Longevity swaps for pension schemes: playing the long game

Neil Bowden

I’m often asked what I see as the key trends in the pensions industry over the next few years.  Predicting the future usually ends in tears (I should know, I took out a fixed rate mortgage at 5.5% in 2008!) but one development that I think is here to stay is longevity swaps.  There’s of course been a number of high profile deals for pension schemes over the last couple of years (many of which incidentally Allen & Overy was involved in) but hardly a deluge, so why my prediction?

The first reason is simply anecdotal evidence.  The topic is on the agenda (in one form or another) of many of our pension trustee, and employer, clients, whether in respect of an actual proposal or as a training session with a view to getting trustees up to speed.

If everyone is talking about it, at least some of them will do it.

Secondly it makes economic sense.  Longevity represents the last big slug of unrewarded risk for pension schemes and sponsors – inflation and interest rate swings have been hedged away under a lot of schemes over the last 10 years.  Controlling longevity risk is the last jigsaw piece in completing the pensions puzzle for finance directors long frustrated by scheme volatility.

The downside of a market still in its relative infancy is that transactions are not as smooth as they should be – trustees and counterparties are still feeling their way to some sort of “market practice”.  However this will improve.  I remember the first pension scheme interest/inflation rate swaps in the 1990s were equally sticky to negotiate.

So if you are looking at longevity swaps as a trustee or sponsor what should you look out for?  My top tips would be:

A. Sort out your member data/issues on benefits in advance.  You need to know what you are swapping – grey areas and ambiguities inevitably cause delays and problems when you start putting together a deal.  Worse still, discovering errors after signing the contract will allow the counterparty to re-price or even escape the contract.

B.  Be clear on what security you are looking for.  Not just lodging collateral against the obligation (becoming market practice now although some insurance counterparties still drag their feet) but thinking through how comfortable you would be if there was a change of control in respect of the counterparty.  The swap contract will last fifty years or more – the one thing you can be sure of is that the financial world will change radically over that time.  The household name you are contracting with today may look very different in 2050.  After all the decline of the British merchant banks in the 1980s and 1990s would have been inconceivable to those striking deals in the 1970s.  The lesson is, over the kinds of time period longevity swaps deal with, everything changes, so you need to build in the contractual tools to protect yourself.

C.  Be careful what you warrant for.  Longevity swap contracts are long and complicated.  They will impose lots of obligations on trustees both to verify certain facts and to perform certain tasks over the contract life.  You need to be sure that both what you say is true and you can actually do what you have committed to do.  Schemes might get away with slap dash processes in the early years when the counterparty is expecting a healthy profit from the contract but things might look very different in 20 years time if medical advances have most of us receiving the Queen’s telegram.  You can be sure that the counterparty will be scrutinising the contract for any way out and a breach of an administration process or a trustee covenant might give them the lever they need.

D. Call in a good lawyer!

I may be able to help you with that last one….

Neil Bowden is a partner at Allen & Overy LLP.

Comments published on Pensions Talk do not necessarily reflect the views of Allen & Overy or its clients.

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