June 2010

LONGEVITY: an age-old problem

Life settlement funds ran into trouble in the US because longevity risks had not been properly calculated. Fiona Rintoul looks at pooled solutions for managing longevity and other pension fund risks. Life settlement funds exemplify the grislier side of longevity risk. Such funds essentially consist of life insurance policies sold to the fund by insured lives. The sooner those lives end, the better the fund will peform. Aside from any psychological angoisse this might induce in the fund manager – and the risk of creating a secondary market in hit men – these funds ran into serious trouble in the US because the longevity risks had not been properly calculated.

“All the mortality tables were based on the average population in the US,” explains Niklaus Hilti, head of insurance-linked strategies at Credit Suisse Asset Management, “but 99% of the policies had a face value of $1-5m. The lives insured were not the average life-assured population.”

Wouldn’t you just know it, those pesky HNWIs went and lived too long. No one had thought about the fact they had better health care and a healthier lifestyle than the average population. “The data were not applicable,” says Hilti. “That came as a big suprise to many participants.”

From the murky waters of life settlement has emerged the longevity market. At the moment mainly a UK phenomenon within Europe, the longevity market is based on pension funds selling portfolios of longevity risk on the capital markets.

The need to do this has become more pressing in the light of the EU’s Solvency II directive, which increased capital adequacy requirements for insurance companies. Because of the general press on capital in the markets, longevity hedging strategies looked like an attractive solution. Some pension funds have gone directly to the capital markets, while some have sold their risk to longevity funds, such as those offered by Credit Suisse.

“For investors, they are a very nice diversifying asset, says Hilti. “Other investments tend to be correlated, but longevity funds are not driven by financial markets. It’s nice to have something that is driven by mother nature.”

Global potential
At the moment, this is a young market, with only a handful of investment banks active in longevity transactions and about four asset managers providing fund-type products. But, says Stephen Foster, COO of single managed hedge funds at Credit Suisse’s asset management business, it is likely to grow over the next couple of years. “The UK will become a large market, and there is huge potential in the Netherlands and maybe Japan.”

Some countries will not support growth, however. “In Switzerland longevity is never a risk because it is possible to put up the premiums,” says Hilti.

Meanwhile, in the Netherlands, ING Investment Management has come up with another solution to the sharpening problem for defined benefit (DB) pension plans of making sure assets match liabilities: duration-matching funds. With DB plans challenged by rising longevity and by accounting changes enforced by the regulator, the market has come up with “all kinds of products that increase the duration of asset portfolios”, says Alexander van Eekelen, senior investment manager, structured products at ING Investment Management.

ING IM can create tailor-made duration-matching solutions for single clients using interest-rate swaps and as of July last year it already has a long duration-matching fund. Now it is about to launch a range of three duration-matching funds: medium, long and extra long. The funds invest in high-rated euro government bonds and have an interest rate swap overlay. The idea is that pension funds invest in a combination of the three funds in order to achieve the result they want.

“The drawback of pooled solutions is always the question of whether you can tailor enough to fulfill individual client needs,” says van Eekelen. “But analysis shows that if we tailored completely, the difference with the pooled is just a couple of basis points.”

The new range of funds will be a Dutch-based range, but, says van Eekelen, “it would be pretty easy for us to copy”. And although the analysis that backed up the funds was based on Dutch funds, van Eekelen believes that, because ING IM looked at such a big pool of pension funds, the finding would be true of international funds as well, leaving the door open for ING IM to roll these funds out in other markets.

Longevity funds and duration-matching funds are two solutions being offered to DB pension plans to deal with longevity risk and with the related (and much wider) problem of covering future liabilities. In the expanding European defined contribution (DC) pensions marketplace the situation is, of course, very different.

“When pension funds go to DC they shift the risk on to the individual,” says Foster.

Accordingly, other solutions to the issue of longevity risk are being developed in the DC marketplace, of which the most talked about at the moment are target-date funds, which have already been in place for several years in the DC-heavy US market.

These funds have their detractors, among them Damian Stancombe, head of corporate DC at Punter Southall. In March 2010, Punter Southall published a corporate DC survey of the UK market, entitled DC pensions in the UK workplace.

“Target-dated funds, popular in the US, are generating interest as a potential alternative. However, we believe that they are unsuitable for UK investors, at least in their current form,” writes Stancombe in the report. “High equity exposure and the rigidity of a fixed maturity date offer no solution to the issues of unplanned early, late or gradual retirement.”

Target-date funds have the benefit of simplicity, Stancombe told Funds Europe, and that is important because “you can’t educate people about investment”, but they do not tick the box in terms of outcome. Stancombe’s litmus test is: would you use the funds in a DB scheme?
Would you use static equity exposure until five years from retirement in a DB scheme? No, he says.

However, others feel Stancombe’s judgement is a little harsh. There was a Senate inquiry into target date funds in the US, it’s true. But, says David Hutchins, UK head of research & investment DC design at AllianceBernstein, you have to look at the history to understand why that was.

Up until 2006 the standard default in the US was cash, which was inappropriate, explains Hutchins. This was realised, and a switch was made to products with much more equity – just in time for 2008.

The stock markets fell and people got upset, but, according to Hutchins, it was more of a communication failure than a product failure.

“There is no magic solution. People saving for retirement need to take risk. People feel uncomfortable taking risk,” he says.“You can’t guarantee 10% growth per annum with no downside, but when there is a downside you do still have to communicate.” 

The proof, says Hutchins, is in the pudding. “Very few US schemes changed their investment decisions – less than 3%. About two-thirds of funds in the US remain target-date funds.”

Another important thing to remember is that many US target-date funds are ‘through-retirement’ funds and so have a higher equity component at retirement than you would typically expect to see in, for example, a UK fund.

“If you exported that to the UK, it would be a disaster,” says Hutchins. Instead, the AllianceBernstein range of ‘age-based’ funds that was rolled out in the UK in January, and  that the firm and is looking to offer across Europe, is “to retirement with a little bit of through”.

Hutchins believes the funds, which are being marketed to UK DC plans for use as the default fund, offer many advantages over the traditional approach of UK lifestyling. It’s important to get the default fund right as research shows that 80% of pension savers will fail to make an active choice and so will end up in the default fund.

“[In target-date funds] movements are made within the fund rather than trustees making the decisions,” says Hutchins. “One of the huge advantages of future proofing is that you can make changes without constantly having to go back to the members.”

Andrew Soper, head of multi-asset class solutions UK at SSgA, agrees that target-date funds are ideally suited to act as default funds. “Over time you get more certainty in a target-date approach,” he says.

Moving target
How the market develops from here will depend very much on the regulators. One matter that needs to be addressed in the UK is that what the default should be depends on age. “At the moment the UK set-up doesn’t take account of that,” says Soper.

The new UK government has also announced that annuities will go, but it remains to be seen whether this will happen. Meanwhile, it is thought likely that Nest (national employment savings trusts), low-cost pension savings schemes mainly aimed at employees in small companies, which are to be introduced in the UK in 2012, will adopt target-date funds, but, again, this is not certain.

Both on the DB and the DC side, the European pension fund market is changing fast. Providers are coming up with innovative solutions to meet pension funds’ changing needs, but, for the moment at least, it something of a moving target. ©2010 funds europe  

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