Special feature: Happy returns – the increasing popularity of longevity swaps

For now, depressed stock market values have effectively shelved any prospects of companies being able to offload their final salary pension schemes through a buyout funded by the major life insurers or any of the new players on the market. The fact that, in a buyout, schemes hand over their assets to the provider makes it very difficult right now, since it's not an attractive proposition to have their assets valued and their losses crystallised at today's prices.

The question, then, is what this means for finance directors, most of whom remain deeply unhappy about the cost and balance sheet volatility associated with their final salary schemes. The increasingly fashionable answer right now is to think about a 'longevity swap' as a way of taking some risk out of the scheme.

Longevity creep adds hugely to a scheme's liabilities since it has to fund members' retirement for longer – possibly much longer – than it had anticipated. The beauty about a longevity swap is that it transfers to a swap provider the risk that scheme members will enjoy their retirement years for what scheme sponsors would consider an annoyingly long time.

Whether a longevity swap is worth doing depends on two things: the amount of pain that mortality creep is likely to inflict and the cost of the swap. But there's a third factor: whether the trustee board is up to the task of understanding what a longevity swap is all about.

How it works
As Jerome Melcer, a partner with Lane Clark & Peacock (LCP) explains, in a longevity swap:
• The provider (an insurance company, bank or money market player), takes the risk that scheme members who are currently receiving retirement benefits will live longer than a specified average span. (No swap has yet been structured for active or deferred members – ie, current or ex-employees.)
• In exchange, instead of paying benefits to the members, the scheme pays an equivalent revenue stream to the swap provider.
• Ultimately, the scheme will pay out as much as it would have done had all the scheme's pensioners covered by the swap members (those already receiving benefits) lived to an agreed average age.
• To the extent that they live beyond this age, the swap provider takes over paying the benefits.

The clear benefit here is that the scheme's liability to members is capped. Effectively, the uncertainty over longevity is swapped out of the scheme. Trustees can sleep more easily at night knowing they are not going to have to go cap-in-hand to the sponsor for more funding every time the scheme actuary tells them that longevity has gone up by another year.

A key factor to be taken into consideration is counterparty risk. Clearly, if you are writing a (virtually) indefinite longevity swap, there is a risk that your counterparty will not be around to back up its promises. (Anyone who thinks this risk is small hasn't been paying attention for the last couple of years.)

Gavin Orpin, head of trustee investment at LCP, points out that the solution is to ensure that counterparty risk is dealt with through effective collateralisation of the contract as time moves on. Whoever is 'out the money' in the swap arrangement (the bank provider, if longevity increases more than expected; the scheme if longevity were to behave lemming-like and shorten more than expected) must put up extra collateral – generally, a mixture of cash, government bonds and possibly some investment grade corporate bonds.

However, this is where Orpin sees some severe difficulties ahead for the longevity swaps market. 'You can collateralise swap deals for inflation and interest rate risk since there is a market that determines the price, so the collateral can be marked-to-market on a daily basis,' he says. Longevity is less volatile than interest rates so the two parties involved would probably agree to review the collateral on a monthly or quarterly basis.

But this is where the problem would arise: there is no market to determine a value for longevity. An insurance company may use existing data and a bank would use an internal proprietary model to calculate probable longevity. But in each swap what is at issue is a specific scheme with its own, very specific longevity 'challenge'. Longevity swaps can be based on a particular scheme's mortality experience but who determines how the collateral should move?

Take the following worst case scenario as outlined by Orpin:
• A scheme takes out a longevity swap.
• Five years later the bank defaults.
• Over the five-year period, longevity experience worsened such that the bank owed the scheme money.
• However, the collateral the scheme received was based on the bank's internal model, not on what the scheme actuary specified as the longevity for the scheme.
• In such a case, the bank collateral may not cover the additional liability and the scheme would be out of pocket.

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