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

Orpin says there is already some evidence that difficulties in resolving this question are preventing longevity swaps moving from initial agreement to inking the contract.

Costly option
Another critical point is the cost of a swap: it's not cheap. Exact figures are hard to come by and will depend on trustees' own view of how long their scheme members are likely to live. If trustees are more cautious (ie, their longevity estimates are at the 'old' end of the range), the relative cost of the hedge will be lower and vice versa. Orpin says that, based on pricing his firm is seeing at present, hedging out longevity might increase the value of pension liabilities by around 5%. So, for a pension scheme with liabilities valued at around £500m, a hedge today might add to that around £25m.

That's a fair amount of additional corporate cash. However, it doesn't all have to be funded up front and Orpin expects corporates and trustees will agree to settle the extra cost over a long period of time. (For the first-ever longevity swap, involving the Babcock International pension fund, trustees agreed to funding over 20 years, according to Orpin.)

Hamish Wilson, managing director of pensions advisory HamishWilson, points out that a much simpler approach to dealing with the longevity issue is for employers to strike a deal with employees which basically shares the risk. 'The employers say: we will set aside a certain amount to deal with reasonable increased longevity. Beyond that we will cut back on benefits to compensate for the fact that scheme beneficiaries are living longer.

'Pension schemes run a huge range of risks and there is no reason why all these risks should be borne by the scheme sponsor,' he argues. That is well and good where the employer has some flexibility as far as the contract with the scheme is concerned, but most sponsors of final salary schemes will not have this kind of flexibility available to them. The pension plan will, in all probability, have been set up before longevity was an issue, so the employer's covenant to meet all the liabilities will be set in stone – unless it can be renegotiated with employees.

Gordon Fletcher, a consultant for Mercer, raises a major difficulty that longevity swaps will have to overcome before they can become mainstream instruments. Most such swaps, he points out, will be seen by scheme trustees and sponsors alike as interim arrangements, a stepping stone on the way to an eventual full scheme buyout. The problem, then, is working out what value a buyout provider will put on a swap. At present, that is a completely unknown factor – and with a longevity swap potentially adding £25m to a £500m scheme's liabilities (as in the example mentioned), this uncertainty will not make swaps any easier to do.

Fletcher also points out that longevity swaps are only possible for a scheme's current pensioners. No provider, as yet, is offering swaps on deferred members. 'The deferred pensioners present a bigger longevity risk. Someone aged 45 has more than 20 years to go to retirement – 20 years in which anything can happen to improve mortality. So it is great that there are providers around for existing scheme pensioners, but we need providers to step forward for the deferred members longevity risk as well,' he says.

Today, banks such as JP Morgan and Credit Suisse are keen to do longevity swaps. They pass the risk on to third-party investors and Fletcher says the banks Mercer is talking to suggest there is a big appetite for longevity risk deals among investors. One of the things these investors like about longevity swaps is that they are not correlated with other asset classes or with other kinds of risk, such as weather or property risk.

David Johnson, an actuary and consulting director at Trustee GAAPS, an executive search firm specialising in providing independent trustees and trustee board chairmen, argues that trustees should be extremely wary of complex new instruments such as longevity swaps.

'I am not saying it is not an interesting instrument for trustee boards to have as an optional tool, but there are some very serious issues about price right now,' he says.

'You are swapping a definite revenue stream for an unknown future payment. Instead of removing uncertainty, trustees could find that a longevity swap simply replaces one kind of uncertainty with another.'

Johnson points out that the fact there are interested providers is not, of itself, an argument for doing deals. 'Some very adventurous money may well come sweeping into this space, but the value of longevity swaps to the buyout market of the future is completely unknown right now,' he says. 'Often, doing nothing is sound advice and there is a very good argument to be made for trustees not to venture into longevity swaps until the market has matured a good deal more.'