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04/19/231
Demography, Capital Markets Demography, Capital Markets and Pension Risk Managementand Pension Risk Management
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
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
7
Mortality improvements over time
04/19/23Strategic Asset Allocation8
04/19/239
10
What is longevity risk?What is longevity risk?(Broken limits to life expectancy – Oeppen & Vaupel)(Broken limits to life expectancy – Oeppen & Vaupel)
12
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
13
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”
14
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
15
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
16
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”
17
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
18
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
19
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
20
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
21
Survivor Products: Survivor Products: Managing longevity risk & Managing longevity risk & mortality improvementsmortality improvements
22
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…
04/19/23Strategic Asset Allocation23
04/19/2324
25
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
26
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
27
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
28
Reinsurers (eg Swiss Re) have stopped reinsuring
longevity risk of life offices!
Significant concern!
29
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
30
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
31
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
32
BNP Paribas Longevity Bond
Mortality swap
Floating S(t)
BNP
Interest-rate swap
Issue price
Issue price
EIB
Bond holders
Partner Re
33
34
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
35
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
36
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
38
$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
39
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
40
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
41
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
42
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
43
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
44
Government:– Securitising social security budget
Corporates long longevity risk:– Pharamceuticals
Supply side of market
45
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
46
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
47
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