05/03/23Strategic Asset Allocation1

Demography, Capital Markets Demography, Capital Markets and Pension Risk Managementand Pension Risk Managementsessionsession 2 2

Andrei Simonov

Analysing pension riskAnalysing pension riskIllustrative example

-300

-200

-100

0

100

200

300

Liab

ilitie

s

Long

evity

Equi

ty

Cre

dit

Alte

rnat

ives

Div

ersi

ficat

ion

Tota

l

£ m

illio

n

LIABILITY EXPOSURES

Unrewarded (no risk premium)

ASSET RETURN RISKS

Rewarded

Surplus/Deficit Progression

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0

100

200

300

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Year

Surp

lus/Def

icit

(£m

)

5% Percentile 25% Percentile 50% Percentile 75% Percentile 95% Percentile

1 in 20 chance that deficit is at least £Xm higher than expected

Y% probability of being at least 100% funded in 10 years time

Longevity hedging should be considered alongside other risk mitigation techniques using risk return framework

3

Demographic factors at workDemographic factors at work Increasing longevity

Lower fertility

Retirement of Baby Boom

4

From pyramids to columnsFrom pyramids to columns

0 - 45 - 9

10 - 1415 - 1920 - 2425 - 2930 - 3435 - 3940 - 4445 - 4950 - 5455 - 5960 - 6465 - 6970 - 7475 - 7980 - 8485 - 8990 - 9495 - 99100 +

Age Group

B

A A

B

A

B

5

People over SPA to those aged People over SPA to those aged 20 – SPA*20 – SPA*

0

0.1

0.2

0.3

0.4

0.5

0.6

2006 2020 2030 2040 2050 2060 2070

* SPA: State Pension Age

With SPA fixed at 65

With SPA rising proportionally (to 68.5 in 2050 and 70.2 in 2070)1

(1) This proportionate adjustment maintains the proportion of life over 20 years old which is spent in retirement at 27.5%

6

Lower fertility – The inherent Lower fertility – The inherent challenge to pension systemschallenge to pension systems

Increased ratio of pensioners to contributors

Savers of generation 1 have to sell accumulated assets to “smaller”* generation 2

Transitional asset price fall effect

K/L rises: return on capital falls

Lower pensions relative to average earnings

Increase Pension Age more than proportionally with life expectancy

Higher contribution rates

PAYG

Funded

* Smaller can mean either absolutely smaller than G1 (if fertility 2.0) or “smaller than would be the case if fertility had not fallen”

7

Possible de facto demographic effects on Possible de facto demographic effects on funded systems and capital marketsfunded systems and capital markets

Transitional asset price fall effect (at sale)

K/L rises: return on capital falls

Transitional asset price rise effect

Longer-term effect; K/L rises, return on capital falls

Not inherent but could occur if future pensioners do not adjust retirement ages but instead increase savings rate

Inherent effect of shift to lower fertility

Lower Fertility

Increased Longevity

8

Demographic impacts on Demographic impacts on returns to capital returns to capital

Garry Young: Baby-boom generation -0.1%Increased longevity -0.1%Falling fertility -0.3%

David Miles: Given future actual trends in UK demographics, returns fall:

4.56% (1990) to 4.22% (2030) 4.56% (1990) to 3.97% (2060) if PAYG

phased out

Model Results

9

Real S&P500 price index and % of 40-64 Real S&P500 price index and % of 40-64 year olds among total U.S population year olds among total U.S population 1950-20031950-2003

Source:: Poterba (2004), with additional data to 2006

0200

400600

8001000

12001400

16001800

2000

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Real

S&P

500

Pric

e In

dex

2425

2627

2829

3031

3233

34

Perc

enta

ge o

f 40-

64 P

opul

atio

n

Real S&P500 (LHS) 40-64 population/ total population (RHS)

Forecast

10

Theoretical & empirical approaches Theoretical & empirical approaches to measuring demographic effectsto measuring demographic effects

“Given the limited amount of time series on returns and

demographic variation, and the difficulty of controlling for all

of the other factors that may affect asset values and asset

returns, the theoretical models should be accorded substantial

weight in evaluating the potential impact of demographic

shifts”

Poterba: “The Impact of Population Ageing on Financial Markets”

11

Global glut of savings Global glut of savings hypothesishypothesis

• Fewer children enable higher savings rate

• Awareness of greater longevity, fewer children and lack of social welfare net, require a high savings rate

Global glut of savings relative to investment

Long-term, not just cyclical, fall in real interest rates

In China and other East Asian countries

Developed countries save more to cope with their demographic/pension challenges

Transitional positive asset price effects

12

Real yields to maturity on UK Real yields to maturity on UK index-linked giltsindex-linked gilts

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

01/0

1/19

86

01/0

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87

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1/19

88

01/0

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89

01/0

1/19

90

01/0

1/19

91

01/0

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92

01/0

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93

01/0

1/19

94

01/0

1/19

95

01/0

1/19

96

01/0

1/19

97

01/0

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98

01/0

1/19

99

01/0

1/20

00

01/0

1/20

01

01/0

1/20

02

01/0

1/20

03

01/0

1/20

04

01/0

1/20

05

Per

cent

2.5 Year5 Year10 Year20 Year

1986 – 2004

13

UK Long-term real interest UK Long-term real interest ratesrates

Source: Morgan Stanley Research

-7%

-5%

-3%

-1%

1%

3%

5%

7%

9%

11%

1700 1716 1732 1748 1764 1780 1796 1812 1828 1844 1860 1876 1892 1908 1924 1940 1956 1972 1988 2004

Real interest rate

Long-term average (1700-2004)

Estimate for 2005

Estimate for 2005, as of 02 March 2005

14

Whole world gross savings rateWhole world gross savings rate1981 - 2005

Source: IMF World Economic Outlook database

15

20

25

1981 1986 1991 1996 2001 2006

15

Gross savings rates: developing Gross savings rates: developing Asia and the US % of GDPAsia and the US % of GDP

1981 - 2005

Source: IMF World Economic Outlook database

USA

DevelopingAsia

5

10

15

20

25

30

35

40

1981 1985 1989 1993 1997 2001 2005

16

Demographic challenges to Demographic challenges to funded pension systems funded pension systems

Increasing longevity

• Lower fertility

• Uncertainty of longevity forecasts

Not inherent problem but possible de facto

Overwhelmed in short-term by globalisation effect

17

Survivor Products: Survivor Products: Managing longevity risk & Managing longevity risk & mortality improvementsmortality improvements

18

Current Forces Affecting the Size and Current Forces Affecting the Size and Ownership of Longevity RiskOwnership of Longevity Risk

The Mosaic Today

Retirement population growing

Longevity risk moving from corporates to individuals

Cost of longevity significant and rising

Inflation could exacerbate longevity costs

Longevity extending

Credit Crunch moving longevity risk arguably to Government

The UK population of retirees (i.e. people 65+) is set to increase by 60% by 2032 from 10 million to 16 million due mainly to the ageing of the baby boom generation

Longevity continues to increase for retirees at historically high rates against largely fixed retirement / entitlement dates

The current cost of life extension in the UK is estimated at £12.5 to £24.7 billion per year

Current fiscal and monetary policy may be sowing the seeds of high inflation and expectations of inflation

Strong forces are causing corporates to close existing Defined Benefit (DB) schemes and transition to Defined Contribution / Personal Account schemes

The Credit Crunch is causing a significant increase in DB pensioner risk to move to the Pension Protection Fund (PPF)

Source:Pension Corporation LLP. . 19

Moving Longevity Risk:Moving Longevity Risk:Recent Transactions (Europe)Recent Transactions (Europe)

Date Risk Owner Size (GBP millions)

Type of Longevity

RiskRisk Recipient

January 2008 Lucida Not disclosed Life annuitants Capital markets investors

July 2008 Canada Life £500 Life annuitants Capital markets investors

February 2009 Abbey Life £1,500 Life annuitants Reinsurers

March 2009 Aviva £475 Life annuitantsReinsurers and capital markets

investors

June 2009 Babcock International £500 – £750 Pensioners Reinsurers

July 2009 RSA £1,900 Pensioners Pension insurer and reinsurers

September 2009 (announcement)

Royal County of Berkshire [£500 – £750] Pensioners [Pension insurer]

Total (Jan 08 – Sep 09) £5,375 – £5,875

20

Nothing is certain in life except death and taxes (B Franklin).

Over last 20 years, it has become clear that, while death is no less inevitable than before:– it is getting later– and its timing has become increasingly uncertain.

The problem

21

When British welfare state began in 1948, men could draw their state pension at 65 and expect to live until 67 and only a few lived beyond 70.

At beginning of 21st Century, British men can still draw their pension from age 65 but now live into their early 80s.

Significant proportion of women living into their late 80s.

The problem

22

Mortality improvements over time

23

What is longevity risk?What is longevity risk?(Broken limits to life expectancy – Oeppen & Vaupel)(Broken limits to life expectancy – Oeppen & Vaupel)

25

Evident for many years that mortality rates have been evolving in apparently stochastic fashion.

Sequences do exhibit general trend, but changes have an unpredictable element:– not only from one period to next – but also over the long run.

Stochastic nature of mortality improvements

26

Large number of products in life insurance and pensions have mortality as key source of risk.

Products exposed to unanticipated changes over time in mortality rates of relevant reference populations.

Eg annuity providers exposed to risk that mortality rates of pensioners will fall at faster rate than accounted for in pricing and reserving calculations:– Current pool of annuitants living 2 years longer than

anticipated

Longevity risk

27

Annuities are commoditised products selling on basis of price, profit margins have to be kept low in order to gain market share.

If mortality assumption built into price of annuities turn out to be gross overestimate, cuts straight into profit margins of annuity providers.

Most life companies claim to lose money on annuity business.

Longevity risk

28

Yet life annuities are mainstay of pension plans throughout the world: – they are the only instrument ever devised capable

of hedging longevity risk. Without them, pension plans will be unable to

perform their fundamental task of protecting retirees from outliving their resources for however long they live.

Real danger that they might disappear from financial scene.

Longevity risk

29

Equitable Life:Embedded options in annuity contracts

became very valuable in 1990's due to combination of falling interest rates and improvements in mortality.

Problems avoided if EL could hedge exposures to:– interest-rate risk– mortality improvement risk.

Longevity risk

30

Longevity risk in UK pension Longevity risk in UK pension provision, £billion of total liabilities- provision, £billion of total liabilities- broad estimates: end 2003broad estimates: end 2003

Figure 5.17 p181

31

Reinsurers (eg Swiss Re) have stopped reinsuring

longevity risk of life offices!

Significant concern!

32

Long-dated survivor bonds:Life annuity bond: coupon payments decline

in line with mortality index:– Eg based on population of 65-year olds on issue

date. As population cohort dies out, coupon

payments decline, but continue in payment until the entire cohort dies.

Eg, if after one year 1.5% of population has died out, 2nd year’s coupon payment is 98.5% of 1st year’s etc

Survivor Products

33

Bond holder, eg life office writing annuities, protected from aggregate mortality risk it faces.

Based on Tontine Bonds issued by European governments in 17th and 18th centuries

Recently revived by Blake and Burrows (2001) and Lin and Cox (2004).

Survivor Products

34

November 2004Issuer: European Investment Bank (AAA)Issue: £540m, 25 year Mortality index: 65 year-old males from

England & Wales (ONS)Structurer/manager: BNP Paribas (assumes

longevity risk)Reinsurer of longevity risk: PartnerRe, BermudaInvestors: UK pension funds

BNP Paribas Longevity Bond

35

BNP Paribas Longevity Bond

Mortality swap

Floating S(t)

BNP

Interest-rate swap

Issue price

Issue price

EIB

Bond holders

Partner Re

36

37

Provides better match for liabilities of pension funds and life insurers than other available investments:– other than purchasing (re)insurance to cover the

longevity risk (i.e annuities)Bond also provides long term interest rate

hedge. Longevity index transparentEIB has AAA credit rating. Life insurers holding longevity bond as hedge

may be able to hold lower prudential margins.

Advantages of longevity bond

38

Longevity Bond AnnuityPartial hedging of the

longevity risk Full hedging of longevity risk

Low credit risk of EIB (rated AAA)

Higher credit risk of the insurer but there is additional protection through the government compensation scheme

Fixed term of 25 years Covers the full term of the liability

Only level pensions matchedDifferent annuities can be

used to match non - level pensions

39

Short-dated, mortality-linked securities:

Market-traded securities whose payments are linked to mortality index

Similar to catastrophe bonds (Schmock, 1999, Lane, 2000, Wang, 2002, and Muermann, 2004)

Survivor Products

40

Designed to securitise Swiss Re’s own holding of mortality risk!

3-year contract (matures 1 Jan 2007) which allows issuer to reduce exposure to catastrophic mortality events:– severe outbreak of influenza– major terrorist attack (WMD)– natural catastrophe.

Mortality index (MI):– US (70%), UK (15%), France (7.5%), Italy (5%), Switzerland

(2.5%).– Male (65%), Female (35%)– Also age bands

Swiss Re Bond 2003

42

All resulted from avian flu virus mutating with human flu virus

11 outbreaks in 300 years 1580

– First confirmed flu pandemic 1782

– Summer Flu– Started in China – Hit young adults

1889– Russian Flu– Over 20% of world population infected– 1m deaths

Influenza pandemics

43

1918-19– Spanish Flu– Started in Kansas– Killed 50m people worldwide:

250,000 in UK– More than died in WW1, in shorter period– 20% of world’s population infected and 1% killed– Spread along trade routes and shipping lines

Influenza pandemics

44

1957-58– Asian Flu– 2m deaths– Hit teenagers hardest– Spread around world in 6 months

1968-69– Hong Kong Flu– Started in China– 1m deaths– Spread slowly with moderate symptons

Influenza pandemics

45

2005-06– Started in SE Asia– H5N1 virus – Closely related to 1918 Spanish virus

Influenza pandemics

46

$400m, principal at risk ‘if, during any single calendar year, combined mortality index exceeds 130% of baseline 2002 level’.

Principal exhausted if index exceeds 150%Equivalent to a call option spread on the

index with:– Lower strike price of 130%– Upper strike price of 150%

Investors get quarterly coupons of 3-mo USD Libor + 135bp

Swiss Re Bond 2003

47

Swiss Re Bond 2003

Swiss Re Bond holders SPV (Vita Capital)

Check terminal mortality

index value

Up to $400m if extreme mortality is not experienced

Up to $400m if extreme mortality is experienced

Annual coupons (USD LIBOR + 135bps)

Principal payment $400m

Off balance sheet

48

Swiss Re Bond 2003

100% - 90% -

70% - 60% - 50% - 40% - 30% - 20% - 10% - 0% -

80% -

1 1.05 1.1 1.15 1.2 1.25 1.3 1.35 1.4 1.45 1.5 1.55 1.6

Mortality Index Level (q)

Prin

cipa

l Rep

aym

ent (

%)

Atta

chm

ent p

oint

Exha

ustio

n po

int

Capital erosion

49

Bond valued using Extreme Value Theory (Beelders & Colarossi (2004))

Assume Generalised Pareto DistributionProbability of attachment:

– P[MI(t)>1.3MI(2002)] = 0.31%Probability of exhaustion:

– P[MI(t)>1.5MI(2002)] = 0.15%Expected loss = 22bp < 135bpA good deal for investors!Bond trading at Libor + 100bp in June 2004

Swiss Re Bond 2003

50

Survivor swaps:Counterparties swap fixed series of payments

in return for series of payments linked to number of survivors in given cohort:– UK annuity provider could swap cash flows based

on UK mortality index for cash flows based on US mortality index from a US annuity provider counterparty

– Would enable both counterparties to diversify their longevity risks internationally.

Dowd et al (2004)

Survivor Products

53

Annuity futures:Prices linked to specified future market

annuity rate

Mortality options:Payout depends on underlying mortality table

at payment date.Eg, EL guaranteed annuity contract

Survivor Products

54

Reference population underlying calculation of mortality rates central to both:– Viability– Liquidity of contracts.

Hedging demand from investors (eg life offices) wishing to hedge mortality exposures.

If reference population v different from investor’s specific population, then investor will be exposed to significant basis risk:– Might conclude that mortality derivative is not

worth holding.

Demand side of market

55

Speculative demand: – depends on liquidity.

Adequate liquidity will require small number of reference populations:– Need to be chosen carefully to ensure that level of

basis risk is small for investors with hedging demands.

Demand from hedge funds:– seeking instruments that have low correlation with

existing financial instruments

Demand side of market

56

Government:– Securitising social security budget

Corporates long longevity risk:– Pharamceuticals

Supply side of market

57

After more than year, BNP Paribas longevity bond had not generated sufficient demand to be launched:– Has been withdrawn for redesign

Suggests significant barriers need to be overcome before sustainable market in survivor products and derivatives emerges.

Barriers to development in cash market

58

Reasons why BNP bond did not launch:

– design issueswhich make bond an imperfect hedge for longevity

risk

– pricing issues

– institutional issues

Barriers to development in cash market

59

Small scheme will find it difficult to use bond to match its liabilities:– as variance between actual and expected mortality will

be quite large. Mortality experience of individual pension funds

and life insurers may be different from reference UK population.

Bond only provides hedge for longevity of males:– pension funds and life insurers also exposed to

significant longevity risk from females.

Design issues

60

Liabilities for pension funds and life insurers give greater weight to the lives receiving larger pensions.

Further, significant differences in mortality of those receiving larger pensions compared to those receiving lower pensions.

As payments under bond effectively give equal weight to all the lives in the UK population, the already imperfect hedge provided by the longevity bond is worsened.

Design issues

61

Bond only matches cashflow under level pension – while large portion of pensions paid by pension

funds and life insurers will be increasing at RPI/LPI/CPI.

Bond is progressively worse hedge for pension liabilities related to younger or older cohorts.

Design issues

62

Need to forecast mortality index MI’sNeed to estimate r’sCorrelation between MI and r:

– Anticipated to be low

Pricing issues

31 22 3

1 2 3

.. .(1 ) (1 ) (1 )

d MId MI d MIPr r r

= + + ++ + +

63

Above model valid only in complete marketIn incomplete market, need to convert

projected deterministic mortality rates into risk-neutral probabilities– E.g using Wang transform– Lin & Cox (2005)

Pricing issues

31 22 3

1 2 3

.. .(1 ) (1 ) (1 )

d MId MI d MIPr r r

= + + ++ + +

64

Longevity risk premium built into initial price of bond set at 20 basis points.

Given that this is first ever bond brought to market, markets have no real feeling as to how fair this figure is.

However, concern that up-front capital was too large compared with risks being hedged by bond:– longevity and interest rate risks

leaving no capital for other risks to be hedged – e.g. inflation

Pricing issues

65

Issue size too small to create liquid market.Consultants reluctant to recommend it to

trustees.Fund managers do not currently have mandate

to manage longevity risk.Fund managers have not welcomed bond:

– since believe it would be closely held and they would not make money from it being traded.

Partner Re is unlikely to be perceived as being a natural holder of UK longevity risk.

Institutional issues

66

Last point highly significantReflects view that key determinant of future

issue of longevity bonds is availability of sufficient reinsurance capacity.

Neither UK-based nor EU-based reinsurer willing to provide cover for BNP bond

Partner Re not prepared to offer cover above issue size of £540m.

Has been questioned whether EU’s solvency requirements render reinsurance cover within EU prohibitively expensive.

Institutional issues

67

Following factors key to success of particular futures contract:

– defined as having consistently high volume of trade and open interest:

Must be large, active and liquid spot market for underlying with good price transparency:

– by far the most important factor: – indeed no futures contract has ever survived

without a spot market satisfying these conditions.

Barriers to development in futures market

68

Spot prices must be sufficiently volatile to create hedging needs and speculative interest.

Relative hedging demand can be measured by level of open interest relative to volume:

– since former excludes the many speculators who do not hold overnight positions.

Low open interest to volume ratio is an indication of high liquidity :

– another sign of successful futures contract.

Barriers to development in futures market

69

Underlying must be homogeneous and/or have well-defined grading system.

Market in underlying must not be heavily concentrated on either buy or sell side:

– since this can lead to price manipulation.

Futures contract must be effective in reducing risk.

Barriers to development in futures market

70

Liquidity costs:– bid-ask spreads– execution risk:

risk of adverse price movements before trade execution

Liquidity costs in the futures contract must not be significantly higher than those operating in any existing cross-hedge futures contract.

Barriers to development in futures market

71

CPI futures contract listed on US Coffee, Sugar and Cocoa Exchange in June 1985

Delisted in April 1987 with only 10,000 contracts traded.

Reasons for failure:– no inflation-linked securities market at the time. – underlying was infrequently published index. – no stable pricing relationship with other

instruments.

Failure of futures contracts

72

Futures contract on Treasury inflation-protected securities (TIPS) listed on Chicago Board of Trade in June 1997

Delisted before end of the year with only 22 contracts traded.

Reasons for failure:– TIPS had only started trading five months before. – Only a single 10-year TIPS outstanding. – Futures contract competed with underlying for

liquidity. – Uncertainty over fate of TIPS programme.

Failure of futures contracts

73

CME launched CPI futures contract in February 2004 which is still trading.

Reasons for survival:– Inflation-linked securities have gained acceptance amongst

investors– TIPS have evolved into recognised asset class. – Well understood pricing relationships allowing for arbitrage

possibilities between TIPS, fixed-interest Treasury bonds and CPI futures.

– US Treasury committed to long-term TIPS issuance. – CPI futures do not compete directly with but rather

complement TIPS and uses same inflation index. – Contract traded on Globex electronic trading platform:

automated two-sided price quotes from lead market maker.

Failure of futures contracts

74

Sufficiently large, active and liquid spot market in longevity bonds must be established well before any futures market started.

Mortality index behind longevity bond must be fair estimate of true mortality and have minimal time basis risk:

– CPI index suffers from same potential problems– so survival of CPI futures contract on CME suggests

these problems can be overcome.

Important lessons for development of mortality-linked futures market

75

Although mortality indices are calculated infrequently, spot prices of longevity bonds likely to exhibit high degree of volatility on account of bonds’ high duration.

Underlying mortality indices must be few in number and well-defined:

– small number of contracts helps to increase liquidity– but also leads to contemporaneous basis risk

arising from different mortality experience of population cohort covered by mortality index and cohort relevant to hedger.

Important lessons for development of mortality-linked futures market

76

Potential weak point in longevity bond market is on the supply side:

– since few natural issuers on supply side. Futures contract would be effective in reducing

aggregate risk,:– but small number of mortality indices might well leave

substantial basis risk. No reason to suppose liquidity costs in futures

contract would be any higher than for other bond futures contracts.

Important lessons for development of mortality-linked futures market

77

Existence of survivor products:

– will facilitate the development of annuities markets in the developing world

– and could well save annuities markets in the developed world from extinction.

Essential to prevent annuity providers going bust!

Conclusion

78

If survivor products fail to be issued in sufficient size:

– either the state (i.e., the next generation) is forced to bail out pensioners

– or companies withdraw from pension provision– or insurance companies stop selling annuities– or pensioners risk living in extreme poverty in

old age, having spent their accumulated assets

Conclusion