State Street’s Martin Higgs explains how the company’s integrated derivatives service model supports UK pension schemes entering into longevity hedging transactions.
Clients
UK pension fund clients entering into longevity hedging transactions and removing risk through bespoke buy-in deals.
Background
In 2010, State Street was asked to provide derivative-related support services for a large FTSE 100 UK pension scheme that had entered into a complex transaction to manage longevity risk. The trustees of the pension scheme required a third party to provide an independent valuation and collateral management service through the valuation of a series of cash flows together with the collateralisation of different categories of assets and cash flows. These services, part of State Street’s broader end-to-end derivatives offering, formed the basis of our solution for these pension schemes.
Around the world, life expectancy is continuing to rise and risk is being seen as a growing problem for pension schemes and their sponsors. Growing numbers of schemes are therefore looking to reduce some of these risks through the use of buy-out and buy-in deals. Depending on how they are structured, such deals can remove longevity, inflation and interest rate risks while keeping the assets under the scheme’s control.
One option for pension schemes is the buy-out, whereby the insurance provider effectively takes over the administration of the pension scheme and all assets are transferred to the provider. This option may be acceptable for smaller schemes looking to transfer the scheme’s full liabilities, but may not be appropriate for larger schemes that wish to retain control of the assets and liabilities themselves.
The second option is the buy-in, whereby the pension scheme purchases a form of bulk annuity contract or longevity swap. While there are various forms of
buy-in structures, in all cases the pension scheme trustees remain responsible for the scheme’s liabilities.
One form of this option is the bespoke buy-in, in which the pension scheme purchases inflation, interest rate and longevity swaps. Bespoke buy-in structures can vary, but their basic premise is that the insurance provider agrees to make all payments due to the specified scheme members. In return, the pension scheme makes a series of payments back to the insurance provider. Since this exchange of cash flows creates counterparty risk, just like any other derivative transaction, a collateral agreement usually under an ISDA credit support annex is required. The pension scheme has to pay a fee for the deal, usually over a set period or the life of the transaction, which also creates an exposure for the insurance provider to the scheme.
The solution
To support the needs of the new client, State Street brought its specialist derivatives valuation and collateral management teams together with its client service team to create an integrated solution for the new client.
The first requirement was to provide a secondary but independent valuation of the cash flows. These cash flows, which are based on the current expected payments due to be paid to the scheme members can be calculated using probability-based (stochastic) models of mortality rates as well as more standard deterministic models. The stochastic model enables the best estimate of the cash flows and the related longevity risk to be calculated.
Using the best estimate cash flow, as calculated above, the insurance provider forecasts the cash flows based on both increased and decreased mortality rates as well as the fixed cash flows. A further set of cash flows are adjusted in line with the actual mortality rates the scheme experiences. Each of the individual monthly cash flows are then further split into separate inflation groups that are capped at 2.5 percent, 3 percent and 5 percent and then discounted back based on a standard discount curve. This process results in around 12,500 to 15,000 separate cash amounts that need to be independently valued each day. Furthermore, some of these cash amounts are updated on a monthly basis.
The second requirement was to act as the scheme’s administrator for the provision of collateral management services. This required the collateral team to undertake the daily collateral management services for the scheme and to receive the daily statement from the insurance provider. Working closely with the pension scheme and its investment consultants, State Street agreed to provide a bespoke set of services to match the scheme’s requirements.
On a daily basis State Street inflates each of the cash amounts using standard inflation curves, and discounts them to produce separate valuation vectors. These vectors are then used to produce the net present value of the cash flows and the amount of collateral to be paid by either party. State Street also values any collateral already delivered. Each day the insurance provider sends a collateral statement showing its collateral calculations and the amount of collateral that may be required. State Street compares the insurance provider’s calculations and instructs the movement of any collateral as necessary. On a monthly basis, State Street receives a new set of cash amounts to be used for the next month’s calculations. Additionally, State Street has to provide independent verification of several other inputs to the calculation such as the credibility and experience factors, all of which are used in the overall valuation process. Finally, State Street has to monitor the amount of collateral being held in relation to the fee leg, to ensure that the insurance provider’s exposure to the client in relation to the unpaid fee is fully collateralised.
Benefit to the client
By bringing together State Street’s specialist derivatives valuation and collateral management teams, this model provides the client with a fully independent monitoring service for this complex transaction and a fully outsourced model for valuation and collateral services. The pension scheme trustees receive daily reports showing the valuations and collateral being held in the different accounts thereby meeting their needs around oversight. Additionally, they benefit from State Street’s ability to provide an integrated solution for a complex transaction, enabling them to focus on their key objective.
Global investor / ISF OTC Derivatives Supplement September, 2011
