Engineering firm caps its liabilities by hedging the risk of retirees living longer than expected

Engineering firm Babcock International has finalised a groundbreaking pensions deal to cap the risk of its retirees living longer than expected, in a move which could put pressure on other companies with big pension deficits.

The company said the deal would add to its overall costs, but would fix the amount of money needed to fund potential increases in life expectancy. Shares in the company, which has contracts with the Ministry of Defence, jumped 16% to 480p as investors welcomed the agreement to hedge £500m of life expectancy risks.

Pensions adviser Watson Wyatt said it was working on 10 similar deals covering £10bn in pension liabilities, although it said the growth of the market depended on the appetite of banks and insurers to take on the risks.

Under the deal, Babcock's pension trustees have agreed with an unnamed bank to provide details of the life expectancy of the fund's members. If they live longer than expected, the bank will pick up the extra cost of paying their retirement incomes. If they die earlier, then the bank gains from unpaid pension payments.

It is understood that Babcock has adopted more conservative mortality rates as part of the swap deal, which has increased the fund's deficit. The company, which saw revenues and profits rise 22% in the last year to £1.9bn and £147m respectively, said it had agreed with trustees to spend the next 20 years closing the shortfall in its pension fund.

Leading companies have come under increasing pressure to cap ballooning pension deficits. A collapse in stockmarket values forced the UK's 7,200 major schemes into a £240bn deficit last year until a rally last month brought the figure nearer to £180bn.

John Ball of Watson Wyatt said the risk possibility of poor investment returns remained a risk for the fund, but the significant additional risk of current pensioners living longer "was taken off the table". Babcock said it was also seeking to hedge the risk of volatile interest rates and inflation.

Martin Bird, of consultants Hewitt Associates, said retaining control of the scheme's assets was important when there was still a need to tackle pension fund deficits. "The ability to continue to invest in growth asset strategies is a key part of many scheme financing plans, and at a time when most pension schemes have significant deficits to address, a longevity only solution provides a very attractive solution," he said.

A longevity swap can be an alternative or the first step to a full pension buyout, whereby the scheme offloads all its assets and liabilities to a third party. Unlike buyouts, longevity swaps do not involve the transfer of pension assets and liabilities, and the payments are staggered.