Over the hedge

The Royal County of Berkshire pension fund recently became the first local authority scheme – and only the third fund in the UK – to enter into an insurance contract designed to hedge out its longevity risk. Gary Delderfield explains what longevity swap are and why they may be attractive for LGPS funds.

Local Government Pension Scheme funds (and their Administering Authorities) have long been at the forefront of innovative investment strategies. We have now seen this continue with the Royal County of Berkshire Pension Fund (Berkshire Fund) entering into one of the first longevity swaps.

What is longevity risk?

A key risk affecting defined benefit pension schemes (including LGPS funds) is longevity risk. This broadly means the risk that the longevity assumed by the scheme for funding purposes proves to be inadequate because:

• the rate of increase for the general population's longevity exceeds that which is generally predicted;
• the scheme's members have a different longevity to the general population; or
• while the scheme's membership as a whole may have the same longevity as the general population, certain members may have very different longevity.

What is a longevity swap?

A longevity swap is a means of transferring to the swap provider (the counterparty) some or all of the above longevity risks.

The longevity swaps which have been entered into so far have been scheme specific. Such swaps normally work as follows:

• the scheme estimates how long the members (or a specific category of them) will live;
• the scheme then makes fixed payments based on these assumptions to the counterparty for a given term (fixed leg); and
• the counterparty then pays the scheme variable amounts equal to the pensions due to the particular members (floating leg).

If members live longer than expected, the scheme will make a "profit". The counterparty will benefit if they die earlier than expected.

In reality, these cashflows are netted off against each other, with balancing payments made between the trustees and counterparty normally on a quarterly basis.

There are two main variations to a longevity swap. First, instead of being calculated by reference to the scheme's specific members, it is possible for a swap to be calculated instead by reference to the longevity described on a particular index (so that the floating leg payments are based on changes under a longevity index, for example JP Morgan LifeMetrics Index). Such a swap would only protect a scheme against changes to the general population's longevity.

Secondly, these swaps can be structured as either a derivative or an insurance policy. There have been examples of both in the early longevity swaps entered into.

Why are longevity swaps attractive?

Longevity risk is a key risk for defined benefit schemes like the LGPS.

Unlike private sector defined benefit schemes, LGPS funds have not yet sought to manage this risk by entering into buy-in or buy-out arrangements. A longevity swap would accordingly be the first time that a LGPS fund has taken active steps to manage this risk.

Such a swap enables the Administering Authority to demonstrate to its stakeholders (including members, employers and the taxpayer) that it is tackling longevity risk. At the same time, entering into a swap allows the Administering Authority to retain control and possession of the vast majority of its LGPS fund's assets (which could then for example be invested in return-seeking investments).

What should LGPS funds consider before entering into a longevity swap?

Longevity swaps are complicated and may not be suitable for all LGPS funds. This means that any Administering Authority that is considering entering into a longevity swap should first seek advice on whether this would be appropriate for them.

There any many issues to be addressed in relation to the swap (and which are common to private sector schemes). These include how to value it:

• The swap will need to be valued at the outset of the term for the purposes of calculating: the impact of the swap on the scheme valuation and schedule of contributions; the accounting impact of the swap; and the collateral to be held by either party.
• It will then need to be valued throughout the term of the swap to determine changes to the amounts of collateral that need to be held, and (rarely) any changes to the fixed leg payments. A disputes mechanism will be needed for these purposes in case agreement cannot be reached.
• Finally, it will need to be valued at the end of the swap should it need to be surrendered early.

The Administering Authority should also consider how it will manage the need for collateral to be posted to address the risk of counterparty insolvency. The Administering Authority will need adequate systems to enable potentially large amounts of collateral to be posted quickly.

Finally, the Administering Authority must comply with the requirements of the LGPS Management and Investment of Funds Regulations. These regulations require that the Administering Authority is satisfied that entering into the swap is in accordance with its investment policy and is a suitable investment. The Administering Authority must also ensure that the swap does not infringe the investment restrictions.

In this regard, the Administering Authority will need to be content that the swap provides 'value for money'. There is not yet a market for longevity swaps, and (as described above) they tend to be bespoke for the particular scheme's liabilities. This means that their pricing over time might not be as competitive as that which is available for other risk management tools (including buy-ins and buy-outs).

It is also worthwhile noting that this complexity means that the adviser costs that are incurred before such a swap can be entered into tend to be very material.

Comments

Longevity risk has been an issue which has faced defined benefit pension schemes for a while now. The fact that it has taken until 2009 for such schemes to enter into longevity swaps (despite insurance companies using them for many years) demonstrates the complexity of the issues surrounding them.

Since so few longevity swaps have occurred (the private sector Babcock and Royal & Sun Alliance schemes and, in the public sector, now the Berkshire Fund), there is not yet a developed longevity swaps market.

Bearing in mind the complexities and costs involved with longevity swaps, it remains to be seen how many other pension schemes, both in the public and private sector, go down the longevity swaps route.

Gary Delderfield is a partner at Eversheds. He can be contacted via This email address is being protected from spambots. You need JavaScript enabled to view it..