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Credit Suisse in dockyard longevity swap.

Byline: news@cpifinancial.net (Staff Writer)

The Trustee of the Devonport Royal Dockyard pension scheme has become the first to enter into a longevity swap agreement, having signed a contract with Credit Suisse. Watson Wyatt was the lead adviser on the agreement, which protects the scheme against the risk of having to pay out more because its pensioners live longer than expected.

The scheme's sponsor, Devonport Royal Dockyard Limited, is part of Babcock International Group, and Watson Wyatt is advising Babcock on how to implement a wider strategy for hedging longevity risk across the pension schemes sponsored by Group companies.

In May, Babcock told investors that it expects three of its pension schemes to hedge their exposure to longevity risk during 2009, and that these agreements would cover approximately [pounds sterling]750 million ($1.2 billion) of pension liabilities in total. The announcement means the first of these three transactions is now complete. Babcock is also looking to remove other pension risks, for example through interest rate and inflation swaps.

Steven Dicker, a senior consultant at Watson Wyatt who advised on the transaction, said, "This flagship deal heralds the launch of a new market in longevity risk. Longevity swaps have been talked about for years but, until now, there was no precedent of a satisfactory contract being drawn up. By demonstrating that the technical obstacles can be overcome, a dockyard better known for supporting the Royal Navy's battleships and submarines has boosted the armoury of trustees and employers who want to reduce pension risks."

Under the contract, the scheme will effectively swap pre-agreed monthly payments to Credit Suisse for monthly payments whose value depends on the longevity of the scheme's 4,500 retired members (who have an average age of 67) and their dependants. Steven Dicker said, "The scheme is locking in the payments that would be due if there were no swap and if its pensioners lived slightly longer than Credit Suisse expects them to. If longevity improves faster still, the swap will meet the extra cost."

Because the payments being exchanged stretch over decades, 'counterparty risk' will be high on the agenda of any trustee board contemplating a longevity hedge. A factor in choosing Credit Suisse to complete this swap was the Bank's established counterparty strength. Also, under this agreement, the party which is expected to make net payments in future will be required to post collateral under International Swaps and Derivatives Association rules.

Steven Dicker said, "The rules determining who needs to put up collateral and how much are a crucial feature of any swap contract. This is more complicated in the case of a longevity swap than with interest rate or inflation swaps. You don't just need to record which members are still alive at regular intervals - you also need an agreed method for measuring how long they are expected to live and how this has changed since the agreement was drawn up.

"Longevity hedges can also be structured as insurance policies. To evaluate the products on offer, trustees therefore need to understand derivative contracts and know what is under the bonnet of an insurer as well as swotting up on the latest developments in mortality."

Payments under the contract will be based on the mortality experience of the scheme's own pensioners and their dependants over the next 50 years but providers offer longevity hedges on a variety of terms.

"Contracts based on survival rates across a wider group could be simpler but would leave a scheme out of pocket if its pensioners' life expectancies increase faster than average. It is possible to agree longevity hedges covering younger members who have not yet retired but some providers are more nervous about taking on these risks and, because you do not know which members will exchange part of their pension for a lump sum, there is less certainty about the cash flows you need to swap. Any trustee board looking at these solutions will need to decide what price is worth paying to remove each risk," Dicker said.

Watson Wyatt is advising a number of clients on how to reduce longevity risk and expects interest will increase further now that the first deal is complete.

"Closing off longevity risk can avoid the need for an up-front cash injection from the sponsor and the sale of assets at current prices, so these solutions may prove popular in an environment where employers are cash-constrained and want investment returns to help eliminate deficits. When bulk annuities first took off, there was a limited period when pricing was particularly attractive as providers fought to establish a foothold in a market with huge potential, and the same thing could be happening here. Quotes for longevity hedges have become more competitive over the past few months and pension schemes will be conscious that early buyers could get a good deal," Dicker said.

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Publication:CPI Financial
Date:Jul 8, 2009
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