What it means
A pension fund promises to pay members a monthly income for as long as they live. If people live longer than the fund assumed, it must keep paying for more years, and the bill can run into many millions.
This is called longevity risk, and it is hard to remove through ordinary investing because it comes from medical progress and lifestyle trends rather than markets. A longevity swap is the most common contract.
The pension fund agrees to pay the counterparty (often an insurer or reinsurer) fixed amounts based on expected survival, and in return receives payments based on how many members actually survive. If members live longer than expected, the counterparty pays more, so the fund's extra cost is covered.
Other forms exist, including q-forwards, which are linked to a published mortality rate for a population, and survivor bonds, whose coupons fall if survival is lower or higher than forecast. These index-based contracts are cheaper and easier to trade, but they may not match the exact members of a particular scheme, which leaves some basis risk (the risk that the hedge and the real exposure move differently).
Buyers include defined benefit pension schemes and annuity providers. Sellers include reinsurers, banks and investors who find longevity risk attractive because it is largely unrelated to share prices or interest rates.
That low correlation (tendency to move together) makes it useful for diversification. The market remains specialised.
Contracts are often long, bespoke and run for decades, so they depend on the counterparty staying solvent and on accurate data about the covered members. Trustees normally take advice from actuaries and lawyers before entering one.
Pricing rests on mortality tables and projections of how survival rates may improve. Small changes in these assumptions move the price noticeably, which is why both sides invest heavily in data and why trustees often compare quotes from several providers before agreeing terms.
In practice
Real-world examples.
Example
A corporate pension scheme with 8,000 retirees transfers the longevity risk on $1,000,000,000 of liabilities to a reinsurer through a swap. The sponsor no longer worries that medical advances could suddenly raise the pension bill.
Example
A life insurer that sells annuities buys a longevity hedge because its profit depends on customers not living too long. A sudden improvement in survival rates would otherwise squeeze its margins.
Example
An asset manager sells protection through a mortality-linked forward, expecting a steady return that is not correlated with the stock market, which suits its diversification goals.
Formula
Calculation
Net settlement to the pension scheme = Actual benefit payments on the covered members - Fixed payments the scheme pays to the counterparty
Suppose a pension scheme pays fixed amounts of $10,000,000 a year to the counterparty, based on expected survival of its retired members.
In one year, because members live longer than assumed, the actual pensions paid to the covered members are $10,600,000.
Net settlement received = $10,600,000 - $10,000,000 = $600,000.
Over a five-year period of similar experience the scheme would receive roughly 5 x $600,000 = $3,000,000, which offsets the extra cost of members living longer.
If instead members die earlier and actual payments are $9,700,000, the scheme pays a net $300,000, giving up that benefit in return for certainty. The scheme pays for protection, much as a homeowner pays an insurance premium, so a quiet year in which nothing is received is not a failure of the hedge.Case study
Seen in the real world.
Ironbridge Engineering Pension Scheme is an illustrative, fictional plan with 5,000 retired members and a promise to pay pensions for life. The trustees realised that if members lived just one year longer on average than assumed, the scheme would need roughly $60,000,000 more in assets.
After taking advice, they negotiated a longevity swap with an international reinsurer covering the pensions of all current retirees. The scheme paid fixed amounts based on the original assumptions and received the actual pensions paid, with a fee built into the pricing.
In the fictional years that followed, survival rates improved faster than predicted, and the swap paid out several million dollars. The trustees were able to keep their investment plan unchanged and the sponsoring company avoided an unplanned top-up.
Watch out
Common mistakes.
- Assuming longevity derivatives protect against investment losses, when they cover only the cost of members living longer than expected.
- Overlooking counterparty risk, which matters because contracts may last for decades and the seller must remain solvent.
- Using a population index to hedge a scheme with unusual members, such as unusually wealthy or unusually healthy retirees, without allowing for basis risk.
Questions
People also ask.
What is the difference between a longevity swap and a buy-out?
A swap transfers only the longevity risk while the scheme keeps the assets and investment risk, whereas a buy-out transfers all the liabilities to an insurer.
Who takes the other side of these contracts?
Usually reinsurers and some investors, who earn a premium and value the diversification because longevity risk is mostly unrelated to markets.
Can small schemes use them?
It is harder, because bespoke swaps usually have minimum sizes and high set-up costs, so smaller schemes often use insurance buy-ins instead.
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