Advisers bet on hedging as trustees, employers go all-out to cut risk. By Margaret Taylor
It is a morbid life being a pensions lawyer. You spend years helping clients deal with massive deficits, then, when an exciting new development happens in the industry, your focus shifts to taking a punt on how long it will be before the average pensioner dies.
The recent liability swap deal between the BMW (UK) Operations Pension Scheme and Abbey Life Assurance Company (The Lawyer, 1 March) is a prime example of one new direction the pensions industry is following. And the deal, which saw Barlow Lyde & Gilbert (BLG) advise Abbey Life as it insured the longevity risk of around 60,000 BMW pensioners, with LG pensions head Robert Smith acting for the scheme trustees, was all about either side taking opposing bets on how long members will live (or, depending on your viewpoint, on how soon they will die).
BLG’s life, annuity and pensions head James Parker, who led the deal for Abbey Life, explains that the transaction is effectively a hedge that allows the scheme’s sponsoring employer and trustees to reduce risk.
“It protects against any deterioration in longevity within the pension scheme,” explains Parker. “The scheme and the insurance company will agree assumptions about how long people will live and the scheme sets reserves based on that. If people live longer than expected more assets will need to be put into the scheme. The insurance company will pay for that.”
As Robert West, head of pensions at Baker & McKenzie, explains, this type of transaction is possible because the interests of the scheme and the insurer are so perfectly at odds.
“If you take an insurance company that’s writing life insurance, and take pension scheme trustees who are concerned about longevity, the interests of the insurance company and the trustee are completely different,” says West. “The insurance company wants the policyholder to live as long as possible so no claims will be made. The trustees don’t want to pay the pension for a long time, so it’s in their interests for members not to live as long. There’s the makings of a swap.
“It’s all connected with the urgent need that a number of employers sponsoring DB [defined benefit] schemes and many trustees of DB schemes have to reduce risk in the schemes.”
Yet the trend towards longevity swaps has been slow to take off, and to date it is the less-well-known pensions practices that have won the mandates.
Pensions advisers can be split broadly into two main categories: those that mainly tackle the pensions issues thrown up on deals being handled by their firms’ corporate practices; and those that handle standalone advisory work, mainly for pension scheme trustees. The firms that fall into the latter category include Bakers, Hammonds, Linklaters, Lovells, Mayer Brown and Sacker & Partners, while those in the former include Clifford Chance, Herbert Smith and Slaughter and May.
When one of the first longevity deals was struck last May it was Pinsent Masons that took a leading role, advising the trustees of the Devonport Royal Dockyard Pension Scheme, one of the funds sponsored by engineering group Babcock when it undertook a longevity swap with Credit Suisse.
Last December, when the Royal County of Berkshire Pension Fund signed a deal with Swiss Re subsidiary Windsor Life, Osborne Clarke pensions partner Mark Womersley advised the trustees, while Clifford Chance acted for the insurer.
While schemes have been relatively reluctant to embrace longevity swaps, with a general ignorance of how they work being the main reason for this, it is nevertheless anticipated that more deals will be struck in the months ahead. This is now especially so, with schemes largely eschewing solutions such as buyouts and buy-ins (which became popular for a brief period around two years ago) partly because they are costly to put in place and partly because there is little capacity left in the insurance market.
“There’ll be quite a few of these [longevity hedge] deals in the next few months,” says one partner at a City pensions practice. “They’re complex because they have to take account of what the expected mortality is and have a mechanism for testing experience against actual mortality. Then there has to be an administrative provision for when the insurer feeds money into the pension scheme. They can either pay a premium up front or put in place a swap, where there’ll be a time when the insurer pays the trustees and a time when the trustees pay the insurer.”
So which firms are best placed to win the mandates on the anticipated deals? Given that it is the corporates that are looking for a solution to pension scheme funding, it is a fair assumption that the instructions will go to the practices that rely on the work generated in their firm’s corporate groups.
As BLG’s Parker says: “Final salary schemes are a headache for most large corporates in the UK and there are cases such as BA [British Airways] and BT, where the pension schemes dwarf the size of the companies. Businesses are looking at solutions to try to dampen the effect of ballooning pension liabilities on their balance sheets.”
Then again, with scheme trustees focusing on making sure there will always be enough cash to pay members their dues, it is the standalone practices that potentially stand to benefit the most.
“In most cases it’s the employer that wants to dampen down volatility in the scheme, but most of the work will be done on behalf of the trustees,” adds Bakers’ West. “Their advisers will be in the driving seat in terms of agreeing a policy or swap.”