The longevity liability conundrum

If the ultimate endgame for companies is removing their pensions liability from their balance sheets, they must exercise caution in their approach says Teresa Hunter

If an investment banker offered to sell you a package of mortgages, you’d probably run a mile. But if he promised to magic away one of your biggest pension scheme risks, longevity, you’d probably call him up for a chat.

Not knowing how long members of defined benefit pension schemes will live, and therefore how long they will be drawing a pension, is one of the most serious issues facing companies, trustees and their advisers. We know how long the workforce is currently living, and we can indulge in every calculation under the sun to predict future trends. But no spreadsheet this side of the pearly gates can unlock the secrets of our life span 20 or 40 years hence.

What if there were a major medical breakthrough that found a cure or indeed vaccine for cancer? Alternatively, a new pandemic could wipe out huge chunks of the population.

Of course if disaster did strike, pensions would be the last of our worries, but that doesn’t stop them from keeping finance directors awake today, because tomorrow’s unknowns have to be knowns in the next set of report and accounts.

If disaster did strike, pensions would be the last of our worries, but that doesn’t stop them from keeping finance directors awake today, because tomorrow’s unknowns have to be knowns in the next set of report and accounts

Which is where the investment bankers come in. They have designed ‘longevity swaps’ which promise to remove the risk, by effectively converting a fixed payment from the scheme into a variable pension liability paid by a third party.

So is it an answer to a prayer, or just another wheeze to earn over-paid bankers their next bonus?

As ever, that depends on the price and the terms, not to mention the quality of the counter-parties. If the recent crisis has taught us nothing else, it has been a lesson in not taking the longevity of any institution for granted, irrespective of its reputation.

As Douglas Anderson, founder of a new longevity club, Vita, put it, with characteristic understatement: “It is a case of caveat emptor. Those involved need to understand what they are getting involved with. There is big education job to do, particularly with trustees. We don’t want the next sub-prime crisis in ten years time to be a sub-prime longevity collapse.”

There is a groundswell of opinion that believes these instruments will be the first steps towards the ultimate endgame which is to remove the pension fund risk completely from a company’s balance sheet. They will in time become as familiar to trustees as interest rate swaps and investments in hedge funds; as common as fixed rate mortgages to homebuyers anxious to eliminate the interest rate risk.

But before that can happen, the market has to grow and develop to provide more competition on price and terms. Some argue that currently limited options are keeping the price prohibitively high. They claim that big deficits mean most funds don’t have the cash or collateral to stake anyway. As such, these arrangements are only attractive to well-funded schemes, with particular concerns about their longevity risk.

Others maintain, as with all new markets, there are deals to be done, which will disappear if the idea catches on and turns into a sellers’ market.

And what of the risks? The biggest obviously is the counter-party risk, that those promising to meet the additional liability of increased longevity fail to deliver. The legal status of the pensions does not change. They continue to be the employer’s liability. Such a failure would be a devastating blow.

The second is that you over-pay, either because the price is too high, or the unknowns turn out very differently from current expectations. A mother of all stock market booms might wipe out the deficit bringing buyout within reach. Or it might turn out we have seriously over-estimated our reluctance to shuffle off our mortal coil.

Finally, committing even part of your liabilities to these arrangements might severely impact your ability to fully exploit other strategies, such as maximising investment returns.

All of which makes negotiating a flexible exit strategy almost as crucial as price. Don’t think about your exit strategy when all the unknowns turn into knowns… that you called all the bets wrong.

Teresa Hunter is personal finance editor of Scotland on Sunday