The last great risk facing defined benefit pension schemes

But most schemes have not hedged longevity risk, which could throw them off course. Longevity swaps are an appealing option for some schemes, but more progress is needed to increase access for all pension schemes.

Defined benefit schemes have made significant progress in hedging major risks over the past decade. As a result, compared with the global financial crisis of more than 10 years ago, pension schemes were much better prepared for the market shock when Covid-19 struck.

In 2008, DB schemes had average interest rate and inflation hedging levels of 20-30 per cent of pension fund liabilities. In 2020, hedge ratios were typically much higher at 70-80 per cent, according to our estimates.

Unhedged longevity risk could still throw a pension scheme’s strategy far off course, leading potentially to a delayed buyout or significant deficit contributions

The impact of the pandemic was therefore relatively muted, and pension schemes’ funding levels have rapidly recovered and are now at their highest level in a decade, as data from the Pension Protection Fund 7800 Index shows.

Longevity risk could still throw many schemes off course

Pension schemes are nearing their endgame, with only one in 10 remaining open, according to data from the Pensions Regulator.

With most risks hedged and greatly reduced, longevity risk is now one of the largest remaining risks for many pension schemes.

Unhedged longevity risk could still throw a pension scheme’s strategy far off course, leading potentially to a delayed buyout or significant deficit contributions.

Traditionally, most pension schemes have ignored longevity risk, or sought to manage it through insurance buy-ins.

A buy-in offers a cash flow stream that reflects the actual pension payments for the insured portion of a scheme’s membership, thereby incorporating a longevity hedge for insured members.

However, buy-ins can make it harder for pension schemes to achieve buyout.

For most schemes, unless they are very well funded, our analysis suggests a buy-in is likely to force them to seek out higher returns from their remaining assets, or delay a buyout – and as buy-ins are irreversible, trustees are left with fewer resources to deal with unexpected shocks that affect the economics of the scheme.

Longevity swaps are attractive but progress is needed

The alternative for pension schemes seeking to hedge longevity risk is to use longevity swaps.

Under the terms of a longevity swap, a scheme agrees to make predefined regular payments in return for regular payments that cover the pensions due to a defined set of pensioners.

A longevity swap can remove the same amount of longevity risk as a buy-in, but it has the advantage of leaving all of a scheme’s assets available for investment – avoiding the potential pitfalls of a buy-in.

Some large pension schemes have hedged longevity risk using swaps and the number of longevity hedging transactions has increased recently, but they remain relatively rare when compared with other derisking transactions.

While in principle the flexibility and efficiency offered by a longevity swap are attractive, implementing a longevity swap in practice remains relatively complex and time-consuming. Further standardisation is required.

Fifteen years ago, liability-driven investment solutions focusing on interest rate and inflation risk were only accessible to the largest pension schemes, but through innovation and collaboration across the industry, LDI strategies are now used by schemes of all kinds and sizes.

Longevity hedging could also develop as an approach that is accessible for all pension schemes.

We are therefore seeking to encourage collaboration between stakeholders in the longevity hedging industry, with the aim of increasing standardisation, reducing implementation costs, and opening up the market to schemes of all sizes.

We believe transactions could become less complex, through improved structuring and streamlined legal documentation – this could in turn lead to lower overall legal and advisory costs.

We also believe appetite from reinsurers will grow as implementation timelines shorten and demand from pension schemes increases.

As UK DB schemes mature and near their endgame, managing all their risks effectively – including longevity risk – will help to maximise the certainty of all members receiving their pensions in full.

Jos Vermeulen is head of solution design at Insight Investment