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 DANMARKS NATIONALBANK 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 % Europ e % % 0-14(%) North Am erica 15-64 (%) 65 or over (% ) Source: United Nations DANMARKS NATIONALBANK 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 Li f e expect ancy a t birth Advances in health care, nutrition and sanitation have increased life expectancy Nordic count ries Source: OECD EU-15 USA DANMARKS NATIONALBANK In particular, the increase in life expectancy at retirement age can be a challenge for carriers of longevity risk Years Lif e e xpectan cy at ag e o f 65 Nordic count ries M ales EU-15 M ales US Males Nordic count ries Females EU-15 Females US Females Source: OECD DANMARKS NATIONALBANK 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 for pension funds Upward trend -challenging but manageable life expectancy including projections 5-percent fractile 95-percent fractile DANMARKS NATIONALBANK 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 NATIONALBANK DANMARKS 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 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 longdated? Do these assets give life-long income stream? DANMARKS NATIONALBANK 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 25 Years with early retirement benefits and state pension Political agreement on Velfærdsaftale welfare adjustment, 2006 Langsigtsniveau Long-term level Forslag om fremrykning New proposals 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2035 Source: Labour Market Commission DANMARKS NATIONALBANK 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 risks Longevity risk State pension Government budget deficit Occupational Pension Defined benefit Decline in corporate profits Defined contribution Inflation risk DANMARKS NATIONALBANK Private pension Investment risk 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 by a set formula • Benefit depends on contributed amount and investment returns • Sponsor bears investment or longevity risk • Retiree bears investment and longevity risk No matter who bears the risks, instruments for investment and longevity risk bearing and hedging are needed DANMARKS NATIONALBANK 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 GOVERNM ENT BONDS Count ry Lat est mat urit y Nominal/Linker Aust ria .................................................. Belgium ................................................ Canada.................................................. Canada.................................................. Czech Republic...................................... Denmark ............................................... France ................................................... Germany ............................................... Greece................................................... It aly ..................................................... Japan .................................................... Net herlands ......................................... Poland ................................................... Port ugal ................................................ Spain .................................................... Swit zerland ........................................... UK ..................................................... UK ..................................................... USA ..................................................... Nominal Nominal Nominal Linker Nominal Nominal Nominal Nominal Nominal Linker Nominal Nominal Nominal Nominal Nominal Nominal Nominal Linker Nominal Turnover rate of German federal securities 2006 Bubills (6 months) Schatz (2 years) Bobls (5 years) Inflationlinked Bund (10 years) Bunds (10 years) Bunds (30 years) Security (M aturity at issuance) Source: German Finance Agency DANMARKS NATIONALBANK 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 USA UK France Corporate and government long-term bonds Italy Japan 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 DANMARKS NATIONALBANK 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 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% Investors: 90% domestic. 66% fund managers, pension funds and insurance companies, 33% market makers UKDMO 22 Sep 2005 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 Yield on 1.25% index-linked Treasury Gilt 2055 " The longest-dated sovereign index-linked bond in the w orld" Per cent 1,20 1,00 0,80 0,60 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 0,40 0,20 0,00 sep05 dec05 mar06 jun06 sep06 dec06 mar07 jun07 sep07 dec07 mar08 jun08 sep08 Source: Bloomberg DANMARKS NATIONALBANK 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) Mortality linked derivatives Based on mortality rates Mortality linked securities Based on survivor rates Swiss Re and Scottish Re Asset backed securities on basis of a pool of life insurance policies DANMARKS NATIONALBANK 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 DANMARKS NATIONALBANK 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 DANMARKS NATIONALBANK Hedging longevity Quality Liquid Hedge for basis risk* Hedge for specific risk Instrument Lack of correlation with other assets 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 DANMARKS NATIONALBANK 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 DANMARKS NATIONALBANK 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 DANMARKS NATIONALBANK 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) DANMARKS NATIONALBANK 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: Could provide an unbiased benchmark similar to government yield curve Could be a catalyst in market development Per cent 3,5 2,5 M aturit y Increasing old age dependency ratio, OECD countries Age 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 Cons: Governments are heavily exposed to longevity risk DANMARKS NATIONALBANK Million 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 DANMARKS NATIONALBANK