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The Ultimate Pension Plan?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
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.
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These type of deals are overhyped. The only reason a company does them is because they can be done at virtually zero cost (like any swap they start with zero value) but get big headlines. So for a small investment (say putting up 5% collateral) they get headlines saying they have "hedged" £3bn worth of liabilities. The amount of risk reduction this actually achieves is pretty minimal given that these schemes still invest significantly in equities.
I guess the ultimate hedge here is to enter into agreement with a sufficient number of BMW pensioners who, in exchange for a small increase in their current pension payments, agree to off themselves should the longevity bet on the pensioners as a whole go the wrong way.
Ultimate pension plan = personal savings you pension bitches.
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 one. 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.
the comment from the reinsurer in the economist post above shows you the other side. pensions are short, need to buy. insurers/reinsurers are long, need to sell. banks stand in the middle. Banks arent managing that risk for the pension fund. And in a long-only FI portfolio, how does a pension fund effectively manage longevity? Yes that is their job, but being long-only leaves you with one option, more duration.
Neophiliac, excellent comment, many thanks.
Why would these older manufacturing companies (that have decent future outlooks) not just incorporate a new entity with no pre-existing liabilities and sell the assets of the old company to the new company (over time or all at once) and start fresh with no legacy obligations?
The idea being that the old company would have zero assets to seize during the impending bankruptcy that would be brought upon by exploding pension liabilities--while the new company can operate unfettered by prior obligations.
For example, BMW (Bavarian Motor Works) could incorporate UMW (Unconscionable Motor Works) and then transfer (potentially tax free) their assets (in whole or in part) like PP&E, IP, etc. down to the newly formed entity and start with a clean (but not guilt-free) slate. Alternatively, a private equity fund could buy (see: cherry pick) these assets directly and drop them into their own new entity. Then the fund could pluck the old management team from the old company and also drop them into the new entity, leaving the old company and their creditors and pensioners twisting in the wind.
Besides being totally immoral--because the company would be sidestepping their pension promises--what would keep many of these potentially insolvent companies from doing this?
As a side note: This 'asset sale' would not work with governments (because they would be unable to set up a new shop).
Also, do you think the fact that many of these companies are buying pension liability insurance is more of a short-term smokescreen, so they can proceed under-the-radar with the asset sale strategy mentioned above? Or do you believe the majority of corporate managers are willing to come through on thier pension promises (despite immeasurable difficulty) and that this pension insurance is purchased in good faith and a genuine sign of long-term comittment to its retirees?
Unfortunately side stepping the pension liabilities as you suggest is illegal in the UK and there are various laws designed to specifically catch this type of activity.
Of course, the first horrible thought I have is how ridiculously underfunded with wrong longevity assumptions our state and local government pensions are. It's not bad enough that they're going to assume 8% returns to infinity, but where are the longevity assumptions? Seems like an easy way to fudge the numbers.
FYI there is an upper limit to Vit D intake.
Although a lot can be produced from the skins sun exposure, there is a feedback loop that attenuates the production of vit D after a set amount. Your body will only make so much per week.
Not sure what the actual number is, but don't go crazy on it. I'm doing 8000UI/day, but that already maybe high.
Also, with blood work they found individual differences. For whatever reason some people needed more than others. No known reason yet.
vv111y
OT: This absolutely false. There is a doctor in Toronto who has proven that intakes up to 25,000 or even 40,000 IUs are safe. Direct MS funded a study which will be published in the prestigious journal Neurology showing vitamin D intakes up to 15,000 IUs daily are perfectly safe. Asthon takes 12,000 IUs per day and so do his sons (10 vitamin D drops + 2 g of cod live oil which contains D). I've been taking 5,000 IUs daily for over 10 years with zero side effects. I am now going to swtich to the vitamin D drops, which are more readily absorbed. The harder part of the diet is to go gluten free, which means no bread or pasta whatsoever. I try not to touch dairy products and have not drank milk in years, but giving up bread and pasta is harder.
Nah.......................
Grow it, hunt it, cook it, eat it.
There is nowhere in the book that says hubble-bubble it.
Wow, can I have my extra 15 years on the planet guaranteed by Lehman's?
The counterparty in the transaction may decide that you should only live for 5...................
how does a longevity swap work ?
The Economist had an article on this market in early Feb., Live long and prosper. Note the conclusion:
The market remains relatively small and it isn't clear how it will develop. Hedging longevity risk present sits own sets of challenges. Also, this Mercer article discusses counter-party risk:
Keep in mind what I wrote above, longevity swaps are not the magic pension pill.
It works like this "I'll gladly pay you tuesday for a hamburger today" think Goldman and Greece. Another company and their management with fingers in the pie, is supposed to ADD something?
leo, how they hedge/price longevity swaps?
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