Pensions and Annuities Research:

Buy-ins replaced by DIY swaps in the race to hedge risk

UK - July 14, 2009 - Pension funds are now more likely to design their own ways of hedging risk than buy a bulk annuity solution because of advances in longevity swaps and current market conditions, according to Watson Wyatt. This follows the announcement that the trustees of two of the pensions schemes sponsored by RSA Insurance group plc have completed a transaction to hedge much of their pensioner liabilities against longevity improvement. Watson Wyatt was the lead Investment Consulting adviser to both, and Actuarial adviser to one, of RSA’s pension scheme trustees. The size of the transaction is larger than anything comparable in the pension fund market.

Paul Trickett, European head of investment consulting at Watson Wyatt, said: “As part of their ongoing de-risking strategies, pension funds are now able to hedge multiple risks, including longevity, without having to purchase annuity policies which are less attractive than a year ago. This ‘do-it-yourself’ approach is likely to catch on because trustees can retain control of how the assets are invested and don’t need to sell other assets they are holding in order to enhance returns. There is also a key benefit of increased ability to manage counterparty risk.”

According to the firm, which was also the lead advisor on the recent Babcock transaction, the main attractions of hedging longevity risk in this way are:

no requirement for immediate contributions from the sponsoring employer
no requirement to sell assets at the current depressed prices
its potential cost effectiveness compared to a conventional annuity
that it incorporates the added protection of strong collateralisation processes, supported by very high quality bonds.
As a result, Watson Wyatt has experienced significant demand from pension funds for services in this area, particularly in the current environment, that is characterised by limited liquidity and the need for investment returns to help reduce deficits.

Paul Trickett said: “Now that a few large funds have completed such transactions, we expect more to follow quite quickly. Given our clients’ significant interest in hedging longevity risk in this way we expect the growth of this market to mirror that of the inflation-linked derivatives market which exceeded £20bn* last year.”

The firm warns that no transaction is risk free and points to complexity and counterparty risk as issues that pension funds will need to deal with. It suggests that trustees need to have a thorough understanding of derivative contracts that are more complicated than those used in inflation and interest rate swaps, due to considerations around mortality. Regarding counterparty risk, the firm suggests that structuring longevity hedges using the best features of insurance and banking-style products can be used to obtain better security for pension scheme members.

Keywords: Pension, Annuities, Annuity, Pensions

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