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Survey Report

The Pension Schemes Bill and what this means for the insurance market

Chapter two of the 2020 de-risking report

Pensions Corporate Consulting|Pensions Risk Solutions

By Costas Yiasoumi | January 20, 2020

The upcoming requirement to establish a long-term funding and investment strategy will lead to an increased focus on longevity risk management through bulk annuities and longevity swaps. Costas Yiasoumi explains why.

Where we are

It may surprise observers outside the pensions industry that there is no current legal requirement for trustee boards to have a clear, long-term plan of how they will ultimately meet benefit promises to members and beneficiaries. This will change with the proposed Pension Schemes Bill (draft published in January 2020). The Pensions Regulator’s 2019 annual funding statement explains why this is important – see below.

Paying the promised benefits is the key objective for all schemes. This requires schemes to look ahead and set clear plans for how the objective will be delivered.”

The Pensions Regulator
March 2019

The funding and investment strategy will need to explain how the trustees intend to deliver benefits over the long term. Trustees will be expected to map out the funding and investment journey to reach their long-term objective, including how to manage risks along the way. We have helped many trustee boards and sponsors develop robust, scheme-specific strategies that do just this. Our experience is that a well-defined strategy and understanding of scheme risks provides a strong foundation for clear decision making, identifying insurance opportunities and ultimately improving the benefit security of members.

The process through which a long-term objective is developed is not for this article – what we address below is why the focus on managing longevity risk will increase for two typical such objectives: running off with a low reliance on covenant or full buyout.

Figure 4. Example long-term objectives

  • Running off with low-reliance on covenant (sometimes called ‘low dependency’ or ‘self-sufficiency’)
  • Full buyout
  • PPF plus buyout
  • Transfer to a commercial consolidator (a nascent option)
  • Run-off as a ‘scheme without a substantive sponsor’ (SWOSS)

Example 1: Objective to run off with low reliance on covenant

As the name suggests, this means getting to a position whereby the trustee board expects it can run-off the scheme with little likelihood of needing additional funding in future from the sponsor, beyond what may already have been provided as contingent security. A typical such strategy involves investing in assets that provide reliable income to match pension payments – in other words a cashflow-driven investment strategy.

So why is managing longevity risk a natural consequence when targeting to run off a scheme?

  1. 01

    Investment risk starts being measured on a “cashflow” basis:

    investment risk is often measured as a Value at Risk (VaR), a representation of potential worsening in the value of the assets compared with the value of the liabilities. However, if a scheme is investing on a cashflow-driven basis the value of the assets and liabilities is of less importance. What matters is not market-value volatility but instead the likelihood that assets held will generate the required income to pay pensions – these are measures of the reliability of cashflows not the market values of investments. Under these measures of risk, the more predictable and stable the asset cashflows are, the lower the investment risk and hence the higher proportion of overall risk represented by longevity. This supports hedging longevity risk either through longevity swaps or bulk annuities, both of which reduce that longevity risk.

  2. 02

    Longevity risk starts being measured on a whole of life basis:

    many schemes measure longevity risk but often on a one-year Value at Risk (VaR) basis for comparability with investment risk measures. There is nothing wrong with that but, if the objective is truly to have low reliance on covenant, it makes sense to start measuring longevity on a whole-of-life basis. Simply put, what is the plausible amount by which the pensions we need to pay could increase over the next 30-40 years? The quantum can be enormous – often as high as 15-20% of liabilities.

  3. 03

    Fewer levers to repair problems:

    If the plan is to run off with a low reliance on the sponsor then reducing all but the longevity risks could pose a threat to the sustainability of the run off strategy. Should longevity risk move against the scheme then it could be necessary either to re-risk or seek contributions, both contradicting the intended strategy. A commonly held misconception is that buy-ins can’t form part of a low-dependency portfolio – our experience is that, by using a suitable analysis framework, informed decisions can be made on the role a buy-in can play, the optimal buy-in size and target price.

Figure 5. How longevity risk manifests itself

Note: the proportions of each risk element are illustrative. They do not reflect the probable actual proportions that would be derived on a scheme-specific analysis

Example 2: Full buyout objective

There are significant factors leading to longevity risk being a focus for schemes with the objective to become fully bought out:

  1. 01

    Longevity risk becomes a pricing issue:

    if the aim is buyout then what matters is how the insurance and reinsurance market will price your own scheme’s longevity in the short window of time when you’re seeking a buyout transaction. This will be influenced at the time by insurers’ views of your scheme as well as supply-demand dynamics in the market at that point. This can introduce significant uncertainty even over shorter timeframes to buyout. Managing longevity risk in the shorter term can therefore significantly reduce the volatility of future pricing and hence increase the prospects of achieving the objective.

  2. 02

    A matter of when, not if:

    insurers make significant use of longevity reinsurance. In fact most buyouts will involve an insurer reinsuring at least some of the longevity, if not immediately, then at a later date. The cost of the longevity reinsurance is therefore explicitly or implicitly incorporated within the premium quoted for a buyout. Hence, when it comes to incurring the cost of dealing with longevity risk for schemes targeting buyout, the question becomes one of when rather than if that cost should be incurred, with the risk not being managed until the cost is faced.

  3. 03

    The fall-back: a scheme may not reach buyout.

    Perhaps investments underperform, the buyout market becomes expensive or the sponsor covenant worsens/defaults. These scenarios may lead to a change in the objective. For each alternative objective, the scheme may be in a far better position with some or all of the longevity risks already manged.

What’s the right longevity hedging solution – pensioner buy-in or a longevity swap?

Trustees and corporate sponsors should work closely with advisers to undertake a strategic analysis of their options.The answer as to how longevity should be hedged can be very scheme specific and not just based on quantitative analysis – softer factors such as the trustee board’s view on complexity are as important.

As more and more schemes firm up their long-term objective, their journey plan to achieve this and make progress against those plans, the insurance market is expected to see increased demand for buy-ins and longevity swaps.

What does this mean for the insurance markets?

As more and more schemes firm up their long-term objective, their journey plan to achieve this and make progress against those plans, the insurance market is expected to see increased demand for buy-ins and longevity swaps. As longevity swaps can remove more longevity risk than a buy-in for a given amount of capital, we think that there is also likely to be increased use of longevity swaps by small- and medium-sized schemes.

What should I do?

There is no time like the present. Develop the long-term objective – it is the foundation for clarifying the journey plan to deliver the best outcomes for members. As part of that consider how to tackle your significant actuarial risks such as longevity, especially if you have already started to tackle investment exposures.

Next Chapter - Spotlight on: mortality trends

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De-risking report 2020 - Soaring to great heights PDF 3 MB

Costas Yiasoumi
Senior Director, Transactions

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