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.
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
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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.
Old-age dependency is rising
sharply
Age distribution
Asia
% North America
Europe %
%
100 100 100
80 80 80
60 60
60
40 40 40
20 20 20
0 0 0
1950 2000 2050 1950 2000 2050
1950 2000 2050
0-14(%) 15-64 (%) 65 or over (%)
Source: United Nations
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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.
Longevity risk is the risk that
individuals will live longer than
statistically expected
Years
Life expectancy at birth
82
80 Advances in health care, nutrition
and sanitation have increased life
78
expectancy
76
74
72
70
68
66
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
Nordic countries EU-15 USA
Source: OECD
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In particular, the increase in life expectancy
at retirement age can be a challenge for
carriers of longevity risk
Years
Life expectancy at age of 65
22
20
18
16
14
12
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
Nordic countries Males EU-15 Males US Males
Nordic countries Females EU-15 Females US Females
Source: OECD
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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.
The risk is the speed and magnitude of
the change in life expectancy, not the
direction
Expected and unexpected development in life expectancy for women in Denmark
Age
Uncertainty can be toxic
90
for pension funds
85
80
75
70
65
Upward trend -challenging but
60
manageable
55
50
1850 1900 1950 2000 2050 2100 2150
life expectancy including projections 95-percent fractile
5-percent fractile
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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
consequence, pension scheme funding strategies have to some extent been inadequate, cf.
Slide 7.
(In)accuracy of mortality assumptions
Actual and projected life expectancy at birth, UK males, 1966-2031
Source: Shaw, C., 2007: Fifty years of United Kingdom Population projection: How accurate we have been?,
Population Trends, 128, Office of National Statistics
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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.
Individual's point of view

How much longer?
Live longer

How much longer?
Work longer 
Requires a labor market reform

How to save?

Is there assets that are enough
Save more longdated?

Do these assets give life-long
income 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-ayear 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.
DK: Expected number of years with
early retirement benefits and state
pension for a 60-year-old, 1990-2035
Years with early retirement benefits and state pension
25 25
Political agreement on
Velfaerdsaftale
welfare adjustment, 2006
24 24
23 23
22 22
21 21
20 20
Langsigtsniveau
Long-term level
Forslag om fremrykning
New proposals
19 19
18 18
17 17
16 16
15 15
1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2035
Source: Labour Market Commission
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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.
Risks affecting retirement saving
Macroeconomic
Longevity risk
risks
Occupational Pension
State Private
pension Defined Defined pension
benefit contribution
Government Decline in
Inflation risk Investment risk
budget deficit corporate profits
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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.
Types of pension plans
Defined benefit plan Defined contribution plan
• Benefit determined • Benefit depends on contributed
by a set formula amount and investment returns
• Sponsor bears • Retiree bears investment
investment or longevity risk and longevity risk
No matter who bears the risks,
instruments for investment and longevity risk bearing
and hedging are needed
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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.
Government bonds with maturities over
30 years, OECD-countries
OVERVIEW OF LONG-TERM GOVERNMENT BONDS
Latest
Country maturity Nominal/Linker
Austria .................................................. 2037 Nominal Turnover rate of German federal securities 2006
Belgium ................................................ 2035 Nominal
Canada.................................................. 2037 Nominal 10
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
9876543210
Spain .................................................... 2040 Nominal
Bubills (6 Schatz (2 Bobls (5 years) Bunds (10 Bunds (30
Switzerland........................................... 2049 Nominal
months) years) Inflationlinked Bund years) years)
UK ..................................................... 2055 Nominal
(10 years)
UK ..................................................... 2055 Linker
USA ..................................................... 2038 Nominal Security (Maturity at issuance)
Source: German Finance Agency
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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.
Markets for long-dated bonds are small
relative to the size of pension fund and
insurance company portfolios
USD billion
16000
14000
12000
10000
8000
6000
4000
2000
0
USA UK France Italy Japan
Corporate and government long-term bonds
Life insurance investments and pension funds total assets
Source: Ageing and Pension System reform, Report to the G10
deputies, 2005, Pension Markets in Focus,
OECD Newsletter, Dec 2005
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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
BIS Review 152/2008
to match asset portfolio duration with pension liability duration and to hedge inflation and
interest rate risks.
Issuance of ultra long government
bonds in UK
Yield at opening: 1,112% High inflation and the regulatory demands
Investors: 90% domestic. 66% fund placed on pension funds continue to create
managers, pension funds and insurance solid demand for UK inflation protection from
companies, 33% market makers liability-driven investors
UKDMO 22 Sep 2005 Risk Magazine 1 Jul 2008
Yield on 1.25% index-linked Treasury Gilt 2055
" The longest-dated sovereign index-linked bond in the world"
Per cent
1,20
1,00
0,80
0,60
Due to pension regulations, UK pension
0,40
funds are fighting for a limited supply of
long-dated index-linked bonds to match the
0,20
duration of their liabilities
Risk Magazine 1 Feb 2006
0,00
sep05 dec05 mar06 jun06 sep06 dec06 mar07 jun07 sep07 dec07 mar08 jun08 sep08
Source: Bloomberg
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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.
Other types of instruments for
hedging longevity risk

Longevity bonds (EIB project, withdrawn)

Based on survivor rates

Mortality linked derivatives

Based on mortality rates

Mortality linked securities

Swiss 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.
Size mismatch
Buyers of longevity risk
• Pharmaceutical companies
• Care providers
• Asset managers
Holders of longevity risk
• Pension funds and insurance companies
through provision of annuities
• Governments through state pensions
• Many companies
through pension schemes
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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.
A dilemma
Life insurance and pension sector
needs a very specific instrument to hedge
specific risks (geographic and
socioeconomic diversification)
≠
Investors
want a standardised and liquid product
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Hedging longevity
Quality
Lack of
Hedge for basis Hedge for correlation
Liquid
risk* specific risk with other
assets
Instrument
Ultra long
government
bonds
Longevity bonds
Mortality linked
derivatives and
securities
Asset backed
securities on
basis of a pool of
life insurance
policies
* i.e. imperfect hedging capacity
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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.
Role of the private sector
Advantages

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
Barriers

Hard to find a package that appeals both sellers and
buyers

Pure 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.
Private sector approaches in
longevity hedging

Self-insurance and implicit coverage

Reinsurance

Sale of external buyout funds
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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.
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 benchmark

Issue longevity bonds (more questionable)
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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.
Government issuance of longevity
bonds
Yield curve
Pros: Per cent
4

Could provide an
3,5
unbiased benchmark
3
similar to government
2,5
yield curve
2

Could be a catalyst in
0 5 10 15 20 25 30
Maturity
market development
Increasing old age dependency ratio, OECD countries
2007
2050
Age
80+
75-79
70-74
Cons:
65-69
60-64
55-59
50-54

45-49
Governments are heavily
40-44
35-39
30-34
25-29
exposed to longevity risk
20-24
15-19
10-14
5-9
0-4
40 30 20 10 0 0 10 20 30 40 Million
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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.
The end
Nothing is certain in life except death and
taxes.
Franklin, 1789
Thank you for your attention
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