jens thomsen: ultra long-term financial instruments

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.

DANMARKS NATIONALBANK 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

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.

2 BIS Review 152/2008


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.


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



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.


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


consequence, pension scheme funding strategies have to some extent been inadequate, cf. Slide 7.


(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.


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?


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.


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.


Risks affecting retirement saving

Statepension

Occupational Pension Private pension

Investment riskGovernmentbudget deficit

Decline in corporate profits

MacroeconomicrisksLongevity risk

Inflation risk

Definedbenefit

Definedcontribution


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 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.



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.


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


to match asset portfolio duration with pension liability duration and to hedge inflation and interest rate risks.


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.


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


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

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.


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)



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.


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


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 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.



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.


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.



Nothing is certain in life except death and taxes.Franklin, 1789

Thank you for your attention

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jens thomsen: ultra long-term financial instruments

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