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Demography, Capital Markets and Pension Risk Management session 2

Demography, Capital Markets and Pension Risk Management session 2. Andrei Simonov. Analysing pension risk. Illustrative example. Y% probability of being at least 100% funded in 10 years time. LIABILITY EXPOSURES Unrewarded (no risk premium). ASSET RETURN RISKS Rewarded. £ million.

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Demography, Capital Markets and Pension Risk Management session 2

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  1. Demography, Capital Markets and Pension Risk Managementsession 2 Andrei Simonov Strategic Asset Allocation

  2. Analysing pension risk Illustrative example Y% probability of being at least 100% funded in 10 years time LIABILITY EXPOSURESUnrewarded (no risk premium) ASSET RETURN RISKSRewarded £ million 1 in 20 chance that deficit is at least £Xm higher than expected Longevity hedging should be considered alongside other risk mitigation techniques using risk return framework

  3. Demographic factors at work • Increasing longevity • Lower fertility • Retirement of Baby Boom

  4. Age Group 100 + B 95 - 99 90 - 94 B 85 - 89 80 - 84 75 - 79 70 - 74 A 65 - 69 A 60 - 64 55 - 59 50 - 54 45 - 49 40 - 44 35 - 39 30 - 34 25 - 29 20 - 24 15 - 19 10 - 14 5 - 9 0 - 4 From pyramids to columns B A

  5. People over SPA to those aged 20 – SPA* With SPA fixed at 65 With SPA rising proportionally (to 68.5 in 2050 and 70.2 in 2070)1 * SPA: State Pension Age (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 challenge to pension systems Lower pensions relative to average earnings Increased ratio of pensioners to contributors PAYG Higher contribution rates Increase Pension Age more than proportionally with life expectancy Transitional asset price fall effect Funded Savers of generation 1 have to sell accumulated assets to “smaller”* generation 2 K/L rises: return on capital falls * 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 funded systems and capital markets Transitional asset price fall effect (at sale) K/L rises: return on capital falls Lower Fertility Inherent effect of shift to lower fertility Not inherent but could occur if future pensioners do not adjust retirement ages but instead increase savings rate Transitional asset price rise effect Longer-term effect; K/L rises, return on capital falls Increased Longevity

  8. Demographic impacts on returns to capital Model Results • 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

  9. Real S&P500 price index and % of 40-64 year olds among total U.S population 1950-2003 Source:: Poterba (2004), with additional data to 2006

  10. Theoretical & empirical approaches to 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 hypothesis In China and other East Asian countries Global glut of savings relative to investment • Fewer children enable higher savings rate • Awareness of greater longevity, fewer children and lack of social welfare net, require a high savings rate Long-term, not just cyclical, fall in real interest rates Transitional positive asset price effects Developed countries save more to cope with their demographic/pension challenges

  12. Real yields to maturity on UK index-linked gilts 1986 – 2004

  13. UK Long-term real interest rates Source: Morgan Stanley Research

  14. Whole world gross savings rate 1981 - 2005 Source: IMF World Economic Outlook database

  15. Developing Asia USA Gross savings rates: developing Asia and the US % of GDP 1981 - 2005 Source: IMF World Economic Outlook database

  16. Demographic challenges to funded pension systems Not inherent problem but possible de facto • Increasing longevity • Lower fertility Overwhelmed in short-term by globalisation effect • Uncertainty of longevity forecasts

  17. Survivor Products: Managing longevity risk & mortality improvements

  18. Current Forces Affecting the Size and Ownership of Longevity Risk The Mosaic Today Retirement population growing • 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 extending • Longevity continues to increase for retirees at historically high rates against largely fixed retirement / entitlement dates Cost of longevity significant and rising • The current cost of life extension in the UK is estimated at £12.5 to £24.7 billion per year Inflation could exacerbate longevity costs • Current fiscal and monetary policy may be sowing the seeds of high inflation and expectations of inflation Longevity risk moving from corporates to individuals • Strong forces are causing corporates to close existing Defined Benefit (DB) schemes and transition to Defined Contribution / Personal Account schemes Credit Crunch moving longevity risk arguably to Government • The Credit Crunch is causing a significant increase in DB pensioner risk to move to the Pension Protection Fund (PPF)

  19. 2012… Strategic Asset Allocation

  20. Here’s a useful list of other major UK longevity risk transfer transactions to date: Strategic Asset Allocation

  21. Strategic Asset Allocation

  22. Strategic Asset Allocation

  23. The problem • 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.

  24. The problem • 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.

  25. Mortality improvements over time

  26. Strategic Asset Allocation

  27. Strategic Asset Allocation

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

  29. Stochastic nature of mortality improvements • 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.

  30. Longevity risk • 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

  31. Longevity risk • 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.

  32. Longevity risk • 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.

  33. Longevity risk • 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.

  34. Longevity risk in UK pension provision, £billion of total liabilities- broad estimates: end 2003 Figure 5.17 p181

  35. Significant concern! Reinsurers (eg Swiss Re) have stopped reinsuring longevity risk of life offices!

  36. Survivor Products • 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

  37. Survivor Products • 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).

  38. BNP Paribas Longevity Bond • November 2004 • Issuer: 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, Bermuda • Investors: UK pension funds

  39. BNP Paribas Longevity Bond

  40. Advantages of longevity bond • 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 transparent • EIB has AAA credit rating. • Life insurers holding longevity bond as hedge may be able to hold lower prudential margins.

  41. Survivor Products • 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)

  42. Swiss Re Bond 2003 • 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

  43. Influenza pandemics • 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

  44. Influenza pandemics • 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

  45. Influenza pandemics • 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

  46. Influenza pandemics • 2005-06 • Started in SE Asia • H5N1 virus • Closely related to 1918 Spanish virus

  47. Swiss Re Bond 2003 • $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

  48. Swiss Re Bond 2003

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