Tuesday, February 23, 2010

The Ultimate Pension Plan?

Just came back from Calgary and I'm tired so will keep this short. First, let me thank Ashton Embry and his wonderful wife for hosting me on Sunday evening. Ashton is the founder of direct-ms.org and is simply a great guy. His wife Joan cooked up a storm (absolutely delicious) and I got to meet two of his sons, their wives and his grandchildren. I truly enjoyed the evening and learned to drop vitamin D pills and go for vitamin D drops which I can add to my morning coffee.

In pension news, Hester Plumridge of the WSJ reports that BMW Drives New-Age Hopes for Pensions:

The U.K.'s pension nightmare is seemingly never-ending. But BMW's innovative deal with Deutsche Bank to insure £3 billion ($4.64 billion) of its pension liabilities, or the entirety of its pension-drawing work force of about 60,000, against increased longevity, offers hope to companies eager to reduce exposure to volatile pension deficits. It also offers a potential fresh lease on life to the U.K.'s stalled fledgling pension-buyout industry.

During the boom, a number of start-up funds raised money in the expectation that companies would take advantage of narrowing deficits to shed their pension liabilities to an insurer. But the financial crisis caused deficits to balloon again as asset prices fell and bond spreads widened, increasing the value of liabilities. That made a full pension buyout prohibitively expensive for most fund sponsors.

BMW's deal with Deutsche's Abbey Life subsidiary gets around this issue by passing on only one element of risk to the insurer: longevity risk. The assets and liabilities, including responsibility for the pension fund's deficit, last valued at £545 million in 2007, will remain on BMW's balance sheet, although Abbey Life will assume payments to the pensioners. BMW will pay Abbey Life a fixed premium.

The two parties in the deal need not differ radically in their mortality assumptions for the pensioner group. For BMW, the cost of the deal is likely to be about 5% of the insured liabilities, or about £150 million, but is worth it to reduce the fund's volatility. Abbey Life believes the premiums it charges will be more than the forecast risk assumed.

Besides, if asset prices recover and bond spreads narrow, there is nothing to stop the car maker from seeking a full buyout in the future. Other U.K. companies will want to take note.

Bloomberg citing the FT, said this is the largest deal yet in corporate longevity insurance, effectively doubling the size of the market. BMW is not the only firm to have recently looked to the longevity swap market as a way of covering the risk posed by people living longer:

Last May, Babcock International became the first British company to do such a swap deal using Credit Suisse as counterparty to hedge 500 million pounds.

Then, in December, Swiss Re undertook a longevity swap in a deal in the UK with the Royal County of Berkshire Pension Fund, which was the first transaction by a public sector pension scheme. The longevity swap covered around 1 billion pounds of its pensioner liabilities.

Consultants Hymans Robertson issued a report on Feb. 17 that predicted the longevity swap market would hit $10 billion in 2010.

Hymans said it expected two other longevity swap deals worth well in excess of 1 billion pounds, which were expected to close in the first half of 2010.

"Premier Foods have been reported to be in negotiations over a longevity swap deal covering around 2 billion pounds of Rank Hovis McDougall's pension scheme's liabilities," the report said.

Deutsche Bank is a member of the newly formed Life and Longevity Markets Association (LLMA). The LLMA wants to transfer the UK's 2 trillion pounds of pension liabilities to the capital markets to help pension schemes and insurers manage the financial pressure of increased life expectancy.

Hewitt's Bird predicted another $15 billion in longevity swap deals to come by the end of 2010.

"Most of the capacity of the BMW deal was through reinsurance, but as more standardisation around longevity structures comes into the market, the use of index solutions will increase, which will open up a route veto the capital markets," he said.

Will longevity swaps take off now that BMW and others have entered into these deals? I believe that companies looking into such arrangements should carefully consider the pros and cons, but it's clear that if they're looking to reduce exposure to volatile pension deficits, then such deals may make perfect sense.

Of course, if everyone starts entering into longevity swaps, they may be creating another potential problem down the road without addressing other structural factors that exacerbate pension deficits. In other words, longevity swaps are not the magic pension pill that the media makes them out to be, so buyers beware.

***Comment on longevity swaps***

Posted on Zero Hedge, this was an excellent comment on longevity swaps:

I've done some research on this in the past. For general reference (to a question above) longevity swaps work like any other swap, with the underlying security for calculation of payments to and fro being a longevity/mortality index. The buyer of the swap makes fixed payments to the hedge provider. The hedge provider pays floating based on index performance (the longer people live, the more the hedge buyer receives from the hedge provider). One problematic aspect of it all is that all longevity/mortality indexes are imprecise and capture a much larger population pool than any given pension fund or life insurer's risk pool - but that's only a technical difficulty.

The larger problem that I have with these instruments is that they are a perversion of the whole idea that swaps are used to hedge risks that is not tied to the buyer's core competence/ business. So, for example, airlines are not in the business of oil trading but are in the business of transporting people. A legit hedge in my book is when an airline buys a swap, future or a forward against oil price fluctuation. A ridiculous swap is when that airline tries to buy a hedge against fluctuations in the quantity of passengers that it'll have over the next few years.

The use of longevity swaps by pensions and especially life insurers is much closer to the ridiculous category. Managing longevity risks is their business for chrissake. So when they offload that risk to someone else - the question arises inevitably - who is the ultimate holder of that risk? Banks? But why? Are banks better than pension funds at assessing actual longevity risk profile of a pool of beneficiaries? Obviously not. And no one else is either - so these lazy pension fund managers should suck it up and start doing some actual work.

Last but not least - if the present crisis taught us anything about the use of derivatives is that they never solve a problem if there is on. They only hide it for a while, enabling someone to make a quick buck in the process. But shit hits the fan eventually and when it does it inflicts too much collateral damage. The subprime moment of these longevity hedges may end up being some medical breakthrough (e.g., cancer treatments) that rather dramatically lengthens expected lifespan of current and future retirees. Just what we need then - more bailouts, in this case for Deutche Bank.

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