Jenna Gadhavi asks whether schemes should put plans to transfer longevity risk on hold after a few years of heavy mortality experience
Trustees have got used to the idea that longevity rates are increasing rapidly in the UK. We have enjoyed decades of accelerating improvements in life expectancy, and the first ten years of the 21st century showed no sign of a slowdown.
Calling time on longevity swaps?
But since then there have been indications that the tide might be turning. Mortality improvements in UK males have averaged just 1% over the last three years, compared to 3% in the decade before. We’re still living longer, but is the rate of improvement beginning to tail off? And if so, what does this mean for the way schemes manage longevity risk?
Aon Hewitt sounded the alarm last year. The consultancy warned that the slower rates of improvement were leading to a dislocation in current pricing for longevity swaps, and urged schemes to delay transactions until the market corrects.
This is the most extreme reversal in mortality improvement trends in the past 40 years
Tim Gordon, partner & head of longevity at Aon Hewitt said at the time: “This is the most extreme reversal in mortality improvement trends seen in the past 40 years. What was initially assumed by many actuaries to be a blip is increasingly looking more like an earlier-than-expected fall-off in mortality improvements.
“The industry is currently trying to digest all the implications of this emerging information and – inevitably – it is taking time to feed through into insurance and reinsurance pricing.”
Is the trend reversing?
But is this really a trend rather than a blip? It’s well documented that an ineffective flu vaccination programme in 2015 explains a spike in deaths that year, so can the industry really change its view on mortality improvement rates based on a just a couple of years of data?
Two years don’t make a trend - it’s very volatile from year to year
Matt Wilmington, director of strategic transactions, pension risk transfer at Legal and General (L&G) isn’t so sure. He says: “These trends have only really presented themselves in the last two years so if you look back to 2011-2012, there were actually fewer deaths than expected, whereas 2015-2016 there were more. But two years don’t make a trend - it’s very volatile from year to year.”
For now, L&G is viewing the shift as “noise”. Wilmington reasons: “If we had another five years where we saw far fewer deaths than expected, then we might start to see fairly significant changes but where we are now, there’s not enough to persuade us – or many of the pension schemes we work with – that there’s a vast reversal in trend in terms of life expectancy just yet.”
We’re waiting to see a strong trend rather than just 18 months
In the meanwhile, L&G is reducing its life expectancy assumptions very slightly, taking a more measured view as to what might happen. “We’re waiting to see a strong trend rather than just 18 months’ worth before we adjust our assumptions.”
However Aon Hewitt is standing by its cautious approach. Gordon explains: “In practice when we’ve gone back to the market on large deals and said we thought the pricing was stale and didn’t reflect recent experience, on the whole we saw quite material shifts in pricing which suggests that the reinsurers do have their eye on what’s going on.”
The notion that the trend has fallen off and might continue seems quite plausible
He continues: “It’s quite likely that the high mortality improvement rate trend that we saw in the decade at the start of this century has fallen away, but I would be very cautious in saying that it couldn’t reverse, or even that it couldn’t fall further. The notion that the trend has fallen off and might continue seems quite plausible to me.”
So does that mean that when looking at a longevity deal there is potential there to get a reasonable reflection of recent experience with mortality rate improvements in the pricing? If so schemes should ensure they get up-to-date pricing when looking at a longevity deal.
Shelly Beard, senior consultant at Willis Towers Watson takes a balanced view, and says fundamentally it comes down to what trustees of each individual scheme believe.
Insurers and reinsurers haven’t given full credit, but they are giving partial credit
“The last two years saw higher deaths within the UK population,” she says. “Insurers and reinsurers haven’t given full credit to what that might mean for future improvements to life expectancy, but they are giving partial credit. Do schemes think this is the start of a downward trend for life expectancy in the UK? If they do then perhaps now isn’t a great time to trade because there isn’t the full credit for the higher deaths going into the pricing.
“But if they believe that the past few years have just been a blip, than now might be a good time to hedge, because they’d getting partial credit for something that they don’t actually believe would be a long term trend.”
This should be on a broad brush basis rather than one that assumes the actuary has a crystal ball
Alan Pickering, chairman of BESTrustees, takes a cautious view for the schemes he oversees. He says: “I’ve always taken account of the direction of travel, but fought shy of hardwiring particular assumptions knowing these will change. Obviously where members are exchanging pensions for a transfer value or a lump sum, we do need to have due regard to longevity expectations but again this should be on a broad brush basis rather than one that assumes the actuary or any other professional has a crystal ball that will be future proof.”
Preparation is key
For the schemes that would rather wait, there are still preparatory steps they can take to put them in the best possible position for an eventual longevity swap. First and foremost, trustees should understand the longevity risk that their scheme is exposed to. There are disease-based models looking at how life expectancy may develop in the future that enable trustees to understand what impact longevity risk could have on the scheme funding in future. They need to think about that in conjunction with the strength of their sponsor covenant.
How does it compare to interest rate risk, or equity market exposure?
Beard explains the importance of then thinking about that longevity risk in the context of the other risks that the scheme is running. She says: “How does it compare to interest rate risk, or equity market exposure? Once trustees have done that, they can then build a framework and work out when longevity hedging will make sense in terms of value for money. That will give trustees a really good trigger-based approach to when exactly they will be happy to go ahead and hedge your longevity risk.”
So building a longevity risk management framework is key and will ensure trustees know when they will actually go into market and take action, regardless of whether they choose to delay their current plans or not.
Current market behaviour
So how have schemes been reacting so far? Aon Hewitt has seen a couple of large deals halted, partly because of their concerns that the emerging data isn’t reflective of the pricing.
It might look quiet on the surface, but there has been substantial transfer risk
Gordon doesn’t expect the market to seize up. “I think it’ll be an interesting time, but there is still quite a large longevity transfer market. It might look quiet on the surface, but there has been substantial transfer risk. Some of it hasn’t been from pension plans however, it has been from insurers looking to reinsure their back books of pension liabilities with the reinsurers.”
“We expect to see well advised plans having a good look through to the ultimate pricing that they’re getting from the reinsurer, and making sure that’s up to date.”
The long game
Regardless of what this all means going forward, many argue that schemes that completed longevity swaps in the past few years are losing out. But while it’s true that some of those schemes are now paying money to their insurers, looking at the bigger picture they entered into the deals because they wanted to fix their liabilities with respect to how long people lived. Those swaps are still fulfilling their purpose.
There is still uncertainty - there is still a future left to run
Gordon explains: “There is still uncertainty - there is still a future left to run. There are scenarios where longevity could improve much more than we’re expecting, so there is still protection in those contracts.”
And for the schemes that are deciding whether to bite the bullet? Wilmington thinks that if you can afford to de-risk now, then you should. He says: “The whole point about de-risking is that you don’t know what will happen in the future. So whereas right now schemes may have a slightly different view on life expectancy to insurers, what happens if next year and the year after far fewer people die than expected and as a result insurers pricing becomes more expensive rather than less?
Timing the longevity market in the same way you would an equity market is extremely difficult
“Timing the longevity market in the same way you would time an equity market is extremely difficult, and schemes could be in danger of missing opportunities now if they did that.”
And he’s not the only one who believes there are opportunities to be had.
Beard explains: “The pricing reflects the higher deaths over the past couple of years so if that turns out to be a blip and in 2017 life expectancies start going up again, schemes that trade now will get the credit for those two higher years from 2014-2015. Therefore the pricing could potentially be lower than it might be 12 months down the line.”
The bigger picture
But the importance of considering the bigger picture when looking at longevity risk mustn’t be overlooked. There are a number of reasons for trustees and plan sponsors to manage particular risks within the scheme.
They may want to transfer longevity risk, inflation risk, or financial risk
Pickering highlights: “They may want to transfer longevity risk, inflation risk, or financial risk. But there may well be non-financial considerations determining both the timing and extent of such transfers and it may well be that cost is not always uppermost.”
Governance obligations and the availability of quality management time to manage pension risk within the other business risks of the sponsor may mean that other considerations are given a higher priority than the price.
Pickering concludes: “While I think that comments by Aon Hewitt are obviously worth taking account of, it may not be the deal breaker in terms of whether or when to transfer longevity risk from the scheme to the financial services sector.”