Written by: Robert Wagstaff, Head of EMEA Business Development, and Caroline Cruickshank, Managing Director, Global Strategy | BNY Mellon Corporate Trust
Investment and longevity risks threaten the affordability and availability of defined benefit (DB) pension scheme member benefits in the UK. The volatility inherent in these risks has led many DB schemes to seek a more secure way forward by leveraging innovative risk transfer structures.
Various structures for pension risk transfer are available. The longevity swap is a fully collateralised derivative contract that can be written in insurance policy form. A pension fund ‘swaps’ the longevity risk with a counterparty, such as an insurer or investment bank. In turn, the counterparty lays-off most, if not all, the risk to a reinsurer or into the capital markets. In effect, longevity swaps are designed to convert unknown future longevity liabilities into a fixed payment over time.
Demand from plan sponsors for such structures is rising as pension risk transfer costs fall due to a slight slowdown in the reduction of mortality rates. The prolonged low yield environment has also incentivised plan sponsors to seek solutions that could protect funding levels. Only a third of UK DB pension schemes were in surplus as of 31 December 2017, according to the Pension Protection Fund’s PPF7800 Index monthly analysis.
On the supply side, insurers are increasingly attracted to the revenue opportunity of managing the risks that pension funds are looking to offset. While facing their own challenges – Solvency II’s capital requirements, historically low premiums and the Brexit uncertainty of EU passporting rights – insurers are seeking ways to improve their risk diversification and profitability. Longevity risk can be viewed as a natural hedge to the mortality risk inherent in their underwriting activities.
UK DB schemes have been quick to respond to the emergence of longevity risk transfer, with an estimated £140 billion of liabilities transferred from DB schemes in the last 25 years (source: Mercer UK DB Bulk Pension insurance – Market Review, July 2016). More significantly, the current market for pension de-risking ‘will be dwarfed’ by transaction volumes expected in the next two decades, according to Mercer.
With risk transfer activity prevalent among the balance-sheet sensitive and risk aware pension plans in the aftermath of the financial crisis, approaches to asset and liability management have to be nimble enough to grasp new opportunities. At a time when balance sheets are lean and margins finely calculated, we believe plan sponsors will seek to retain maximum control of their options – such as visibility over collateral – when shedding pension risk. This means they may prefer to partner with a service provider for independent valuation and collateralisation solutions.
The Collateral Agent
In a longevity swap, collateral in the form of eligible financial assets is traditionally used as security to protect each party should either default on their payment obligations under the swap contract. To oversee these contractual obligations, an independent third-party service provider such as BNY Mellon can be appointed as a collateral agent to administer the collateral accounts over the lifecycle of the transaction. The breadth and depth of the service provider’s capabilities is a key consideration.
Using bespoke valuation, collateral management and tri-lateral custody services, a sophisticated collateral agent can monitor collateral eligibility, provide daily collateral valuation reports, hold assets in custody and can oversee a dual instruction mechanism for control and exchange of assets. This approach relies upon bespoke data analytics capabilities to supply accurate daily pricing of liquid and illiquid collateral types throughout the lifetime of the transaction.
This combination of solutions offered by the collateral agent lends transparency and flexibility critical to the effectiveness of risk transfer structures, because it can reduce counterparty risk, without restricting balance sheet optimisation. The involvement of an independent third party service provider to act as collateral agent to manage complex asset and data flows between multiple parties, can add substantial value for plan sponsors.
As access barriers to the risk transfer market reduce and longevity swaps gain momentum, the sophistication of service providers’ valuation and collateralisation solutions will help to facilitate more deals and encourage new participants into the market, further reinforcing the efficiency of risk transfer.
Media Contact:
Peter Gau
+1 212 815 2754
peter.gau@bnymellon.com