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Integrating management of longevity risk within the investment strategy

Chapter four of the 2021 de-risking report

Pensions Corporate Consulting|Pensions Risk Solutions|Pension Board and Trustee Consulting|Pensions Technology
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By Suzanne Vaughan | January 19, 2021

Hedging a scheme’s other liability risks (interest rates, inflation and currency) first and leaving management of longevity risk to the end of the journey plan can expose the scheme to considerable market risk, potentially increasing the overall costs should the cost of longevity hedging increase over time as capacity is used. Suzanne Vaughan considers how longevity risk can be integrated within the wider investment strategy risk framework.

When considering a holistic hedging programme, including longevity risk, it is important to consider:

  • The optimised journey plan to the scheme’s preferred end goal (considering scheme funding, liability duration, risk appetite and other specific features)
  • How much of the risk budget to allocate to longevity risk
  • The wider investment framework to ensure an optimal risk and return ratio is achieved.

The following four step approach can be used to integrate longevity risk within the investment strategy:

  1. 01

    Consider the minimum longevity risk range

    Longevity is a single-factor risk affecting all of the liabilities, so adverse experience will have a material impact on a scheme’s fortunes. Members will either live longer than expected or they won’t - compare this to equity risk where returns are derived from a wide variety of sources (stocks, sectors, countries etc). We believe unrewarded risks, such as longevity, should be minimised by hedging if it is cost effective to do so.

  2. 02

    Set long-term target longevity hedge ratio

    Although risk is minimised at high levels of longevity hedging, target hedge ratios are likely to be lower (at least initially) reflecting wider factors such as:

    • The duration of the liabilities. Specifically, at least initially, it is likely that the shorter duration pensioner liabilities will be hedged, as although it is possible to hedge/buy-in deferred members the costs are typically higher reflecting their longer durations and optionality of benefits at retirement.
    • The need for return-seeking assets. For schemes which need to run significant levels of investment risk to close the funding deficit, the capital available to hedge longevity risk is likely to be limited.
    • Funding impact. If there is any negative overall impact that cannot be managed by the scheme.
    • Most efficient use of de-risking budget. For example, it may be more efficient to reduce investment risk rather than longevity risk and vice versa, depending where in the de-risking journey the scheme is.
  3. 03

    Set current conditions longevity hedge ratio

    Whilst there is a cost to hedging longevity (like any other risk), we believe now is a good time for schemes to hedge longevity risk, with attractive pricing in the market. It could therefore make sense for schemes to stretch the target they would have otherwise selected. The supply for longevity hedging, which is also used by insurers to support the writing of buy-in and buyout deals as well as their individual annuity business, is currently dictated by the global reinsurance market. Reinsurers have appetite for longevity risk to offset the mortality risk (life insurance) they hold on their books and to provide diversification against other types of risk (for example property and casualty). As more longevity risk is hedged, the marginal benefits to the reinsurer are likely to reduce and prices may increase. This potential increase in pricing may happen sooner if the pace of demand increases materially.

  4. 04

    Agree design / implementation of the longevity hedging strategy

    Which of the two key implementation routes (buy-in or longevity swap) is most appropriate for a scheme depends on a number of factors, and in some instances a combination of approaches may be optimal. Particular consideration will need to be given to the impact on the investment strategy for example taking into account the capital intensive nature of a buy-in and the possible restrictions this places on the levels of collateral needed to support other hedges and on the extent to which a scheme can take advantage of other illiquid opportunities (e.g. secure income assets).

    In our experience there can be real advantages in phasing the longevity hedging for a scheme. Firstly, part of the longevity risk can be removed immediately, with the rest managed over time as members retire and de-risking increases investment flexibility. This can be achieved by hedging all or a subset of the current pensioner liability (for example insuring say every second pensioner). Secondly, it results in cost averaging, smoothing out volatility in market pricing. Thirdly, building a relationship with the insurance market and building the knowledge and operational structures to undertake transactions means the scheme is “transaction ready” when further opportune market or scheme conditions arise.

Putting this integrated approach into practice

Recognising the importance of integrating longevity risk within a scheme’s investment strategy, we are increasingly seeing clients delegating implementation of the agreed investment and de-risking strategy to Willis Towers Watson under our fiduciary investment offering. With UK fiduciary investment management experiencing strong growth, reaching £200bn of assets under management, we expect de-risking longevity under this type of approach will become increasingly commonplace. I had the pleasure of working with a client under this model over the last 18 months, and would call out two key advantages:

  • The speed of execution and agility surrounding this, means schemes have better access to great pricing when such opportunities are presented (for example during the unprecedented market turmoil of the first lockdown of the pandemic).
  • All transaction execution risks are fully mitigated, with no risk of anything falling between the gaps of two advising parties.

Member outcomes benefitted as a result, and importantly the scheme achieved the right buy-in transaction at the right time for the scheme’s overall journey plan. More information on this project is set out in the case study below.

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Case Study – Project Stingray: An integrated buy-in within our fiduciary investment offering

 
The goal

The Sponsor and the Trustee agreed they were on a path to full buyout with an insurer. When Willis Towers Watson was appointed as fiduciary manager, we modelled the scheme’s specific characteristics, plotted the optimised journey plan, taking full account of the varying investment and transaction drivers, to show that full buyout could be achieved within 10 years. Further the modelling showed that, critically, all risk relating to pensioners could be removed immediately via a buy-in, whilst leaving (1) sufficient assets to generate returns for the journey plan; and (2) a residual population that would have an attractive pensioner/non-pensioner balance at the point of eventual buyout.

Mobilising the buy-in workstream

The buy-in workstream mobilised straight away, setting a pricing target that aligned with the holistic strategy to achieve buyout in a reasonable timeframe and the wider investment portfolio. With excellent engagement from five leading insurers in an extremely busy market, the project went from insurer selection, to the preferred insurer going on risk in around six weeks. Considering longevity risk in this integrated way, not only gave certainty on the right strategic approach to de-risking, but meant greater efficiency and clarity of execution with a “one-team” accountability mindset.

Additional benefits from the integrated approach

The investment portfolio changes, identified as part of the fiduciary investment implementation, were aligned to be implemented at the same time as the buy-in, reducing transaction fees and driving efficiency.

What our client told us:

“We were delighted with the outcome of our recent buy-in, which was delivered within the integrated Willis Towers Watson fiduciary investment offering. Willis Towers Watson embedded a team of multi-disciplined professionals to deliver our objectives, we were delighted with their dedication to a “one-team” client service mindset. We appreciated having one point of contact, with one set of accountabilities as we implemented our goal. The innovative fee structure also represented excellent value for money, including streamlined pre-negotiated legal and commercial contracts with a leading law firm.”

Trustee Chairman, Project Stingray, a (confidential) pension scheme in the services sector

Next chapter - Innovation in the UK de-risking markets

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Suzanne Vaughan
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