Pension plans face many risks — from interest rates heading the wrong way to investments going sour to plan participants’ living longer than anticipated, or so-called longevity risk. Some can be addressed through the capital markets. For instance, plans mitigate interest risk through swaps. But longevity risk has always been as intractable as a force of nature.
But now in the U.K. — and possibly soon in the U.S. — pension plans can offload this risk through a technique similar to interest rate swaps. “Longevity swaps are a real market in the U.K.,” notes Kevin McLaughlin, a principal in Mercer’s Financial Strategy Group.
He anticipates that there could be demand for longevity swaps from U.S. pension plans in a year or two. “There is no reason why not,” he says. “The risks are much the same.”
And those risks are increasing. Retirees are living longer, straining underfunded pension plans. Rand Health, a divison of Rand Corp., says the life expectancy of males at the age of 50 has increased by six years over the past four decades, to 78.9 years. For plans that have not updated actuarial assumptions and face potentially longer payout periods, longevity swaps may be a way to temper the risk.
Though the swaps can be complex, the idea is simple. “They are very similar to interest rate swaps,” explains Guy Coughlan, co-head of the European pension group at J.P. Morgan Securities, the first firm to do the swaps. In the typical structure the pension plan swaps its uncertain payments (based on best estimates of its participants’ life expectancies) to a counterparty — say, a hedge fund. The hedge fund, in turn, gets the pension plan to pay it a fixed premium for assuming that longevity risk. In effect it’s a fixed-for-floating-rate swap.
One recent high-profile U.K. deal was a £1.9 billion ($2.94 billion) transaction based on premium value between the pensions of Royal and Sun Alliance and Rothesay Life, an insurance subsidiary of Goldman, Sachs & Co. Rothesay assumes most of the plans’ longevity risk. Says Rothesay managing director Thomas Pearce: “Swaps are a very good risk management tool. It is a very precise solution if you are concerned about longevity risk in particular.”
One proven solution for longevity risk already exists: Plans can turn over their assets and obligations alike to an insurer. But this is most viable for well-funded plans. Notes Pearce: Underfunded plans, like so many in the U.S., “can use them for longevity risk, and there are very little premiums on day one, which is why longevity swaps may have legs.”
