Paternoster: An Increasingly Popular Approach to Pension Risk – Myles Pink

As the cost of insuring defined benefit pension schemes against investment risk has increased, sponsors are increasingly turning to longevity hedges. Having worked with Abbey Life on structuring its longevity hedge for BMW, Myles Pink of Paternoster explains the value of these products and why they will have long-term importance.

Managing risk and meeting pension liabilities is an increasingly challenging task for finance directors. The three main routes for transferring the risk of defined benefit pension schemes are buy-outs, buy-ins and longevity hedges. The first two of these offer the apparent advantage of transferring a pension schemes assets and liabilities wholesale to an insurance company. But, after strong growth in 2008, the market stalled in 2009 as premiums increased to cover the rising cost of insuring investment risk.

Corporate sponsors and trustees are now looking to longevity hedges as an alternative way of mitigating pension risk and the total value of these deals is estimated to top £10 billion this year, up from £4 billion in 2009.

Specialist pension insurer Paternoster has considerable experience in structuring risk transfer solutions for pension schemes, including the groundbreaking longevity hedge between BMW and Abbey Life. Business development director Myles Pink argues that it is not just the relative expense of buy-outs that makes longevity hedges attractive. By decoupling mortality and investment risks, sponsors are able to take a more sophisticated approach to the way their fund is managed.

"A lack of affordability for full risk transfer", he says, "and the use of more prudent or accurate longevity assumptions by pension schemes is the reason why longevity hedges have started taking off in the last 12 months."

From the sponsoring employers' perspective the elimination of one unknown means that finance directors are better able to achieve certainty in cash flow liabilities and concentrate on managing the other risks the fund is exposed to. They can better hedge against inflation and interest rate risks if they choose to.

"Finance directors and trustees would say that they have an understanding of investment risk," Pink explains, "By fixing the longevity assumption so that the liabilities don't increase with an increase in life expectancy, they can then dial up or dial down their investment exposure to manage payments in the future."

Longevity hedge products remain fairly exotic but Pink expects that as awareness of this particular risk grows, an increasing number of sponsors will follow BMW's lead and explore these new methods of controlling it.

Even if the price of insuring investment risk decreases in the future, longevity hedging could remain an attractive prospect, especially as a first step towards a buy-out for a fund with weaker underlying funding levels and cash flow.

"Trustees exploring the removal of longevity risk find there's not necessarily any up-front cost to doing so," Pink says. "They can then continue to manage the assets as best they can so that a buy-out or buy-in is achievable at a later date."

Although analysts have described 2009 as the year the longevity hedge market came to maturity, significant obstacles to further growth remain. For the most part, deals have to be structured on a fund-by-fund basis as this puts lower limits on the transaction size insurers are interested in taking on.

Despite these challenges, smaller schemes valued at around the £200 million mark are starting to access the market. "There is the potential that within this calendar year we will see the first trade or two below £100 million,"Pink says,"but that is going to be dependent on the appetite of people who aren't active in this area at the moment."

However, if this does happen, the nature of the market will have to change to accommodate the lower potential revenues. "If we start to see much smaller trades happening, then people will have to take a slightly more regimented approach to the solution," Pink acknowledges. "It's purely because the cost of creating a bespoke contract will be relatively expensive compared with the scheme's assets."

Paternoster's creative approach to tackling pension risk puts it in a strong position to structure attractive solutions for corporate sponsors and trustees. "We have the experience of completing 42 trades, each different from one another," Pink says. "Developing new concepts – like innovative collateral and benefit variation mechanisms within longevity hedges – and structuring transactions is what we're good at. That's what we brought to BMW's contract with Abbey Life and what we will bring to the longevity hedge market."

Longevity hedges are not a panacea for managing the challenges of a defined benefit pension scheme. But by working with a skilled partner like Paternoster, an increasingly diverse range of companies in the coming year will be able to find workable solutions to benefit their fund members.