jens thomsen: ultra long-term financial instruments
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BIS Review 152/2008 1
Jens Thomsen: Ultra long-term financial instruments
Speech by Mr Jens Thomsen, Member of the Board of Governors of the National Bank of Denmark, at the OECD Seminar: ”The pension payout phase: Annuities and implications for financial markets”, Paris, 12 November 2008.
* * *
Prologue Today I have two messages for you: The positive news is that people today live longer than ever before. However, this implies that if people are not working longer, they may outlive their financial reserves and may at some point need to reduce their standard of living, cf. Slide 2.
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Prologue
I have two messages for you today:
The positive news is that people today live longer than ever before
At the same time they may outlive their reserves and may at some point need to reduce their standard of living
Introduction During the last half century the ageing of world population has increased rapidly. On one hand, the decrease in fertility rates in past decades and on the other the higher life expectancy at older age have caused a sharp increase in the current old age dependency. The trend of population ageing shows no sign of a turn, quite the opposite: The world population is expected to age at increasing speed, cf. Slide 3.
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Old-age dependency is risingsharply
Asia
0
20
40
60
80
100
1950 2000 2050
0-14(%) 15-64 (%) 65 or over (%)
% Europe
0
20
40
60
80
100
1950 2000 2050
% North America
0
20
40
60
80
100
1950 2000 2050
%
Age distribution
Source: United Nations
Living longer in good health is a fantastic accomplishment from the society to which improvements in health care, nutrition and sanitation have contributed, cf. Slide 4. On the other hand, the increasing life expectancy – in particular the increasing life expectancy at retirement age – poses challenges to individuals, governments, labour markets and life insurance and pension sector, cf. Slide 5.
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Longevity risk is the risk thatindividuals will live longer thanstatistically expected
Source: OECD
Life expect ancy at birth
66
68
70
72
74
76
78
80
82
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
Nordic count ries EU-15 USA
Years
Advances in health care, nutrition and sanitation have increased life expectancy
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In particular, the increase in life expectancyat retirement age can be a challenge for carriers of longevity risk
Life expectancy at age of 65
12
14
16
18
20
22
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
Nordic count ries Males EU-15 Males US Males
Nordic count ries Females EU-15 Females US Females
Years
Source: OECD
Demographic changes, such as increasing life expectancy, imply risks for the financial institutions. Longevity risk is the risk that individuals live longer than expected. The apparent upward trend in life expectancy is manageable but it is the speed and magnitude of the change in life expectancy that involves the risk: The life expectancy of the current generations may deviate substantially from the course projected today and that could imply problems to the pension sector depending on issued guarantees, cf. Slide 6.
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The risk is the speed and magnitude ofthe change in life expectancy, not thedirection
50
55
60
65
70
75
80
85
90
1850 1900 1950 2000 2050 2100 2150
life expectancy including projections 95-percent fractile
5-percent fractile
Age
Expected and unexpected development in life expectancy for women in Denmark
Upward trend -challenging but manageable
Uncertainty can be toxicfor pension funds
Thus far, the increases in life expectancy have been systematically under-estimated, which has lead to under-estimation of the number of elderly and old-age dependency. As a
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consequence, pension scheme funding strategies have to some extent been inadequate, cf. Slide 7.
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(In)accuracy of mortality assumptions
Source: Shaw, C., 2007: Fifty years of United Kingdom Population projection: How accurate we have been?, Population Trends, 128, Office of National Statistics
Actual and projected life expectancy at birth, UK males, 1966-2031
Retirement saving From an individual's point of view longevity raises a financial question: Will there be enough resources to sustain an adequate life quality if life expectancy increases? The individuals that hold a pension plan where the retiree bears investment and longevity risk now have to become portfolio managers and decide upon the portfolio in an environment of uncertainty with no appropriate instruments for hedging the uncertainties, cf. Slide 8.
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Individual’s point of view
Live longer
Work longer
Save more
How much longer?
How much longer?Requires a labor market reform
How to save? Is there assets that are enough long-dated?Do these assets give life-longincome stream?
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Some countries have increased general retirement age so that the dependency of retirement savings can decrease while retirement savings increase. In Denmark, for instance, the Labour Market Commission's new proposal is to start to extent retirement age by a half-a-year every year between 2009 and 2012. The previous political agreement on welfare adjustment from 2006 stated that the extension would begin in 2019, cf. Slide 9.
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DK: Expected number of years with early retirement benefits and state pension for a 60-year-old, 1990-2035
15
16
1718
19
20
21
2223
24
25
1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 203515
16
1718
19
20
21
2223
24
25Velfærdsaftale
Forslag om fremrykning Langsigtsniveau
Political agreement on welfare adjustment, 2006
New proposals Long-term level
Years with early retirement benefits and state pension
Source: Labour Market Commission Retirement saving is exposed to a number of risks depending of the form of saving. However, longevity and macroeconomic risks affect all forms of retirement saving, cf. Slide 10.
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Risks affecting retirement saving
Statepension
Occupational Pension Private pension
Investment riskGovernmentbudget deficit
Decline in corporate profits
MacroeconomicrisksLongevity risk
Inflation risk
Definedbenefit
Definedcontribution
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Depending on the type of pension plan, it is either the sponsor or the retiree that bears the longevity and investment risk. As the defined benefit retirement plans are being reduced in favour of defined contribution plans the risks are shifted from the sponsors to individuals. Some sponsors have attempted to renegotiate the agreed pension plans with the retirees within the scope of the pension contracts to take into account the longevity risk. Anyhow, appropriate risk management for interest rate, inflation and longevity risks are needed, cf. Slide 11.
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Types of pension plansDefined benefit plan
• Benefit determined by a set formula
• Sponsor bears investment or longevity risk
Defined contribution plan
• Benefit depends on contributed amount and investment returns
• Retiree bears investment and longevity risk
No matter who bears the risks,instruments for investment and longevity risk bearing
and hedging are needed
Long-term government bonds The ultra-long government bonds are not a recent invention. Perpetuals were used in war financing for example in United Kingdom that in 1919 issued two ultra-long bonds, 57-year "Victory Bond" and 71-year "Funding Loan". Today many governments have long-dated outstanding loans with maturities up to 50 years. The issued ultra-long bonds tend to end up in investors' buy-and-hold positions, which affects bond liquidity. In Germany, for instance, the turnover ratio of the 10-year Bund is almost the double compared to the 30-year Bund, cf. Slide 12.
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Government bonds with maturities over 30 years, OECD-countries
OVERVIEW OF LONG-TERM GOVERNMENT BONDS
Count ry Latest
maturity Nominal/Linker
Aust ria .................................................. 2037 Nominal Belgium ................................................ 2035 Nominal Canada.................................................. 2037 Nominal Canada.................................................. 2041 Linker Czech Republic...................................... 2057 Nominal Denmark ............................................... 2039 Nominal France ................................................... 2055 Nominal Germany ............................................... 2040 Nominal Greece................................................... 2040 Nominal Italy ..................................................... 2035 Linker Japan .................................................... 2038 Nominal Netherlands ......................................... 2037 Nominal Poland................................................... 2037 Nominal Portugal ................................................ 2037 Nominal Spain .................................................... 2040 Nominal Switzerland........................................... 2049 Nominal UK ..................................................... 2055 Nominal UK ..................................................... 2055 Linker USA ..................................................... 2038 Nominal
Turnover rate of German federal securit ies 2006
0123456789
10
Bubills (6months)
Schatz (2years)
Bobls (5 years) Inf lation-linked Bund
(10 years)
Bunds (10years)
Bunds (30years)
Security (Maturity at issuance)Source: German Finance Agency
Supply of ultra-long bonds is small compared to the size of pension fund and life insurance company portfolios. For instance in USA, the supply of government and corporate long-term bonds is only 10 per cent of the size of life insurance sector's investments and pension funds' assets, cf. Slide 13.
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Markets for long-dated bonds are small relative to the size of pension fund and insurance company portfolios
Source: Ageing and Pension System reform, Report to the G10 deputies, 2005, Pension Markets in Focus,OECD Newsletter, Dec 2005
0
2000
4000
6000
8000
10000
12000
14000
16000
USA UK France Italy JapanCorporate and government long-term bonds
Life insurance investments and pension funds total assets
USD billion
Moreover, many countries have lately introduced new pension regulations requiring pension fund managers to update their pension plan assumptions and apply mark-to-market approach in valuation of risks. As a result many companies have implemented asset liability risk management (ALM), which implies a closer linkage between pension fund assets and liabilities and an increased demand for long-term bonds, cf. Slide 14. Together with the limited supply of the long-term bonds this has lead to increasing use of derivative instruments
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to match asset portfolio duration with pension liability duration and to hedge inflation and interest rate risks.
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Yield at opening: 1,112%Investors: 90% domestic. 66% fund managers, pension funds and insurance companies, 33% market makersUKDMO 22 Sep 2005
Issuance of ultra long governmentbonds in UK
Yield on 1.25% index-linked Treasury Gilt 2055" The longest-dated sovereign index-linked bond in the world"
0,00
0,20
0,40
0,60
0,80
1,00
1,20
sep-05
dec-05
mar-06
jun-06
sep-06
dec-06
mar-07
jun-07
sep-07
dec-07
mar-08
jun-08
sep-08
Per cent
Due to pension regulations, UK pension funds are fighting for a limited supply of long-dated index-linked bonds to match the duration of their liabilities Risk Magazine 1 Feb 2006
High inflation and the regulatory demands placed on pension funds continue to create solid demand for UK inflation protection from liability-driven investors Risk Magazine 1 Jul 2008
Source: Bloomberg
Markets for longevity hedging Against this background there is an increasing interest in new instruments that can be used to hedge longevity risk. The 2004 EIB announcement of longevity bond issuance generated a wide interest and a lot of attention. However, the issue was later withdrawn without being issued; According to anecdotal evidence, this was mainly because the pension industry found the price of coverage on longevity risk too high, cf. Slide 15.
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Other types of instruments for hedging longevity risk
Longevity bonds (EIB project, withdrawn)Based on survivor rates
Mortality linked derivativesBased on mortality rates
Mortality linked securitiesSwiss Re and Scottish Re
Asset backed securities on basis of a pool of life insurance policies
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The largest hinder for development of longevity risk market is that the market lacks interested buyers of the risk. The natural investors – who would benefit from unexpected rise in life expectancy – such as pharmaceutical companies and care providers are marginal in size compared to the longevity risk holders and may be hindered to enter into longevity risk transactions due to corporate governance reasons, cf. Slide 16.
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Size mismatch
Holders of longevity risk
• Pension funds and insurance companies through provision of annuities
• Governments through state pensions
• Many companies through pension schemes
Buyers of longevity risk
• Pharmaceutical companies• Care providers
• Asset managers
Another obstacle for development of longevity risk market is that thus far the packaging of longevity risk has not appealed to both sellers and buyers of the risk, cf. Slide 17. Life insurance and pension sector needs to transfer very specific risks while the potential investors want a standardised product with high level of liquidity, cf. Slide 18.
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A dilemma
Investors want a standardised and liquid product
≠
Life insurance and pension sectorneeds a very specific instrument to hedgespecific risks (geographic and socio-economic diversification)
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Hedging longevity
Mortality linkedderivatives and securities
Hedge for specific risk
Longevity bonds
Asset backedsecurities onbasis of a pool oflife insurancepolicies
Ultra longgovernmentbonds
Lack ofcorrelation with otherassets
Hedge for basis risk*Liquid
Quality
Instrument
* i.e. imperfect hedging capacity
The role of the private sector Pension funds and life insurance companies are experts in management of longevity risk. Yet they are heavily exposed to this risk category and therefore they have an interest in hedging some of the exposure. From the investor side longevity risk is very appealing due to its low correlation with the yield of other financial instruments. Nevertheless, the attractive contribution in asset managers' portfolios, the longevity instruments have failed to attract buyers, cf. Slide 19.
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Role of the private sectorAdvantages
Life insurance companies are experts in longevity risk Why wouldn’t the natural hedgers for longevity risk issue longevity bonds?Lack of correlation between life expectancy and all other assets should appeal to a broad range of investors
BarriersHard to find a package that appeals both sellers and buyersPure longevity risk transfer is possible only when risk is fully priced
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Until now the private sector has used other types of hedging tools in longevity hedging:
1. The pension sector has managed liabilities related to longevity risk without specific hedging instruments. Thus the exposure to longevity has been part of the pension sector's overall risk management.
2. Reinsurance companies have provided capital to the pension sector seeking hedging opportunities.
3. The pension sector has also transferred their pension contracts to external investors who have assumed the contractual obligations, cf. Slide 20.
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Private sector approaches in longevity hedging
Self-insurance and implicit coverageReinsuranceSale of external buyout funds
The role of governments Regarding the limited supply of instruments that could be used in longevity risk hedging, governments could issue ultra-long bonds in larger quantities to help in liability duration management. However, it should be stressed that in many countries this would need a change of mandate for the debt management office.
In addition, potential issuers of longevity instruments should keep in mind that the world financial markets are open and that there could be a considerable international investor interest to buy such a product. Hence, it is difficult to target the longevity instrument to the domestic pension sector.
Governments could produce a reliable and widely accepted longevity index that private sector longevity bond issuers could use as an unbiased benchmark to their bonds. Recently several private sector entities have launched longevity indices to be used as benchmark to various risk transfer instruments. Nevertheless, standardisation in this area has yet to emerge, cf. Slide 21.
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What could governments do?
Issue ultra long government bonds (taking place today)Produce a reliable and widely accepted longevity index to be used as a benchmarkIssue longevity bonds (more questionable)
Governments could issue longevity bonds, which would serve as benchmark similar to government yield curve and act as a catalyst in developing a private sector longevity bond market. However, the governments are heavily exposed to longevity risk through public pension systems and social security schemes, cf. Slide 22.
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Government issuance of longevity bondsPros:
Could provide an unbiased benchmarksimilar to governmentyield curveCould be a catalyst in market development
Cons:Governments are heavilyexposed to longevity risk
2050
0 10 20 30 40 Million
2007
010203040
80+ 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
Age
Increasing old age dependency ratio, OECD countries
2
2,5
3
3,5
4
0 5 10 15 20 25 30
Maturit y
Per cent
Yield curve
In the end, nothing is certain in life except death and taxes, cf. Slide 23. The need for development in market for longevity risk transfer is apparent. In view of the innovation seen in other financial areas, it is not impossible that a private market for longevity bonds will emerge, although not necessarily based on the product structures known today.
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Nothing is certain in life except death and taxes.Franklin, 1789
Thank you for your attention
The end
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