In the context of the risk of yields on UK gilts staying low for longer, or getting even lower, increasing following the countries recent Brexit vote to leave the European Union, Hymans Robertson believes pensions may be facing up to 50% more in longevity related liability costs.
As a result of this increase the use of longevity risk transfer instruments, such as longevity swaps, and the requirement for longevity reinsurance capacity may grow, as pensions come to terms with an even lower-yielding world and the resulting climb in longevity risk costs.
Hymans Robertson, the specialist pensions, benefits and risk consultancy, estimates that with negative real yields on UK gilts looking like the ‘new norm’, the cost of longevity risk to pension funds, so the amount of money a Defined Benefit (DB) pension scheme needs to hold to pay pensions for its members’ lifetimes, has risen by 50%.
Andy Green, Chief Investment Officer at Hymans Robertson, commented on the effect of low interest rates on pension plan longevity risk; “Any trustee or plan sponsor will know that the fall in yields weighs heavily on the cost of pension fund provision. The continued erosion of interest rates over the past 12 years has already hit pension schemes hard. Scheme liabilities have increased by 50% over that timeframe to £2.3 trillion. And the situation could get worse over the coming months if the Bank of England chooses to lower rates even further.”
The Brexit vote has resulted in a plunging pound and an expectation that the UK government will need to keep interest rates lower for longer, potentially even cutting them further than they are today.
“What many don’t realise is that interest rates and longevity risk are highly correlated,” Green continued. “When interest rates were much higher, if people lived one year longer than expected, this increased the cost of providing their pension by around 3%. However, with real yields on index-linked gilts now below -1%, more money needs to be held today to pay a year’s pension in 25 years’ time than is needed to pay next year’s pension.
“Consequently a one year change in life expectancy is now more likely to add 4.5% to the cost of paying a pension for someone’s lifetime. That’s a 50% increase in longevity risk.
“In combination with the increase in liabilities, there has been a 125% increase in like for like longevity risk in pound terms.”
As a result of the lower interest rate environment, longevity risk has become the largest risk facing pensions and there is now an expectation that longevity risk transfer could move up the agenda for UK pension funds.
James Mullins, Head of risk transfer solutions at Hymans Robertson, explained; “Longevity risk now represents a larger risk than ever before for DB pension schemes. We will therefore inevitably see longevity risk management move higher up the agenda for those running DB schemes.
“This is right. Schemes should be seriously considering reducing their exposure to members living longer. Longevity solutions such as buy-ins and longevity swaps will be more relevant to risk management plans than ever before. The good news is that prices for these types of insurance have not been adversely affected by the market shocks following the Brexit referendum result. So longevity risk has leapt up for DB pension schemes but the cost of insuring against this risk has remained nicely competitive.”
The cost of reinsurance capacity to back longevity risk transfer transactions remains low and capacity abundant, meaning the opportunity is there for pension schemes that wish to offload longevity risk as they come to terms with the increased costs and exposure faced.
This is no longer solely the domain of large pension funds either, with smaller funds able to access longevity swaps thanks to more efficient structuring and cheaper reinsurance capital.
Mullins continued; “While longevity insurance using longevity swaps has played an important role in the de-risking plans of some of the UK’s largest schemes, smaller schemes have found the costs prohibitive. Fortunately the longevity swap market is innovating to make longevity hedges more accessible and affordable to smaller schemes too.”
Could we see a flurry of longevity swaps come to market? Time will tell, but as the reality of a post-Brexit vote world sinks in and pensions calculate their expected liabilities, the option is going to look increasingly attractive.
To-date the reinsurance market has soaked up the majority of the longevity swaps that have come to market, but appetite has been waning among global reinsurers of late and if a significant amount of capacity was required we could see capital markets players getting more of a look-in.