De-risking report 2015 The evolving bulk annuity and longevity swap markets
De-risking report 2015 The evolving bulk annuity and longevity swap markets AWARDS 2014 Deal of the year Contents Introduction 4 Looking back at 2014 6 Views on 2015 9 Longevity hedging 12 Conclusion 16 De-risking report 2015 The evolving bulk annuity and longevity swap markets 3
Introduction 2014 was the biggest year to date for pension scheme de-risking, with around 35bn of liabilities hedged and, once again, the records for the largest ever transactions were broken. The past year has also been notable for innovation, with schemes finding new methods of accessing the longevity reinsurance market more directly and new deal structures being utilised in the bulk annuity space to achieve competitive pricing. The 2014 Budget had a dramatic impact on the size of the individual annuity market and has increased demand from providers in the bulk annuity market to fill the gap left in their books. Some definitions Bulk annuity a single annuity policy supplied by a PRA authorised insurance company to pay pensions for a group of people, typically members of the same pension scheme. The premium is usually paid as a lump sum at outset but can be spread or deferred. Buy-in a bulk annuity policy that is owned by the trustees, and which remains a scheme asset. The insurance company pays pension payments to the trustees. The trustees still have legal responsibility for paying member benefits. Buyout instead of one single bulk policy held by the trustees, each individual member holds their own policy with the insurer. Legal responsibility for paying members pensions passes to the insurance company. Longevity hedge the scheme makes an agreed schedule of payments to a counterparty based on an expected mortality assumption in respect of a specified group of members. In return, the scheme receives actual payments, which are linked to whether the scheme members underlying the hedge are alive or not at each payment date. The longevity risk for this group of members passes from the scheme to the hedge counterparty. 4 towerswatson.com
With more schemes now looking to the market for de-risking solutions, and the process for completing these transactions becoming more streamlined, the demand for these products from pension schemes in the coming years is likely to increase. Only a fraction of the potential demand from pension schemes could be met from the existing supply in the market, even considering the expanding capacity of this market. This could be a key driver of prices in the longer term. In this report, we look back at the activity in the market over the last year and look forward to how the market might continue to develop during 2015. As well as drawing on our own analysis and experience in working with trustees and scheme sponsors in this market, Towers Watson has carried out a forward-looking survey of several major annuity and longevity hedge providers to gauge their views on how the pension scheme de-risking transaction market will develop in the coming months. We hope that you will find this report a useful tool in understanding this market, which continues to develop year on year. Towers Watson has continued to lead the market in innovation in 2014, advising on the largest longevity hedge ever for the BT Pension Scheme and launching Longevity Direct with the MNOPF longevity swap, a solution to help pension schemes access the reinsurance market directly and efficiently. Towers Watson March 2015 De-risking report 2015 The evolving bulk annuity and longevity swap markets 5
Looking back at 2014 Following a busy year in 2013, 2014 has reset all the records with a transaction volume of more than 35bn (see Figure 01). Notable transactions during 2014 include: March 2014: 3.6bn buy-in for the ICI Pension Fund across two transactions with Legal & General for 3bn and 600m with Prudential. March 2014: 5bn longevity swap by the Aviva Staff Pension Fund with SCOR, Swiss Re and Munich Re. July 2014: 16bn longevity swap by the BT Pension Scheme with Prudential Insurance Company of America (PICA). November 2014: 2.6bn partial buyout for the TRW scheme with Legal & General. December 2014: 1.5bn longevity swap by the Merchant Navy Officers Pension Fund (MNOPF) with Pacific Life Re. Record breaking bulk annuities and longevity swaps A key driver for the higher levels of activity in 2014 has been an increasing focus from pension schemes on longevity risk, where a lot of schemes have already taken action as part of their journey plan to manage other key risks through their investment strategy. More and more schemes are looking to approach the market to hedge some of the longevity risk they are running, either through a bulk annuity or longevity swap, recognising the favourable pricing currently available in the market. Reinsurers typically take on the longevity risk associated with both longevity hedges and bulk annuities. Many reinsurers have a considerable amount of mortality risk on their books the risk that more people die than expected. By taking on longevity risk which is the opposite they benefit from diversification and can reduce their overall capital reserving requirements. Even with the growth seen in 2014, supply from insurers has continued to exceed demand from pension funds and the broking processes that we have seen have been able to achieve significant competitive tension. Rothesay Life Figure 01. Volumes of business by year billion 40 35 30 25 20 15 10 5 0 2007 2008 2009 2010 2011 2012 2013 2014 Longevity swap Synthetic buy-in Bulk annuities 6 towerswatson.com
At the moment, the reinsurers still have much more mortality risk than the 100bn or so of UK longevity risk that has been transferred, and this diversification benefit is reflected in their pricing. However, over the medium to long term, and with 2tn of UK defined benefit (DB) pension liabilities, this position is expected to change. At a conservative estimate, longevity demand might average 50 to 100bn of liabilities a year, over the coming years which, based on our estimates of supply, is likely to cause upward pressure on prices over the medium to long term. More options for accessing the longevity hedging market The MNOPF, BT Pension Scheme and the Aviva Staff Pension Scheme transactions all accessed the reinsurance market more directly via insurance companies either already owned by the sponsor or cell companies specifically set up to facilitate the transaction (see Figure 02). This presents more options available to schemes keen to choose a cost efficient way to enter into a longevity hedge. These innovative structures can cut down on the complexity and ongoing cost involved in these transactions. Additionally, with more avenues to market, schemes are more likely to find a route suitable for their circumstances, and make the costs of hedging more affordable than previously. Towers Watson advised the BT Pension Scheme on setting up its own cell company and brokered the deal with PICA. The MNOPF used Towers Watson s Longevity Direct offering to set up their own insurance cell company for their transaction. This structure is a streamlined way for pension schemes to gain direct access to the reinsurance market. If you would like more information on this, please see our brochure on Managing Longevity Risk. Figure 02. Options for accessing the longevity hedging market Pension plan Intermediary Pension plan Direct to reinsurer Reinsurance market Pension plan Insurance entity owned by the pension plan or its sponsor De-risking report 2015 The evolving bulk annuity and longevity swap markets 7
A year of change for bulk annuities The changes introduced by the 2014 Budget and the impending introduction of Solvency II have provided incentive for insurers to be price competitively in the bulk annuity market and create innovative solutions to increase the attractiveness of deals in this space relative to gilt yields (see Figure 03). Whilst we saw bulk annuity transactions of a record breaking size in 2014, such as the ICI Pension Fund buy-in, there was also a large amount of activity across the market, with smaller schemes also entering into transactions. Following the 2014 Budget, and the drop off in individual annuities, several insurers are increasingly focusing their attention on the bulk annuity market, which has led to schemes being able to achieve competitive pricing and achieve bigger deals. This includes those providers who previously only offered medically underwritten buy-ins for pensioners. These are now increasing both the type and size of bulk annuity offered, with Partnership announcing a 206m medically underwritten transaction for the 2bn Taylor Wimpey Pension Scheme in December 2014. Furthermore, we are also aware that over the course of 2014, several insurers have been investigating entering the bulk annuity market. The other impact of the 2014 Budget that may affect the bulk annuity market longer term is the expected increase in transfers out at retirement. To the extent that actual and expected transfers out improve the funding level of a scheme, bulk annuities may become more affordable. Increased trivial commutations in particular removing members where administration costs typically make up a disproportionate percentage of the cost of purchasing a bulk annuity for the member may help affordability further. At the current time, insurers are not able to give credit in their pricing for the fact that deferreds may transfer out at retirement. This may make some sponsors and trustees hesitant to insure deferred members. But if evidence of transfers comes through, this should be reflected in pricing over the longer term, and help to improve solvency funding levels. Finally the TRW Pension Scheme s bulk annuity in late 2014 included several interesting features; a partial buyout, allowing the sponsor to remove the liabilities from its balance sheet, and building a pension increase exchange into the process. Increased transfers could defer full buyouts in the short term but lead to increased buyouts in the medium term due to improved funding levels. Pension Insurance Corporation Figure 03. Approximate buy-in pricing and gilt pricing for a sample member Cost of 1pa of pension 40 38 36 34 32 30 28 26 Jan 2013 Apr 2013 Jul 2013 Oct 2013 Jan 2014 Apr 2014 Jul 2014 Oct 2014 Jan 2015 Gilts Annuities 8 towerswatson.com
Views on 2015 Will the market continue to grow? 2014 was the biggest year for pension scheme de-risking transactions to date, with around 35bn of liabilities hedged. As Rothesay Life note, with over 5,000 pension funds seeking buyout at some stage, demand for bulk annuities and longevity hedges is likely to grow over time. However, it looks unlikely that 2015 will see growth relative to 2014. With funding and buyout deficits higher than ever, many trustees and sponsors will have limited appetite to de-risk at the current time (see Figure 04). However, in many ways, current market conditions only re-emphasise the need to properly manage risks. Insurers appetite is still strong, and they are anticipating an increase in demand should solvency levels improve. Legal & General noted that based on their current pipeline, they believe 2015 has the potential to get close to the record set for bulk annuities in 2014. Figure 04. Approximate assets and liabilities for the FTSE 100 pension schemes billion 1100 1000 900 800 700 600 500 400 300 Jan 2013 Apr 2013 Jul 2013 Oct 2013 Jan 2014 Apr 2014 Jul 2014 Oct 2014 Jan 2015 The chart shows the approximate cost of settling the entire pension liabilities (covering pensioners and non-pensioners) of the schemes sponsored by the FTSE 100 companies. Settlement cost Accounting liability Assets De-risking report 2015 The evolving bulk annuity and longevity swap markets 9
More innovation to make buyouts affordable The low gilt yield environment, combined with benign equity markets, may mean that the gap to achieving full buyout is too large for many trustees and sponsors. One solution to this is to consider a partial buyout where part of a scheme s liabilities, typically the pensioners, are bought out with the insurer (see Figure 05). This shrinks the size of the scheme on the balance sheet, as the bought out members now look to the insurer for their pension payments. The advantages of this from a corporate perspective are clear a smaller scheme on the balance sheet and lower administration requirements. And there are other cost savings that are only available through partial buyouts. For example, the exercise is often structured in such a way as to allow companies to conduct a winding-up lump sum exercise where lump sums of up to 18,000 can potentially be paid to members to extinguish their liability in the scheme. Another area of innovation is the concept of a PIE-out, as used in the TRW transaction. Running a Pension Increase Exchange (PIE) exercise for existing pensioners can significantly reduce the cost of securing a scheme s liabilities with an insurer, because: The pricing underlying the pension increases valued by insurers differs from that of a typical scheme s technical provisions or cash-equivalent basis. Schemes may choose to pass on less than 100% of the value of the pension increases to members. This could be advantageous for schemes that have RPI with an annual floor of 0% pa and cap of 5% pa increases on their pension built up before April 1997, and is particularly the case where pension increases have more complex structures (such as RPI increases with an annual floor of 3% pa and cap of 5% pa) or are linked to CPI (where insurers are not currently able to give the full credit for the expected differential between RPI and CPI). In some instances, this could be combined with a partial buyout, as set out above, where members who accept the PIE are bought out with the insurer, which can improve take up rates for the PIE. Figure 05. The impact of a partial buyout Before After Group Sponsor Group Sponsor Insurer assumes pensioner liabilities Pensioners Pensioners Deferreds Deferreds Actives Actives PPF PPF FSCS tpr tpr PRA & FCA 10 towerswatson.com
Case study: Project Shot The sponsor of the Project Shot pension scheme wanted to take steps to shrink the size of the 150m pension scheme before their financial year ended on 31 December 2014. It was decided that a partial pensioner buyout, using a small surplus that existed in the scheme, combined with a retirement transfer option exercise (to increase the surplus) could help achieve these aims. The trustees were comfortable with the partial buyout given the funding level in the remaining scheme and the covenant provided by the sponsor. Work began on a bulk annuity transaction in August. Towers Watson led the brokering process, which was highly competitive, with excellent pricing achieved. The 76m partial pensioner buyout transacted at the start of November 2014 with individual policies issued to members six weeks later. The sponsor achieved the aim of discharging the liabilities and reducing the size of the scheme by its year end. We expect that a number of schemes will consider transfer value exercises or introduce at retirement initiatives. These should increase affordability of buy-in or buyout for the remaining members. Legal & General There is an increased awareness that schemes with contracts in place are well placed to seize opportunist future transactions when favourable market conditions arise. Prudential De-risking report 2015 The evolving bulk annuity and longevity swap markets 11
Longevity hedging Will demand start to outstrip supply? The Aviva, BT, MNOPF, Phoenix and Scottish Power longevity swaps completed over 2014 took the total UK pension liabilities hedged through swaps or longevity insurance to just over 50bn since 2009. After a somewhat slow start, with only 20 or so longevity swaps transacted between 2009 and 2013, it seems that the longevity hedging market is gathering pace and we expect deals to flow more regularly during 2015. Undoubtedly a key driver for this is likely to be the expansion of options available for hedging the risk in particular the different ways of accessing the global reinsurance market which have reduced the cost and complexity of longevity swaps. In addition, on the demand side: For many pension schemes, following de-risking on the asset side, longevity is now a significant risk which they are now looking to manage. With gilt yields at very low levels, hedging longevity risk offers a way to continue reducing risk in the scheme without locking into potentially unattractive current asset pricing. We are also seeing sponsors and trustees take flexible approaches to dealing with the costs of hedging for example by taking slightly more investment risk, whilst still reducing the risk in the scheme overall. And on the supply side, for now at least, reinsurers continue to have significant appetite for UK pension scheme longevity risk. A bigger challenge over 2015 is likely to be whether the reinsurers have the resources to cope with the increase in demand for quotations and contract negotiations. 2015 may also be the year when index hedging finally takes off. These contracts tend to be of a fixed term and linked to the development of life expectancies in England and Wales. These hedges have the advantage of being more liquid, and are also more accessible for smaller schemes and those with less mortality experience data. Advances in methods to analyse the longevity risk left behind after an index hedge should help with this. 12 towerswatson.com
With a large number of transactions completed to date, processes are becoming more efficient and there is increasing standardisation of terms which should lead to greater confidence in the solutions available and improved efficiency in transaction completion. Pacific Life Re We believe that this aspect of longevity business will continue to be of value to reinsurers for several years to come. However, if market activity increases significantly whether internationally or in the UK and there are more deals like the BT 16bn deal, this may hasten up this process. Munich Re It would seem prudent to plan in advance and prepare reinsurers for future projects, in particular emphasising the likelihood of a trade. In times of a lot of activity, projects that are not well thought-through with good data may get worse or perhaps no pricing from some reinsurers. Deutsche Bank We are equally happy to use the traditional intermediated method or a more direct route using a captive. We expect to see a mixture of these deals in the coming years. SCOR De-risking report 2015 The evolving bulk annuity and longevity swap markets 13
Figure 06. How does Longevity Direct work? Beneficiaries TW Guernsey ICC Limited MNOPF Payments based on actual experience Payments based on agreed assumed experience MNOPF IC Limited Payments based on actual experience Payments based on agreed assumed experience Reinsurance market Reinsurer Case study: MNOPF longevity hedge The Trustee of the MNOPF has a journey plan that aims to fund on a low-risk gilts basis. In reviewing the journey plan, alongside Towers Watson, their investment advisers, they identified that the section had a concentration of longevity risk. Towers Watson undertook a stochastic mortality analysis to establish the size of the risk within the Fund. A de-risking budget was agreed with the Trustee, reflecting both the optimal level of longevity risk and anticipated market pricing, which suggested undertaking a 1bn longevity hedge. The Trustee approached the market, looking to transact via an insurance cell structure using Towers Watson s Longevity Direct offering (see Figure 06), which enabled them to transact with the reinsurance market. Towers Watson undertook a competitive quotation process, extracting price tension to achieve better terms. Due to the attractiveness of the pricing received the Trustee was able to increase the size of the transaction to 1.5bn with Pacific Life Re, covering all of the pensioners and dependants in the Fund, some 16,000 members. The Fund set up an incorporated cell, MNOPF IC Limited and entered into the longevity swap in December 2014. Longevity Direct led to a simplified process the direct negotiations with the reinsurance market meant that the transaction was completed in less than three months from entering exclusivity. Using this structure has saved MNOPF several million pounds on the cost of the hedging. The Fund has now hedged a significant proportion of longevity risk whilst maintaining flexibility over its assets and can continue on its journey plan. Longevity was a significant, concentrated risk for the MNOPF and, having considered the different options available, the Trustee Board decided that Towers Watson s Longevity Direct structure was the most cost effective and efficient structure. Ensign Pensions & MNOPF Chief Executive, Andy Waring 14 towerswatson.com
Releasing the prudence The increase in size of deals being written by those insurers offering medically underwritten bulk annuities supports the view that these are now becoming more main stream. The question is then, who they best apply to? Many insurers will argue that for schemes with over, say, 100m of liabilities to insure, postcode, pension amount and date of birth provide enough information for them to price, and overall the scheme membership should experience average life expectancy. Medical underwriting utilises extra information for evaluating mortality the expectation being, for most pension schemes, on average, lower pricing. The proof is that in 2013 and 2014 we saw 93% of these deal processes conclude with successful insurer selection. Partnership Choosing to insure a subsection of the pensioners has been a common approach, although choosing those with the highest pensions has been less common as these members tend to cost relatively more to insure. However, this need not necessarily be the case if a medically underwritten approach is taken. This approach, known as top slicing can lead to significant price savings in respect of those members with higher pensions, where the insurer would otherwise price very prudently. We are seeing an increasing number of requests in both the top slicing and all pensioner/full scheme transactions and we expect this to continue. Just Retirement De-risking report 2015 The evolving bulk annuity and longevity swap markets 15
More efficient bulk annuities Over the last few years, the approach to buy-ins, and to a lesser extent buyouts, has become much more standardised. This has allowed schemes to benefit from streamlined selection and implementation processes, reducing the time before the financial risks are secured (see Figure 07). Towers Watson s streamlined bulk annuity process can help with this by using pre agreed legal contracts, the selection and implementation process could take as little as three months. Figure 07. Buy-in completion timeline Agree objectives. Data and benefit specification prepared. Issue request for quotation to provider market. Respond to queries. Consider initial quotations. Move to shortlist. Beauty parade for shortlisted providers. Enter exclusivity with one provider. Agree contractual terms. Final advice issued. Transaction completes. 2weeks 6weeks 1week 1week 2weeks Complete Effective monitoring of bulk annuity pricing can also help to ensure scheme s achieve the best deal possible. Towers Watson s Settlement Watch monitors insurer pricing on a monthly basis, including pricing information from four providers, overlaid by the pricing we observe in the market. The buy-in module in Asset Liability Suite can then track buy-in pricing relative to a scheme s liabilities and assets on a daily basis to identify opportunities (see Figure 08). Figure 08. Asset Liability Suite In our experience, timing is the number one reason why transactions don t occur. Efficient transactions now take less than three months to get to a position to transact, giving all parties the best chance to benefit from favourable financial conditions. Aviva 16 towerswatson.com
Conclusion So what do all of these developments mean for the market in 2015? Whilst 2014 was a record breaking year, nearly 50% of the liabilities hedged were in respect of one transaction for the BT Pension Scheme. Unless there is another very large deal, the overall level of activity is, therefore, likely to fall in 2015. However, the pension scheme de-risking market certainly continues to grow at a pace. We predict that there will be more transactions in 2015 than in 2014, and we are likely to see a significant growth relative to 2013, which was the next busiest year. This is supported by the appetite of the providers both insurers and reinsurers who spent the second half of 2014 building their teams for higher volumes of business. With many schemes now a number of years into their journey plans, managing longevity risk in some way either through a pensioner buy-in or a longevity swap is likely to be front of mind for many trustees and sponsors. If pricing improves over the first half of 2015, or there is a rise in equity markets, we could see unprecedented demand from pension schemes; providers may have to pick and choose where they can quote. Will your scheme play a part in the market in 2015? For scheme sponsors and trustees who want to do a deal this year, now is the time to start the ball rolling. If pricing improves over the first half of 2015, or there is a rise in equity markets, we could see unprecedented demand from pension schemes; providers may have to pick and choose where they can quote. De-risking report 2015 The evolving bulk annuity and longevity swap markets 17
Further information If you would like to discuss your next steps in this area or you have particular interest in any of the comments made in this report, please contact your Towers Watson consultant or any of the following risk transfer specialists: Ian Aley +44 20 7170 2692 ian.aley@towerswatson.com Keith Ashton +44 1737 274629 keith.ashton@towerswatson.com 18 towerswatson.com
Will your scheme play a part in the market in 2015? For scheme sponsors and trustees who want to do a deal this year, now is the time to start the ball rolling. De-risking report 2015 The evolving bulk annuity and longevity swap markets 19
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