Out-Law Analysis | 24 Mar 2017 | 1:04 pm | 3 min. read
The longevity swap market, for example, has traditionally been regarded as the domain of the very largest and most sophisticated schemes. But a £50 million deal last year, covering around 90 named pensioners and future dependents, marked a significant step in the evolution of this market, and showed that longevity sways can be a viable solution for much smaller pension schemes. Pinsent Masons, the law firm behind Out-Law.com, provided legal advice to the trustees of the pension scheme.
This is of particular significance at a time when many small schemes have been struggling to find competitive pricing or meaningful engagement from insurers in the buy-in/buy-out market. Although, even with a streamlined solution in place, there will be a number of issues for trustees to get comfortable with before executing a longevity swap, the very fact that this may now be a viable option for some small schemes is a welcome sign of progress in the market.
What should trustees expect?
As you might suppose, the trustees' bargaining position in relation to a solution like this will usually be relatively modest. The trustees will essentially be offered a streamlined solution on a 'take it or leave it' basis, with no real scope to negotiate legal terms and no great incentive for the insurer to refine its pricing once it falls within a reasonable range.
However, this will not necessarily present a problem. There are various ways of testing the 'reasonableness' of the price offered. These include considering what the trustees would need to pay to hedge the longevity risk in the bulk annuity market, and considering the implied cost of holding the risk in the scheme.
On the legal side, the main commercial terms will be pre-agreed with the fronting insurer and presented to the trustees in a heads of terms. If the trustees are comfortable with this, their lawyers will need to review the full suite of legal terms. The terms are designed to include many of the checks and balances that one would expect to see in a typical, negotiated longevity swap, although there are inevitably some areas where the balance is tipped in the insurer's favour.
At this point, though, the solution will become slightly less 'streamlined'. A longevity swap is, by its very nature, a complex financial instrument, resulting in just short of 100 pages of legal terms to digest. This is an important point for trustees to be aware of: they should not mistake the 'accessibility' offered by this solution for 'simplicity'. It may therefore be appropriate for some trustee training, to help the trustees understand the features of the swap and the risks flagged by their lawyers in their legal review.
What should insurers consider?
One area where the small scheme solution differs from larger longevity swaps is counterparty exposure.
Under larger longevity swaps, the party which is 'out of the money' is required to post collateral in favour of the other, in addition to the collateral posted by the trustees in respect of the insurer's risk premium. This means that if the former party defaults, the latter can step in and take control of the collateral, therefore minimising its counterparty risk.
For smaller schemes, this is simply not viable as the cost of operating a collateral structure is likely to outweigh the benefits. Instead, the trustees and the insurer must be comfortable with the other's covenant.
For the trustees, this may involve taking some advice on the financial position of the insurer, although the primary focus should be on understanding the level of protection afforded by the insurance regulatory regime. The trustees should also appreciate that the longevity swap policy is an illiquid investment, although it does include a framework for the policy to be novated to another insurer if the trustees wish to buy-in or buy-out benefits with such an insurer in the future.
Things are a little different for the insurer. It will want a comprehensive understanding of the scheme's funding position; a termination right if the funding level deteriorates significantly; and a very clear right of recourse to the scheme's assets in respect of any amounts owed to it. If there is any ambiguity over the insurer's right of recourse, the insurer may well insist that the scheme's trust deed is amended to cater for this.
Robert Tellwright is a pensions law expert at Pinsent Masons, the law firm behind Out-Law.com.