Demography, Capital Markets and Pension Risk Management

1. Demography, Capital Markets and Pension Risk Management Andrei Simonov

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. 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.

7. Mortality improvements over time

8. Strategic Asset Allocation

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

11. 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.

12. 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”

13. 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

14. 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

15. 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”

16. 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

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

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

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

20. Survivor Products: Managing longevity risk & mortality improvements

21. 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)

22. 2012… Strategic Asset Allocation

24. 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.

25. 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.

26. 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.

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

28. 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

29. 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).

30. 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

31. BNP Paribas Longevity Bond

33. 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.

35. 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

36. 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

37. Swiss Re Bond 2003

38. Swiss Re Bond 2003

39. Swiss Re Bond 2003 • Bond valued using Extreme Value Theory (Beelders & Colarossi (2004)) • Assume Generalised Pareto Distribution • Probability of attachment: • P[MI(t)>1.3MI(2002)] = 0.31% • Probability of exhaustion: • P[MI(t)>1.5MI(2002)] = 0.15% • Expected loss = 22bp < 135bp • A good deal for investors! • Bond trading at Libor + 100bp in June 2004

40. Demand side of market • 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.

41. Demand side of market • 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

42. Supply side of market • Government: • Securitising social security budget • Corporates long longevity risk: • Pharamceuticals

43. Important lessons for development of mortality-linked futures market • 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.

44. Conclusion • 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!

45. Conclusion • 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