How does a longevity swap work and why do pension funds use them?

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AcadiFi · Accepted Answer

A longevity swap transfers the risk that a group of people live longer than expected from a pension fund to a counterparty. The pension fund pays a fixed leg based on expected mortality and receives a floating leg based on actual mortality.

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**Cash Flow Mechanics**

Suppose the Meridian Public Employees Pension Fund has 50,000 retirees and enters a longevity swap with Grandview Re:

1. **Fixed Leg (Pension Pays):** Each year, Meridian pays Grandview Re an amount based on the *expected* number of surviving retirees times a fixed per-capita rate. If the actuarial table projects 48,200 survivors in Year 3, Meridian pays 48,200 x $1,200 = $57.84 million.

2. **Floating Leg (Pension Receives):** Grandview Re pays Meridian based on the *actual* number of survivors. If 48,900 are actually alive (people lived longer than expected), Grandview pays 48,900 x $1,200 = $58.68 million.

3. **Net Settlement:** Meridian receives $58.68M − $57.84M = **$840,000** net. This offsets the extra pension benefits Meridian must pay because more retirees are alive.

4. If fewer people survive than expected, Meridian makes a net payment to Grandview Re — but that's fine because Meridian's actual pension obligations are also lower.

**Who Takes the Other Side?**
- **Reinsurers** diversify longevity risk against their mortality risk (life insurance) book — if people live longer, reinsurers lose on longevity swaps but gain on fewer life insurance claims.
- **Capital markets investors** (pension risk transfer funds, ILS funds) take longevity risk as an uncorrelated alpha source.

**Key Risks:**
- Basis risk if the swap references a population index rather than the fund's actual members
- Counterparty risk over the very long tenor (20–40 years)
- Model risk in the mortality projections used to set the fixed leg

Check out our FRM community for more discussion on insurance risk transfer.

How does a longevity swap work and why do pension funds use them?

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