Defined benefit (DB) pension schemes promise their members a pension for life. However, while one member may live to age 75, another might live to age 95. When working out how much money a DB scheme needs to fund the benefits it has promised members, trustees (or rather their actuarial advisers) therefore have to make an assumption about how long, on average, members will live – a longevity assumption.
If that longevity assumption proves to be incorrect and the scheme has to pay benefits for longer than expected, the trustees will need to find additional money to fund those benefits. And usually they will look to the scheme’s sponsoring employer for that money.
Finding ways of managing a scheme’s longevity risk is therefore beneficial for both the trustees and the employer. One way of doing this is a transaction called a longevity swap. Between 2009 and 2018, nearly 50 pension schemes entered into longevity swaps, including schemes sponsored by Astra Zeneca, AkzoNobel, BA, BAE Systems, BMW, BT, Heineken, ITV and Rolls-Royce.
A longevity swap is essentially a contract under which:
- the trustees agree to make payments to a bank or insurer for a fixed period that are equivalent to the pension payments they expect to make over that period (plus a fee);
- the bank or insurer agrees to make payments to the scheme for the same period that are equivalent to the pension payments that the scheme actually has to make in practice over that period; and
- the two amounts are netted off against one another.
A longevity swap therefore basically transfers the scheme’s longevity risk to the bank or insurer. This reduces the volatility of the scheme’s liabilities – in turn giving the employer more certainty on the level of funding it will have to provide in future.
This all sounds very simple in theory so why aren’t all schemes doing longevity swaps? Well, in practice they’re quite complicated – there are various ways of structuring them, they require quite a lot of lengthy and complex documentation, and they can be relatively expensive to put in place. As a result, it has tended to be larger schemes that have decided to do them.
But pricing for longevity swaps is generally improving, making them more affordable. And as the market matures and develops, set-up costs may reduce. Longevity swaps could therefore become a viable option for a much wider range of schemes – and their employers.
In 2018, Mayer Brown advised on a £2 billion longevity swap transaction for the National Grid Group of the Electricity Supply Pension Scheme with Zurich. The swap featured sophisticated title transfer and fixed security collateral arrangements and was structured to ease conversion into a buy-in or buy-out if desired in the future. One of the team involved, Stephen Walsh, will be discussing this transaction at the 17th Conference on Bulk Annuities and Longevity Swaps in London on 9 – 10 April. For more information on our pensions risk transfer capabilities, please visit our practice overview page.