2014.01.10 - NAEC Seminar_Fostering long-term investment (Presentation 2)

RESPONDING TO THE

CHALLENGES OF

AGEING AND

LONGEVITY RISK

Pablo Antolin OECD Financial Affairs Division, Pension Unit

New Approaches to Economic Thinking Seminar on Project A4, 10 January 2014

The challenges posed by population ageing What is population ageing? The impact of population ageing Addressing its impact on pension systems

Improvements in mortality and life expectancy and the uncertainty surrounding future improvements Assessing the amount of longevity risk (pension funds and

annuity providers) Managing longevity risk: capital markets solutions and the

role of governments

The analysis and policy messages herein stem from the work discussed and examined within the context of the CMF, IPPC and WPPP.

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Issues addressed in this work

MEETING THE

CHALLENGES POSED

BY POPULATION

AGEING ON PENSION

SYSTEMS

Population Ageing

Population ageing refers to an increase in the average age of the population

Increase is the result of a decrease in fertility, (already over: return to previous levels) baby boom.

And an increase in life expectancy (LE). The baby boom is temporal The increase in LE is relatively permanent

effect (bar wars and epidemics)

4

4

Population ageing:

Increase in the median age

0

5

10

15

20

25

30

35

40

45

50

55

Brazil China France Germany Japan USA

Japan

Germany

France

USA China

Brazil

5

Population Ageing

•Fertility returns to previous lower levels

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

193

3

193

6

193

9

194

2

194

5

194

8

195

1

195

4

195

7

196

0

196

3

196

6

196

9

197

2

197

5

197

8

198

1

198

4

198

7

199

0

199

3

199

6

199

9

20

02

20

05

6

Population Ageing

•Fertility fall (developing countries)

0

1

2

3

4

5

6

7

20

00

20

02

20

04

20

06

20

08

20

10

20

12

20

14

20

16

20

18

20

20

20

22

20

24

20

26

20

28

20

30

20

32

20

34

20

36

20

38

20

40

20

42

20

44

20

46

20

48

7

Population Ageing • Large increases in life expectancy

60

65

70

75

80

85

195

0

195

3

195

6

195

9

196

2

196

5

196

8

197

1

197

4

197

7

198

0

198

3

198

6

198

9

199

2

199

5

199

8

20

01

20

04

20

07

20

10

Life expectancy at birth (increase = 2.2 yrs per decade)

8

Population Ageing

Large increases in life expectancy (at age 65)

10

12

14

16

18

20

22

24

195

0

195

3

195

6

195

9

196

2

196

5

196

8

197

1

197

4

197

7

198

0

198

3

198

6

198

9

199

2

199

5

199

8

20

01

20

04

20

07

20

10

Life expectancy at 65 (increase = 1 yrs per decade)

9

Population Ageing: Implications

•More people in retirement and for longer.

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

Brazil

China

Japan

USA Germany

France

Source: UN Population Projections, 2010 Revision

Number of people in working age per person 65+

10

Population Ageing: Implications • Major future impact: increases in Lex.

0

1

2

3

4

5

6

20002005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060

Number of working age people per person 65+

Baby boom only

Life expectancy

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Impact of Population Ageing (PA)

• GDP growth = productivity and labour force growth

• Productivity decreases with age?: hard to assess (cognitive, learning by doing) (self selection bias)

• PA reduces workforce if fertility rates continue falling (not the case).

• Increases life expectancy with constant retirement age means people retired with longer claims on GDP

• Savings will fall as long as retirees’ saving rates lower that those of the working age population.

• Lower saving, lower investment (I=S) unless borrowing from abroad

• Financial markets: PA may lead to potential lower returns, contributing to the current environment of low interest rates

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Fiscal impact of PA

• Main fiscal impact of ageing population is through pensions and health care

• Expenditures on both will increase as a share of GDP, in particular health care (percentage points of GDP)

• Postponing retirement will go a long way to contain the increase in pension expending

Country Pensions Health care

EU 1.5 3.4

US 1.8 4.4

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What is the impact of PA on pensions?

• Basic principle: what it goes in (saving during working life) and what it gets out (pension benefits during retirement) need to be equal

• Baby boom (temporary): smaller cohorts working than retiring.

• This affects mainly PAYG-financed pensions because current workers pay for current pensions.

• Affects also indirectly (through returns on investment) funded pensions

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What is the impact on pensions?

• Higher life expectancy (permanent) increases the years in retirement relative to the years saving to finance retirement.

• ΔLE creates problems of

• Sustainability to PAYG-funded public pensions

• Funding and solvency to funded DB pensions

• Adequacy to funded DC pensions

• PA also affects pensions indirectly through GDP growth, wage growth and returns on investment

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OECD messages to address the impact

of PA on pensions

Do not put all eggs in the same basket

Diversify the sources to finance retirement

Necessary to have public pensions as well as funded private pensions

Funded private pensions are complementary to public pension provision.

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How to address the impact of PA on

pension gap of ageing populations?

• Link retirement age to life expectancy (Sweden): PAYG-financed pensions.

• Better still, link years contributing to years saving for retirement (NDC, DCs)

• Contribute and contribute for long periods

• Promote annuities to protect people from longevity risk (increase role of defined contribution, DC)

OECD Roadmap Good Design DC Plans

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MORTALITY

ASSUMPTIONS

LONGEVITY RISK

More permanent problem of PA

• How to deal with future improvement in mortality and life expectancy

• Future improvements are uncertain Longevity Risk (LR)

• Difference between how future improvements are accounted for and their future realisation (unknown) is the amount of longevity risk that individuals and financial systems potentially are exposed to

• Pension funds and annuity providers can go bankrupt, and individuals may fail to have adequate pensions

• Government budgets and pension promises may become unsustainable

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OECD (CMF, IPPC, WPPP) Project

• Assess the amount of longevity risk that pension funds and annuity providers (insurance companies) may potentially be exposed to.

• So far 16 countries including China, Brazil and Mexico.

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Assessing LR

1. Look at the regulatory requirements and market practice regarding mortality assumptions

– Many countries do not have requirements to account for improvements

– In practice most countries account for improvements

– It is more common in annuity providers than in pension funds

• Are they still expose to LR? 21

Assessing LR

2. Compare the annuity values that the regulatory requirements and the market practice mortality assumptions suggest (what is accounted or provisioned for) with what future improvements would suggest

• As a proxy for the future, the project uses the mortality projections from 4 common mortality models

• This comparison provides a measure of the value of additional reserves or provisions needed to meet future payments

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Assessing LR

• The study finds that countries vary from those needed to be monitored (less than 2% shortfall in provisions) to significant (5% - 10%) and serious shortfall (10% - 20%)

• Countries least exposed to LR seem to be those where industry experts actively participate in defining standards and driving the analysis of mortality experience and assumption setting.

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How to manage LR?

• In house (traditionally) through reserving and constant updating of actuarial parameters, accounting for future improvements and using stochastic modeling (probabilities)

• Additionally, there is a need for financial instruments to help pension funds and annuity providers to hedge LR

• Existing arrangements to manage LR (e.g. buy-ins) focus almost exclusively on transferring the LR from one party to another

• Instruments that allow for hedging LR (longevity hedges) may be better 24

Government role?

• Legislation and regulation

• Provide standardisation, liquidity and transparency

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Government role?

• Regulate mortality tables to include stochastic forecasts of future improvements and regular updates

• Develop a reliable longevity index to encourage standardisation and transparency

• Issue longevity bonds? What is the market failure that justifies government intervention? – Provide liquidity

– Idiosyncratic LR and aggregate (cohort) LR 26

Policy conclusions

• The main long term problem of PA stems from future improvements in mortality and life expectancy

• Need to deal with the uncertainty surrounding these improvements, longevity risk

• Require pension funds and annuity providers to use mortality tables that include improvements, require them to update their actuarial calculations and tables regularly, and use stochastic modelling (probabilities)

• Governments should issue longevity indices

• Encourage hedging financial instruments

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THANK YOU

VERY MUCH

www.oecd.org/insurance/private-pensions