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

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.

The consultancy is making the claim following 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. It predicts this market to mirror that of the inflation-linked derivatives market which exceeded £20bn last year.

Watson Wyatt. which was lead investment consulting adviser to both, and actuarial adviser to one of RSA’s pension scheme trustees, says the size of the transaction is larger than anything comparable in the pension fund market.

According to the firm, which also advised on the recent Babcock transaction, the main attractions of hedging longevity risk in this way are the lack of a requirement for immediate contributions from the sponsoring employer, and the fact there is no requirement to sell assets at the current depressed prices. Other attractions include potential cost effectiveness compared to a conventional annuity, and the fact that it incorporates the added protection of strong collateralisation processes, supported by very high quality bonds.

Watson Wyatt says it is experiencing 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.

However, it points out that no transaction is risk free and points to complexity and counterparty risk as issues that pension funds will need to deal with.

Paul Trickett, European head of investment consulting at Watson Wyatt, says: “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.”