £ 475 Mln Indemnity swap £ 750 Mln £ 100 Mln Index for PALL Pension Indemnity swap for Babcock by for Berkshire swap for Lucida by fund by J.P. for Aviva by RBS Credit Suisse & Pension fund by JP Morgan Morgan & PartnerRe Pacific Life Re Swiss Re July 2008 March 2009 July 2009 Feb 2010 Jan 2008 Feb 2009 May 2009 Dec 2009 Feb 2011 DB plans and longevity risk The fundamental underlying risk for any Defined Benefit pension plan (and its corporate sponsor) is that the plan should be unable to meet its liabilities. Longevity risk – the risk that the pension plan has to provide benefits to its members over a longer period than expected – is increasingly being recognised as a major threat to pension plans and the companies that sponsor them.1 Sources: J.P. Morgan and AEGON3 On this note, Philip Morris announced in 2010 the possible loss of 176 jobs in its Netherlands factories, citing thedecrease in demand for cigarettes in the Netherlands. 1 March 2011
  2. 2. Longevity swaps and the derisking dilemmaLongevity swaps can help pension plans – and their corporate sponsors – to protect themselvesfrom one of the major risks they face (the other major risk include asset risk, inflation risk andinterest rate risk). In addition, longevity swaps provide an excellent diversifying effect on a pensionfund’s portfolio, particularly for low risk portfolios (typical of closed Defined Benefit plans with oldermembers).In calculating how much they should be willing to pay for a longevity swap, some companies may befaced with the challenge of reconciling their present estimates of future costs with the potential ‘worstcase’ scenario against which the longevity swap provides a hedge. As with many derisking solutions,companies are faced with the dilemma of whether to take action now or not. When derisking isaffordable, it is often viewed as being less necessary. At times when the appetite for deriskingincreases (typically when the risk materialises), it is also usually less affordable.In the present environment, there are two elements at play that may be leading some pension fundsto hold back – the contrast between the pension funds’ perceived liabilities and their actual liabilities,and the relative newness of the market in longevity swaps. However, as new regulatory regimes(including Solvency II) will increasingly recognise longevity risk, it is likely that more companies willstart actively looking to protect their pension funds.Pricing longevity riskWith a longevity swap, a variable stream of cash flows is exchanged for a fixed stream. Whenlooking to price a longevity swap, both parties to the swap need to agree on the best estimate offuture cash flows, which includes the most accurate and up-to-date mortality statistics. At present,many pension funds rely upon a deterministic model, based on official actuarial tables against whichto measure their liabilities. While mortality rates have been improving for decades, actuaries haverepeatedly assumed that this growth would slow. It is this assumption that is now increasingly beingrevisited.Although current deterministic models can assist a pension fund to reach a best estimate of theirfuture cash flows, they do not always provide a good picture of the measure of risk around thenumbers. For this reason, in pricing a longevity swap, stochastic (or probability-based) models ofmortality rates are increasingly being used. A stochastic model enables the best estimate cash flowsand the related longevity risk to be calculated, taking into account diversification at all levels, thelatest statistical data for the specific country or region involved, and pension-specific mortalityexperience.When comparing the perceived liabilities of a pension fund using a deterministic model and theactual ‘best estimate’ liabilities using a stochastic, pension-specific model, the deterministic model isoften revealed to underestimate future liabilities. Although this ‘liability gap’ needs to be bridged, itshould not be viewed as part of the cost of the derisking solution itself but rather be seen as a costadjustment that is required in recognition of the new best estimate of future liabilities. 2 March 2011
  3. 3. Figure 2: Breakdown of longevity swap pricing (source: AEGON Global Pensions) Total Pension Plan Cashflows 50.000 45.000 Current Valuation Expectation Current Cash Flow Projection 40.000 Cash Flow (in Thousands) 35.000 Expected Cash Flows Cash Flows Actual Best Estimate Cash Flow 30.000 Fixed Cash Flows+ Risk Premium Best Estimate 25.000 20.000 15.000 10.000 5.000 - 1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 Source: AEGON Time (in years)Once the best estimate cash flows have been quantified, the price of the longevity swap itself has tobe determined. When discussing pricing, a comparison is often made between longevity swaps andinterest rate swaps. There is, however, a key difference, as interest rate risk is a ‘tradeable’ risk andthe price of the swap is largely determined through supply and demand. In contrast to interest raterisk, however, there is no market-based price-setting mechanism for longevity risk. Market playerstherefore generate best estimate projections and add a risk premium to compensate for the risk.Insurers – a ‘natural counterparty’The price of a swap also depends on the counterparty involved. Although longevity risk is not aperfect match for mortality risk, the two can offset each other to some degree. As insurancecompanies are well diversified and also carry mortality risk, they are able to assume longevity riskmore efficiently than other parties. Despite the lack of a liquid market, the existence of insurancecompanies with mortality risk on their books therefore creates something of a ‘natural counterparty’for longevity risk.Although it is impossible to provide a general price for a longevity swap, a risk premium above bestestimate cash flows typically ranges between 3% and 7% for a pensioner-based portfolio. At thisprice, the pension fund protects itself for a sum it can afford against a risk it cannot afford to have.ConclusionAs with all risks, there is a temptation with longevity risk to wait and see how the market – andmortality tables – develop (‘it may never happen’). However, for companies with Defined Benefitpension plans, in the light of the present demographic trends and regulations, it is a good idea toquantify the potential impact of longevity risk on your company. Once these calculations have beenmade, it is possible to address the derisking dilemma and to find the right solution at the right price. 3 March 2011
  4. 4. AEGON and deriskingAEGON Global Pensions offers a broad range derisking capabilities (including buyouts and buy-ins, liability driven investments and longevity swaps) in the UK, continental Europe and the USA. Ifyou are a multinational company with pension funds in one or more countries, AEGON GlobalPensions can help you decide on the most efficient derisking route, taking into account the cultural,legislative and accounting aspects of your local pension schemes.To find out more about our derisking capabilities, please contact AEGON Global Pensions.Tel: +31 (0)70 344 8931 | | 4 March 2011