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04/18/23Strategic 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
Lia
bili
ties
Lo
ng
evit
y
Eq
uit
y
Cre
dit
Alt
ern
ativ
es
Div
ersi
fica
tio
n
To
tal
£ m
illio
n
LIABILITY EXPOSURES
Unrewarded (no risk premium)
ASSET RETURN RISKS
Rewarded
Surplus/Deficit Progression
-400
-300
-200
-100
0
100
200
300
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Year
Surp
lus/D
efici
t (£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 - 4
5 - 910 - 1415 - 1920 - 24
25 - 2930 - 3435 - 3940 - 4445 - 4950 - 5455 - 5960 - 6465 - 69
70 - 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
0
200
400
600
800
1000
1200
1400
1600
1800
2000
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Rea
l S
&P
500
Pri
ce I
nd
ex
24
25
26
27
28
29
30
31
32
33
34
Perc
enta
ge
of
40-
64
Po
pu
lati
on
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
/01
/19
86
01
/01
/19
87
01
/01
/19
88
01
/01
/19
89
01
/01
/19
90
01
/01
/19
91
01
/01
/19
92
01
/01
/19
93
01
/01
/19
94
01
/01
/19
95
01
/01
/19
96
01
/01
/19
97
01
/01
/19
98
01
/01
/19
99
01
/01
/20
00
01
/01
/20
01
01
/01
/20
02
01
/01
/20
03
01
/01
/20
04
01
/01
/20
05
Pe
rce
nt 2.5 Year
5 Year
10 Year
20 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)
2012…2012…
04/18/23Strategic Asset Allocation19
Date Fund ProviderApprox size
Solution
February 2013 BAE Systems Legal & General £3.2bn Pensioner bespoke longevity swap
December 2012 LV= Swiss Re £800mPensioner and all members over age 55
May 2012 Akzo Nobel Swiss Re £1.4bn Pensioner bespoke longevity swap
January 2012 Pilkington Legal & General £1bn Pensioner bespoke longevity swap
December 2011 British AirwaysGoldman Sachs / Rothesay Life
£1.3bn Pensioner bespoke longevity swap
November 2011 Rolls-Royce Deutsche Bank £3bn Pensioner bespoke longevity swap
August 2011 ITV Credit Suisse £1.7bn Pensioner bespoke longevity swap
February 2011 Pall J P Morgan £70mNon-pensioners index based longevity hedge
July 2010 British AirwaysGoldman Sachs / Rothesay Lif
£1.3bnSynthetic buy-in (longevity swap plus asset swap)
February 2010 BMWAbbey Life / Deutsche Bank
£3bn Pensioner bespoke longevity swap
November 2009 Royal Berkshire Swiss Re £1bn Pensioner bespoke longevity swap
July 2009 RSA Insurance GroupGoldman Sachs / Rothesay Life
£1.9bnSynthetic buy-in (longevity swap plus asset swap)
May 2009 Babcock Credit Suisse £1.5bnPensioner bespoke longevity swap (three schemes)
04/18/23Strategic Asset Allocation20
Here’s a useful list of other major UK longevity risk transfer transactions to date:
04/18/23Strategic Asset Allocation21
04/18/23Strategic Asset Allocation22
23
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
24
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
25
Mortality improvements over time
04/18/23Strategic Asset Allocation26
04/18/23Strategic Asset Allocation27
28
What is longevity risk?What is longevity risk?(Broken limits to life expectancy – Oeppen & Vaupel)(Broken limits to life expectancy – Oeppen & Vaupel)
30
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
31
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
32
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
33
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
34
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
35
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
36
Reinsurers (eg Swiss Re) have stopped reinsuring
longevity risk of life offices!
Significant concern!
37
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
38
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
39
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
40
BNP Paribas Longevity Bond
Mortality swap
Floating S(t)
BNP
Interest-rate swap
Issue price
Issue price
EIB
Bond holders
Partner Re
41
42
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
43
Longevity Bond Annuity
Partial 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 yearsCovers the full term of the
liability
Only level pensions matchedDifferent annuities can be
used to match non - level pensions
44
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
45
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
47
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
48
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
49
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
50
2005-06– Started in SE Asia– H5N1 virus – Closely related to 1918 Spanish virus
Influenza pandemics
51
$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
52
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
53
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
Exh
aust
ion
poin
t
Capital erosion
54
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
55
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
58
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
59
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
60
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
61
Government:– Securitising social security budget
Corporates long longevity risk:– Pharamceuticals
Supply side of market
62
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
63
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
64
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
65
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
66
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
67
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 MIP
r r r= + + +
+ + +
68
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 MIP
r r r= + + +
+ + +
69
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
70
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
71
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
72
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
73
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
74
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
75
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
76
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
77
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
78
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
79
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
80
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
81
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
82
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
83
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
