"Pensions swaps - it can cost less to live longer"

Defined benefit ("DB") pension schemes continue to cause major headaches for UK corporates.  In particular, sizeable funding deficits can be a barrier to the successful acquisition or restructuring of a company, and can also present an obstacle to raising new finance in what is already a difficult market.  As a result, most employers have taken steps to control their pension costs by making changes to their benefit design structure - for example by closing their schemes to new members, ending benefit accrual or by making members pay more to meet the cost of their pensions.  However, DB pension reform is now moving to the next stage and sponsoring employers of DB pension schemes are progressively turning to investment driven solutions as a means of de-risking their pension schemes and reducing pressure on their balance sheets.

The holy grail for all scheme employers is to secure their scheme liabilities through the purchase of bulk annuities with an insurer - a pensions "buy-out" or a "buy-in".  However, buy-outs require significant up-front capital, and given the new gearing and liquidity requirements which will come into force through Basel III this may not be a viable option for many companies.  A more attractive and affordable option may however be for a scheme to protect itself against longevity risk by entering into a swap arrangement with an insurer.

2011 saw approximately £7 billion worth of so called "longevity swaps" negotiated between pension schemes, banks and insurers.  The framework is really quite simple - the pension scheme will pay a fixed monthly premium to an insurer and in return they receive a monthly payment to cover the cost of paying its pension benefits.  Schemes can either agree bespoke payments for particular members, or an index model based on the overall demographic of the scheme membership.  Once payments have been agreed, if member longevity improves then the insurer will need to pay more in person payments than it receives in premiums.  In the same way, if longevity decreases, then the scheme bears the risk of overpaying premiums to the insurer.  On the face of it, longevity swaps seem to offer a number of advantages to tackling scheme funding issues - in particular, they give the scheme employer complete visibility and control on its cashflow obligations, do not require an upfront premium and give employers the flexibility to hedge other scheme risks separately.

However, before embarking on a longevity swap pension schemes will need to take detailed financial advice and will also need to exercise a high level of diligence as regards the potential pitfalls - not least the risk of counterparty default by the insurer.  In particular, the FSCS may not apply to swaps entered into by the scheme - making the long term covenant of the counterparty a significant concern.  There is also no guarantee that a swap arrangement will deliver value to either party if there is no differential between the premium paid and the longevity outcome.  There are also no standard market terms on swaps and so it is possible that the agreement itself could include potentially onerous terms - for example significant early redemption penalties for early termination.

Another practical consideration is that pension swaps may only be feasible for the larger schemes who have sufficient economies of scale to be an attractive proposition for insurers - and even then, swaps can only be entered into in respect of the pensioner population, which might only be a small proportion of the total scheme liabilities.  That said, as the market continues to evolve, insurers may be able to bring more bespoke tailored products to market which can fit schemes of all descriptions.