9/11/2015 1 Demography, Capital Markets and Pension Risk Management Andrei Simonov.

04/19/231

Demography, Capital Markets Demography, Capital Markets and Pension Risk Managementand Pension Risk Management

Andrei Simonov

Analysing pension riskAnalysing pension riskIllustrative example

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LIABILITY EXPOSURES

Unrewarded (no risk premium)

ASSET RETURN RISKS

Rewarded

Surplus/Deficit Progression

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2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Year

Surp

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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

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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

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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%

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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

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Mortality improvements over time

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

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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

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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”

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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

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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

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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”

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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

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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

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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

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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

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Survivor Products: Survivor Products: Managing longevity risk & Managing longevity risk & mortality improvementsmortality improvements

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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…

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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

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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

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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

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Reinsurers (eg Swiss Re) have stopped reinsuring

longevity risk of life offices!

Significant concern!

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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

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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

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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

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BNP Paribas Longevity Bond

Mortality swap

Floating S(t)

BNP

Interest-rate swap

Issue price

Issue price

EIB

Bond holders

Partner Re

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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

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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

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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

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$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

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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

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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

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%)

Atta

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oint

Exh

aust

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poin

t

Capital erosion

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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

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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

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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

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Government:– Securitising social security budget

Corporates long longevity risk:– Pharamceuticals

Supply side of market

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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

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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

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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