Pensions World

The pensions industry is crying out for more products to manage and mitigate longevity risk urges Anthony Hilton, Evening Standard

Inflation is one of the notable risks which pension schemes face and no one knows what the rate of inflation will be in three months, in three years or in 30 years’ time. In theory this could be a major problem for defined benefit (DB) pension schemes in managing their liabilities. But in fact any fund which is particularly worried can negotiate an inflation swap with any one of a dozen counterparties from among the investment banking community, hedge funds and similar financial players, any of whom will be willing to be a counterparty themselves or, failing that, to undertake to find one. It will cost, but it can be done.

Longevity is also one of the major risks faced by pension schemes. No one knows how trends in longevity will move in three months, three years or 30 years. But unlike inflation, or interest rates or several of the other risks, there is as yet no easy way out. The market in products to manage and mitigate longevity risk is a generation behind where we are with inflation. In fairness there are some, but there is no standardisation between what is offered by the few investment banks and insurance companies in the market. As such they can appear expensive and to some extent incomplete in the amount of genuine protection they offer, but most of all there are doubts, too, about how much capacity there is in the market.

Open ended liability

The inability to hedge longevity is one of the things which really scares financial directors because it means that the liabilities of a DB scheme are literally open ended. And while it would be unfair to blame the mass closure of DB schemes on the emergence of longevity as an issue, given all the other problems which have been around in recent years, it has been for many the final straw.

And yet it ought not to be impossible to devise longevity swap and hedging products. Indeed Ed Truell, the chief executive of the Pension Corporation, has been talking for many months now about how he thinks it could be done. One of the most telling points he makes is that though no one knows what inflation will be the market is willing to put a price on it, which it does by the daily trading of inflation linked bonds. It is the availability of this market price which allows the development of other inflation linked financial products because it provides a pricing benchmark which is the core building block around which they can be shaped.

Keeping track

Mr Truell’s point is that government could stimulate the development of the longevity swaps market which the pensions industry so badly needs by designing and issuing a longevity based gilt. This could be a normal long term government bond but, like an inflation linked bond, it would guarantee to pay a basic rate of interest in all circumstances and an additional rate which would track the movement of a relevant index. In the case of inflation bonds the outside guidance is provided by the retail price index. It would be quite simple to develop a longevity index based on current trends in mortality and price the longevity bond against it, with the coupon rising as the longevity rose.

Government is thus far lukewarm because it says it is exposed to longevity risk through additional NHS costs in caring for an older population and through the public pension schemes. However, it is also exposed to the risks of inflation which did not stop it introducing inflation linkers. Given that there appear to be such clear benefits to follow from the emergence of more longevity hedging products, it needs to think again.

Anthony Hilton is financial editor, Evening Standard; anthony.hilton@standard.co.uk