Lafarge pension scheme enters into longevity swap to reduce risk

The trustee of the building materials giant’s scheme has also decided to change the way in which member-nominated directors are appointed – moving from an election process to the use of a selection panel.

Members living longer than expected is a key risk for defined benefit pension funds.

In a bulk annuity the longevity risk is managed but the assets relating to the liabilities are also passed over to the insurer, which means that there is no further opportunity to earn additional investment returns

Colette Christiansen, XPS Pensions

While life expectancy has flatlined over the past few years, people are still living longer than they were a decade ago. 

Males born between 2015 and 2017 are expected to live 79.2 years – up 2 years since 2005 to 2007, according to Office for National Statistics figures.

Similarly, females born between 2015 and 2017 are expected to live 82.9 years, up 1.4 years since 2005 to 2007.

During Q3 2018, the £3.4bn Lafarge UK Pension Plan, with 26,129 members as at June 30 2018, took an important step to address longevity risk.

The DB scheme’s February 2019 newsletter to members states that “in August, after a thorough market review, the Trustee entered into a longevity swap with Munich Re, a major global reinsurance company, to reduce the Plan’s exposure to longevity risk, which had been identified as the largest individual risk in the Plan”.

While gains in life expectancy are good news, they do increase the cost of providing pensions, the document states.

It notes that it is not easy to predict future life expectancy accurately, adding that “current estimates of longevity may change in future and members may of course live longer than expected”.

Under the longevity swap, the Lafarge scheme will receive payments that offset the increase in liabilities, should longevity be higher than assumed.

Martin Lockwood, head of longevity at Munich Re, says: “Munich Re is delighted to have worked with the trustees on this longevity transaction.”

Longevity swaps less common

Colette Christiansen, head of derisking solutions at XPS Pensions, says longevity risk is a concern for pension funds, particularly as schemes mature and they manage down other risks. 

“Once these risks are minimised, longevity risk starts to dominate. However, the trend in life expectancy improvements has reversed a little in the past few years, which has meant that many trustees are not as worried about longevity risk as they previously were,” Ms Christiansen adds.

Nevertheless, Willis Towers Watson’s 2019 derisking report highlights that, while most schemes have seen reductions in life expectancy reducing their liabilities at their most recent actuarial valuation, prior to that, rises in life expectancy had added approximately 10 per cent to pension fund liabilities in the previous decade.

Longevity swaps, where a series of fixed payments are made to the reinsurer and in return the reinsurer makes payments to the scheme based on how long members actually live, are less common than other derisking approaches, according to Ms Christiansen.

“Trustees most commonly use bulk annuities to manage longevity risk or use LDI to manage interest and inflation risks,” she says.

This is usually because longevity swaps are a more complex solution and are seen by schemes as less of a stepping stone to full buyout, Ms Christiansen explains.

Investment flexibility

One of the main reasons for carrying out a longevity swap is to manage the longevity risk without giving up investment flexibility, according to Ms Christiansen. 

“In a bulk annuity the longevity risk is managed but the assets relating to the liabilities are also passed over to the insurer, which means that there is no further opportunity to earn additional investment returns,” she says.

Shelly Beard, senior director at Willis Towers Watson, says entering into a longevity swap can remove a risk that the scheme sees as unrewarded, while increasing certainty of cashflows, which is helpful when building a cash flow-driven investment strategy.

Another reason why a scheme may enter into a swap is to “lock in now to longevity reinsurance capacity, which is likely to be very helpful in the event that the scheme wishes to undertake a buy-in in the future”, she says.

When it comes to preparing for such a transaction, Ms Beard stresses that schemes should have the right governance structure in place to demonstrate commitment to the market and enable agile decision-making.

She also advises schemes to ensure their data, such as mortality experience data, are of a good standard.

Busy year ahead

Mr Lockwood says that, although early in the year, “it seems the market is likely to remain relatively busy” with regard to longevity swaps.

He explains that the role of the reinsurer can vary dependent on where the longevity risk originates, typically via a traditional insurer or through a captive structure.

“In both instances though a reinsurer ultimately will provide capacity in line with the needs of the trustees,” he says. 

Amy Kessler, head of longevity reinsurance at Prudential Financial, expects 2019 to be one of the strongest years on record for longevity reinsurance.

“Longevity swaps are usually carried out by large defined benefit schemes that are well funded with high fixed-income allocations and sophisticated asset management, where the trustees do not need to eliminate all risk and would prefer to pay for their derisking over time,” Ms Kessler says.

She adds that any pension fund that does not meet this description would likely prefer a buy-in or a buyout, which is a holistic solution for all asset and longevity risk.

Monitor insurer covenant health

According to research by covenant specialists Lincoln Pensions, around 40 per cent of schemes are planning to run-off the pension obligation on a low-risk fully funded basis, rather than transferring these to the insurance regime through an annuity policy.

Adolfo Aponte, director at Lincoln Pensions, says: “Longevity swaps can be an important tool for any trustee that is seriously planning to run its pension scheme over multiple decades.”

He notes that the effectiveness of a longevity swap as a risk transfer instrument depends on the strength of the insurer’s financial covenant and any security feature that has been built into the contract.

“This is a particularly important consideration given the illiquidity and long duration associated with a longevity swap,” he says.

“Monitoring the health of the insurer covenant and mortality trends becomes an important obligation on trustees once the longevity contract is in place,” according to Aponte.

Lafarge switches to selection 

In addition to tackling longevity risk, trustees of the Lafarge pension scheme have also been focusing on how member-nominated directors are appointed.

Following a review of the MND arrangements, the trustee has decided to keep the nomination process for candidates the same, but change the process for selecting MNDs.

“Instead of electing MNDs by a ballot of members, a selection panel will review candidates against an agreed list of skills and attributes,” according to the scheme’s latest newsletter. The panel will then shortlist, interview and appoint the most suitable MND.

There has been an increased regulatory focus on ensuring good trustee knowledge and understanding in recent years.

The requirement of the Pensions Regulator for trustees to demonstrate professionalism means that “it is very important to select the most suitable candidates for the role”, and is one of the main reasons why the Lafarge scheme is changing its approach, the newsletter states.

Furthermore, there are now fewer than 25 active members in the Lafarge scheme, so it is less likely that candidates will be well known across the membership.

“This makes it harder for members to know and judge the merits of the candidates from the limitations of information that can be provided on ballot papers (a short statement and biographical details),” it adds, noting that it is thought that an in-depth interview process would be more likely to determine the best candidate.

Ensuring the right skill-set

David Brooks, technical director at Broadstone, says having a selection panel “is one way of ensuring the skills required on the board are best met by the talent pool available”.

“Elections are a great way of getting diversity on the board, but this can be by chance,” he notes, adding that selection allows boards to be more acutely designed.

The main challenge when using a selection panel is ensuring the process is transparent to the members, according to Mr Brooks. It is important “that members are able to nominate candidates and understand fully the criteria for selection and the reasons for the final decision”, he adds.

At least one-third of a pension scheme’s trustees must be member-nominated.

Alan Pickering, chairman of Bestrustees, prefers selection to an election process.

“Election might work in a small, tightly knit community, but using election in a large complex business means that you are asking people to cast a vote for an office that they might not understand, and for people that they probably don’t know,” he says.

He adds: “If you have a selection approach, where the members of the selection committee are carefully chosen, you can then ensure that every aspirant trustee, irrespective of the size of their particular business unit, have a fair crack at the whip.”