Ageing population and demography: the role of financial institutions José Luis Escrivá

1. Ageing population and demography: the role of financial institutions José Luis Escrivá Chief Economist BBVA Banking Group bbvaresearch.department@grupobbva.com Europe’s competitiveness: how financial institutions can help deliver it 1st EPFSF Annual Conference Brussels, May 15, 2007 1st EPFSF Annual Conference

2. Ageing population and demography: the role of financial institutions 1. The need for an European pension market 2. The need to address the risks of an asset “meltdown” effect 3. The need for more marked-oriented pension systems 1st EPFSF Annual Conference

3. Ageing population and demography: the role of financial institutions 1. The need for an European pension market 2. The need to address the risks of an asset “meltdown” effect 3. The need for more marked-oriented pension systems 1st EPFSF Annual Conference

4. The challenges of demographic ageing: economic growth and public finances • Demographic ageing will accelerate in the coming decades as the baby-boom generation reaches retirement age … and will have a significant impact on European economic growth • Cause: reduction in the size of the labor force: … Holding productivity growth, participation rates and unemployment constant, GDP pc growth will slowdown by 3 p.p. over the next two decades in Europe They could be partially offset by higher participation rates, longer work life, and greater productivity… 1st EPFSF Annual Conference

5. Ageing will require greater labor mobility across European countries • … This requires a more efficient use of the labor factor. The low labor mobility across European countries makes difficult to improve the efficiency • Currently 1.5% of EU-25 citizens live and work in a different member state form their country of origin. Interstate mobility rate in the US is three times bigger • Every year, 7.2% of EU-25 citizens change their place of residence, but only 1.1 p.p. due to a change in jobs (2.8 p.p. in the US) (Eurostat & US Department of Labor, 2002) Are the current European pension systems a barrier for mobile workers? 1st EPFSF Annual Conference

6. Portability of pension rights of migrant workers is essential to increase mobility First Pillar Although EU regulation ensure that pension rights are maintained when a European worker moves across European countries… [EU Regulation 1408/71, implementing Regulation 574/72, and later Council and Commission Regulations] … Most European countries do not refund pension contributions if worker moves to another EU country • Contribution records are kept until workers reach retirement age  contributions paid in one country can neither be transferred to another country nor reimbursed to workers This is a suboptimal solution: public pensions portability between European countries is very limited 1st EPFSF Annual Conference

7. Portability of pension rights of migrant workers is essential to increase mobility Second and Third Pillars: • The European Commission Directive on Institutions for Occupational Retirement Provision (2003) has not been translated in most countries (14 out of 25 member states). Why? • The gap between EU regulation of pension institutions and the national regulation of pension products • Therefore, the development of Pan-European Pension Plans (PEPP) should be a priority • An alternative solution to this problem, focusing on 3rd pillar: “Pan-European Pension Plans. Deepening the concept” (EFR Pensions Steering Group, 2005) 1st EPFSF Annual Conference

8. Ageing population and demography: the role of financial institutions 1. The need for an European pension market 2. The need to address the risks of an asset “meltdown” effect 3. The need for more-marked oriented pension systems 1st EPFSF Annual Conference

9. Old-age dependency ratios in Europe will increase exponentially… • Holding macro and regulation constant, pension expenditure will rise as the old-age dependency ratio, … European social security systems have a problem 1st EPFSF Annual Conference

10. … giving rise to the risk of an “asset meltdown” Higher dependency ratios mean lower overall savings, inducing potential capital losses to those who retire The asset “meltdown” problem: • A massive liquidation of past savings by the retiring baby-boomers will cause a rise in interest rates and a fall in the price of bonds (“asset meltdown”) • Estimation Results.70 - 80 basis points drop in bond prices spread over five decades (Krueger and Ludwig, 2006) Is this problem manageable? What can the financial system do? 1st EPFSF Annual Conference

11. Asset meltdown problem is manageable. Financial institutions can help to provide more income security among the elderly The problem is manageable with the involvement of financial institutions: Older societies can transfer part of the burden to younger ones, if financial markets are integrated Investment strategies for pension fund managers focused on lifetime earnings: Longevity Bonds Development of instruments to make more efficient use of non-financial wealth after retirement: Reverse Mortgages  The “meltdown effect” may still be small and spread over a very long 1st EPFSF Annual Conference

12. Financial institutions can help to provide more income security among the elderly: longevity bonds and reverse mortgages 2. Coverage of longevity risks in private-DC pension markets, • Solution: to implement bonds indexed to life expectancy, i.e., longevity bonds • Difficulties to implement since no obvious counterpart exists • Difficulties to asses uncertainty and associated risks adequately Comparing realized gains in life expectancy at birth with past projections (years) A positive sign means that life expectancy in 2003 has already by-passed projected life expectancy for the average 2000-05 (UN) and 2005 (Eurostat) Life expectancy projections by international orgs. and actuaries have consistently underestimated improvements 1st EPFSF Annual Conference

13. The potential size of the RM market is huge... 3. Instruments to make more efficient use of non-financial wealth after retirement: Reverse Mortgages (RM) • A significant proportion of the wealth of individuals (especially in Southern European countries) is tied to housing  • Home equity conversion products may be useful to all those who are “house-rich but cash-poor” (not limited to the elderly) • The development of RM could play a central role • Demographic projections indicate that elderly people is the fastest growing segment all over the world, especially in Japan and Europe • Literature on RM is unanimous on its huge market potential (Püntner & Röhrs, 2006).Reality has not been up to expectations though… 1st EPFSF Annual Conference

14. …but the actual size of the RM markets is nowhere near its estimated potential… Assuming that the development of the RM market in Spain will be similar to that of the U.S. and the population projections, in 2050 there will be 800 RM per million inhabitants over 60 in Spain 1st EPFSF Annual Conference

15. ... for a variety of reasons from the demand, supply and regulatoriy considerations What are the reasons for the gap between potential and actual RM volumes? • Supply side • RM complexity exposes a lender to several risks: mortality, interest rates and real estate markets • Moral hazard problems: once a RM loan is taken, the homeowners may have no incentive to maintain the house to preserve or enhance it’s market value • Demand side • It is an unusual product for a typical elderly borrower, creating fears of debt burden, eviction and inability to bequeath property • Regulatory uncertainties • Still novel (or non-existent) legislation in most European countries 1st EPFSF Annual Conference

16. Ageing population and demography: the role of financial institutions 1. The need for an European pension market 2. The need to address the risks of an asset “meltdown” effect 3. The need for more-marked oriented pension systems 1st EPFSF Annual Conference

17. First pillar, generally Pay-As-You-Go pension scheme, is the most important in Europe • Countries where private pension plans started decades ago have the largest pension markets (Anglo-Saxon countries) • The size of private-pension asset accumulation is reduced in countries where public pensions play a dominant role (France, Germany, Italy,…) 1st EPFSF Annual Conference

18. Increased longevity and falling fertility rates are major factors making pension systems unsustainable From a fiscal perspective, system sustainability requires reforms of the public social security systems (parametric or structural) Not-reformed PAYG pension systems accumulate commitments between one and three times the current GDP level What will happen if European countries do not reform their pension systems?  The Latin American experience 1st EPFSF Annual Conference

19. Countries that moved from PAYG to DC systems had to face large fiscal transition costs, but will benefit from lower pension debt • Counterfactual: • What if Latin American economies had not reformed their pension systems? 1st EPFSF Annual Conference

20. Countries that gradually move towards DC schemes will make the pension system more sustainable Chile will have large fiscal savings in the future, despite persistent transition costs … Fiscal savings will make possible a major upgrade of the solidarity pillar 1st EPFSF Annual Conference

21. Conclusions Demographic ageing will have a significant impact on public finances and will put the European households under strain Solutions: reforming pensions, improving the efficiency of pension systems, and developing home equity conversion products: • Improving the efficiency of European pension markets requires facilitating public and private pension portability between European countries. The development of Pan-European Pension Plans should be a priority • Financial institutions can contribute to address the pension challenge. They can help to provide more income security among the elderly by means of longevity bonds and reverse mortgages • A more marked-orientation of the European pension schemes, with more DC components, will make the system more sustainable over the long run 1st EPFSF Annual Conference