Transcript Document

Demography, Capital Markets
and Pension Risk Management
Andrei Simonov
1
7/20/2015
Analysing pension risk
Surplus/Deficit Progression
300
Illustrative example
Y% probability of
being at least 100%
funded in 10 years
time
200
300
ASSET RETURN
RISKS
Rewarded
200
0
100
-100
-400
2009
2010
2011
5% Percentile
2012
2013
25% Percentile
2014
Year
50% Percentile
2015
2016
75% Percentile
2017
2018
2019
-300
95% Percentile
Longevity hedging should be considered alongside other risk mitigation
techniques using risk return framework
Total
Diversification
Credit
Alternatives
-200
Equity
-100
Longevity
-300
0
Liabilities
-200
1 in 20 chance that
deficit is at least
£Xm higher than
expected
£ million
Surplus/Deficit (£m)
100
LIABILITY
EXPOSURES
Unrewarded (no risk
premium)
Demographic factors at work

Increasing longevity

Lower fertility

Retirement of Baby Boom
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From pyramids to columns
Age Group
100 +
95 - 99
90 - 94
85 - 89
80 - 84
75 - 79
70 - 74
65 - 69
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
B
B
B
A
A
A
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People over SPA to those aged
20 – SPA*
0.6
With SPA fixed
at 65
0.5
0.4
With SPA rising
proportionally (to
68.5 in 2050 and
70.2 in 2070)1
0.3
0.2
0.1
0
2006
2020
2030
2040
2050
2060
2070
* 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%
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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.
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Mortality improvements over time
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Strategic Asset Allocation
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What is longevity risk?
(Broken limits to life expectancy – Oeppen & Vaupel)
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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.
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Lower fertility – The inherent
challenge to pension systems
PAYG
Increased ratio of pensioners to
contributors
Lower pensions relative to
average earnings
Higher contribution rates
Increase Pension Age more
than proportionally with life
expectancy
Funded
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
* 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
funded systems and capital markets
Lower
Fertility
Transitional asset price fall effect
(at sale)
Inherent effect of shift
to lower fertility
K/L rises: return on capital falls
Increased
Longevity
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
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Demographic impacts on
returns to capital
Model Results

Garry Young:
Baby-boom generation
Increased longevity
Falling fertility
-0.1%
-0.1%
-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
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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”
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Global glut of savings
hypothesis
In China and other East Asian
countries
• Fewer children enable
higher savings rate
• Awareness of greater
longevity, fewer children and
lack of social welfare net,
require a high savings rate
Developed countries save more
to cope with their
demographic/pension
challenges
Global glut of
savings relative to
investment
Long-term, not
just cyclical, fall in
real interest rates
Transitional
positive asset
price effects
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UK Long-term real interest
rates
11%
Real interest rate
9%
Long-term average (1700-2004)
7%
Estimate for 2005
5%
3%
1%
-1%
-3%
-5%
Estimate for
2005, as of 02
March 2005
-7%
1700 1716 1732 1748 1764 1780 1796 1812 1828 1844 1860 1876 1892 1908 1924 1940 1956 1972 1988 2004
Source: Morgan Stanley Research
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Whole world gross savings rate
1981 - 2005
25
20
15
1981
1986
1991
1996
2001
2006
Source: IMF World Economic Outlook database
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Gross savings rates: developing
Asia and the US % of GDP
1981 - 2005
40
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Developing
Asia
30
25
20
15
USA
10
5
1981
1985
1989
1993
1997
2001
2005
Source: IMF World Economic Outlook database
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Survivor Products:
Managing longevity risk &
mortality improvements
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Current Forces Affecting the Size and
Ownership of Longevity Risk
The Mosaic Today

Retirement population growing

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)
Longevity extending
Cost of longevity significant and
rising
Inflation could exacerbate
longevity costs
Longevity risk moving from
corporates to individuals
Credit Crunch moving longevity
risk arguably to Government
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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
2012…
Strategic Asset Allocation
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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.

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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.

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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.
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Significant concern!
Reinsurers (eg Swiss Re)
have stopped reinsuring
longevity risk of life
offices!
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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

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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).
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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
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
BNP Paribas Longevity Bond
Bond holders
Floating S(t)
Issue price
Interest-rate swap
EIB
BNP
Issue price
Mortality swap
Partner Re
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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.

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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 years
Covers the full term of the
liability
Only level pensions matched
Different annuities can be
used to match non - level
pensions
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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
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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
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Swiss Re Bond 2003
Off balance
sheet
Swiss Re
Annual coupons
(USD LIBOR + 135bps)
SPV (Vita
Capital)
Bond holders
Principal
payment $400m
Up to $400m if
extreme
mortality is
experienced
Check
terminal
mortality
index value
Up to $400m if
extreme
mortality is not
experienced
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100% 90% 80% 70% -
Exhaustion point
60% 50% 40% 30% 20% 10% 0% 1
Capital erosion
Attachment point
Principal Repayment (%)
Swiss Re Bond 2003
1.05
1.1
1.15
1.2
1.25
1.3
1.35
1.4
1.45
1.5
1.55
Mortality Index Level (q)
40
1.6
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

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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.
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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
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with existing financial instruments
Supply side of market

Government:
– Securitising social security budget

Corporates long longevity risk:
– Pharamceuticals
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Important lessons for development of
mortality-linked futures market

Potential weak point in longevity bond market is
on the supply side:
–

Futures contract would be effective in reducing
aggregate risk,:
–

since few natural issuers on supply side.
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.
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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!
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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
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