Partly fuelled by rising interest rates in 2022, Defined Benefit (DB) pension funds are increasingly looking to the pension risk transfer market to provide more certainty to the current and future pensioners who are members of their plan. But there are benefits to plan sponsors, too; pension liabilities can be a drag on company performance, so the option to essentially wind up the scheme is an attractive one.
This ‘win-win’ has fuelled the growth in the pension risk transfer industry in the past decade. The UK has the world’s most active and developed market, but meaningful volumes take place in the US, Canada, and the Netherlands as well. Three different types of risk transfer are available, with a full buy-out – where an insurance company absorbs the entire pension scheme, including the assets and the administration as well as the longevity risk – being the holy grail.
The problem is, on a long-term basis, some would argue that there isn’t enough capacity for insurance companies to absorb the entire market because accumulating more and more longevity risk – there is approximately £1.5trn of DB pension liabilities in the UK alone, according to consulting firm WTW – without hedging it means that pensioners and governments will be exposed to much higher risk in the event of a default. Whilst insurance companies can de-risk themselves with other insurance and reinsurance companies, that’s not sustainable for the industry as a whole, and so there needs to be another place for insurers and reinsurers to transfer longevity risk.
Enter the capital markets, including hedge funds, speciality asset managers, and other institutional investors. These players have been studying the market for decades and are eager to participate due to the uncorrelated nature of the risk. But before they can get in, they need a much more systematic process, according to Avery Michaelson, CEO at the longevity risk trading marketplace, Longitude Exchange.
“In order for hedge funds and other institutional investors to get involved in the longevity market, they need a marketplace. Currently, transactions are brokered in an over-the-counter process using transaction formats that aren’t well suited to the investment criteria of these players,” he said. “These investors benefit from a certain level of commoditisation of transactions, something which can be addressed with index-based transaction formats. By basing transaction pay outs on general-population mortality data, information asymmetries can be removed along with much of the analytical complexity involved in pricing and risk analysis.”
The hedge fund industry could be a natural home for these products, as they structurally look like an alternative fixed income product. However, for them to really commit capital to the space, the issue of liquidity needs to be addressed. Here again is where an exchange can serve the markets’ need by providing a digital marketplace for trading.
Michaelson sees the market expanding rapidly in the coming years, both in terms of volumes and participants.
“Rising interest rates have further accelerated pension de-risking, fuelling greater than ever demand for capital. Fortunately, there are already a number of ILS Funds with experienced life risk teams prepared to commit capital to this space. They will be joined by a much broader range of institutional investors as deal flow and liquidity materialize.”
The alternative investment industry manages trillions of dollars. Data and analytics provider Preqin says that, at the end of June 2022, the private equity industry managed $7.97trn, the hedge fund industry $4.13trn, and the real estate market £1.5trn for example. A more developed longevity market would be large enough to stack up against these established markets.
“There are around $100trn of longevity linked liabilities, globally. And every year of unanticipated life expectancy adds around 5% to liabilities. So, if estimates are off by three years, longevity risk could cause $15trn of unfunded liabilities,” said Michaelson. “The enormous quantum of this risk points to the need for capital markets participation. It’s only a matter of time before longevity risk is recognized as its own asset class.”
