Longevity v interest rates – which poses the biggest risk for schemes?

Low interest rates have wreaked havoc on many schemes’ funding levels as liability calculations are revised up.

Earlier this month the aggregate deficit of the Pension Protection Fund’s 7800 Index reached £254.2bn, up from £93.2bn a year ago.

The cost of not hedging longevity in a low interest rate environment is proportionately greater than in a high rate environment

Martin Bird, Aon Hewitt

In its report, ratings agency Fitch Ratings outlined the threat posed by longevity to pension scheme funding levels, claiming a two-year improvement would increase deficits by close to half among its sample group.

The report stated: “There is every incentive for companies to underestimate mortality improvements – an upward revision may materially change the deficits. For example, we estimate that an additional two-year longevity assumption applied to 2014 reported levels [based on current interest rates] will increase the total pension deficit by 47 per cent (£23.8bn) to almost £75bn for our selected sample data of UK companies.”

It also said the current low interest rates would eventually rise, undoing some of the damage to funding levels, but added “barring catastrophes” life expectancy would also rise, leading deficits to increase regardless.

But Alan Collins, director at actuarial consultancy Spence & Partners, said: “For many schemes I’d still expect interest rates to be the biggest risk factor. Even if [interest rates] do rise there’s still a risk they’ll fall back again.”

He added: “Be mindful of longevity [risk], but I’d still have it quite far down the list against interest rate, discount rate and covenant risk.” Collins caveated that interest rate risk was easier to hedge against.

Managing longevity risk

Schemes typically hedge longevity risk in two ways: completing a buy-in or buying longevity swaps. But Collins said longevity swaps “are still pretty rare and they tend to be the preserve of larger schemes”.

Kazim Razvi, director at Fitch Ratings’ credit policy group, cited BT and Rolls Royce as large UK corporates that entered longevity swaps with insurers.

He said: “Another way corporates have mitigated the longevity risk specifically, and pension risk in general, is by a negotiable conversion of [defined benefit] schemes to [defined contribution] schemes. The affected employees are paid a one-off sum as settlement for voluntarily transitioning to a DC scheme.”

Martin Bird, senior partner at consultancy Aon Hewitt, said low interest rates compounded the risk posed by longevity.

He said: “The cost of not hedging longevity in a low interest rate environment is proportionately greater than in a high rate environment.”

James Mullins, partner at consultancy Hymans Robertson, said that while larger schemes had dominated the longevity swap market, there was no reason small or medium-sized schemes could not access such deals.

“To an extent [the dominance of large schemes] will continue, but if there’s a small or medium-sized scheme… You simplify the contracts and go for a more standardised approach,” he said.

Mullins added that the reinsurance market for longevity had become more competitive over the past few years, potentially signalling better deals.

“That’s meant getting rid of life expectancy risk is much cheaper today than it was five years ago,” Mullins said.

However, he added that buy-ins would continue to be the favoured way for schemes to reduce risk.

“Longevity swaps will tackle life expectancy risk specifically in isolation,” he said. “Buy-in tackles financial risk, interest rate and inflation risk as well.”