Longevity Risk Transfer: A PPF Perspective

Sixth International Longevity Risk and Capital Markets Solutions Conference 9th & 10th September 2010

Martin Clarke,PPF Executive Director of Financial Risk

Pension Protection Fund (PPF) was established in April 2005 to protect members of defined benefit pension schemes

• PPF pays compensation to members of DB pension schemes where the scheme sponsor becomes insolvent and there are insufficient assets to buy compensation on the open market

– PPF compensation is 100% of pensions in payment and 90% of pensions in deferment– There is a cap in the case of deferred members and indexation/escalation is also capped

• PPF is funded by:– A levy on eligible pension schemes currently £720 million per annum– The assets of schemes that it takes over– Recoveries from insolvent scheme sponsors

• PPF is a public corporation established by Act of Parliament but it has no Government guarantee

Vision: Protecting people’s futures.Mission: Pay the right people the right amount at the right time

Its easy to see why we’re worried about longevity…..

“Demographic picture very worrying – we

face a pensioners crisis. Baby boomers

reaching age 65 in the next three years –

what will they live on?” Ros Altmann 2009

“For a 65 year old male today a 20%

improvement in longevity will reduce his

annuity by 9%”

Financial adviser

“Sharply rising longevity

adds urgency to pension

review”

Financial Times June

2010

Nobody is disputing the evidence on mortality improvements – people are living longer and this will impact upon pension scheme costs”The Pensions Regulator 2008

“I've got all the money

I need for my old age...

provided I die before

4pm today”

Groucho Marx

…but how do you assess the available options?

• For a traditional carrier, risk is measured as cost of the economic capital required to cover extreme outcomes

– Hedging solutions such as reinsurance can be judged by the net effect on risk adjusted profit

• A UK pension scheme it is not required to hold a reserve against uncertain outcomes although its funding has to be based on prudent assumptions

• Schemes can evaluate the cost of risk as threats to their funding objectives

– Do they apply risk pricing techniques? Are they looking at all risks or just longevity?

• There is still room for a qualitative overlay which may come from the sponsor’s overriding desire for stability/predictability

In PPF’s case the position is complicated by its potential to continue to accrue additional liabilities as a result of future insolvencies

PPF targets “self sufficiency” in 20 years’ time; off-balance sheet risks will then be limited and on balance sheet liabilities mature:

• The impact of claims will decline over time

– Scheme funding will improve– Risk mitigation trends continue including buy

outs– Scheme closures to new entrants / accruals

• Both UK DB & PPF liabilities will mature over the next 20 years

– Average age of DB members will increase from 56 to 71

– 70% of DB liabilities will be pensioner– Outstanding duration of PPF liabilities will fall

from 21 to 12

• The population of levy payers will continue to decline

– Number of levy payers may halve– PPF liabilities become 10 to 15% of total

DB

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

C/L

Mean average

50th percentile (median)

75th percentile

90th percentile

Overall age distribution

0

100

200

300

400

500

600

700

800

900

1000

Age

Now

10 Years time

20 Years time

30 Years time

PPF claims as % of PPF liabilities

Age distribution of PPF members

“Self sufficiency” means that the potential future burden on residual levy payers by 2030 remains affordable

• PPF investment risk will be reduced to a minimal level– Scope to underwrite investment risk positions limited by capacity and appetite of levy

payers

• Residual interest rate and inflation risk will be hedged– Dependent on market for available instruments

• Margin for “unhedgable” risks such as residual claims and longevity – Margin initially set at 10% to give a 90% certainty over the remaining period of the fund– Balances interests of levy payers and beneficiaries– Extreme longevity scenarios likely to prompt a policy reaction– But how do we decide to hedge and if so when?

The PPF Board believes that, given future uncertainty and the absence of any external guarantee, a chance of success of 80% over 20 years is reasonable

A good hedge for PPF is one that improves the funding success rate during the accumulation phase or that reduces the reserve for adverse experience in the decumulation phase

%

100

0

2010 2030 2020

PPF risk composition through time

Market risk

Credit risk

Longevity risk

Note that PPF’s appetite for longevity risk transfer will progressively increase

Base Case• PPF base case has 83% success percentage• 1.5% reduction to our funding target improves success rate by 1% (equivalent to a levy reduction of £50m)

Diversification effect• Over 20 years credit/market risk reduces by two thirds (in economic capital terms from £10 bn to £3bn)• Longevity risk rises from 0.8% of liabilities to 7.5%• Impact of stochastic vs deterministic mortality in accumulation phase is 1% to success rate

Accumulation phase Decumulation phase

Using our funding model we can evaluate the impact of our diversification effect on hedging strategies as shown in this example

2010 20302020

Breakeven liability margin vs market prices

Year Base probability of success*

Breakeven liability margin/market price*

2010 83% 75%

2015 85% 85%

2020 88% 100%

2030 100% (by definition) 100%

Forecastmargin

Price

• Let base case assume that PPF will hedge when it becomes self sufficient in 2030• We also assume this will be at the current price points we have discovered• We can compare alternative strategies that hedge liabilities at an earlier date• Breakeven margin is price below which our probability of success improves on base case

75%

100%

*Note that the numbers in this slide have been camouflaged to disguise actual price information in our possession. The feature illustrated is however based on actual price information

Supported by this analysis we can evaluate different strategies and, in principle, develop a hedging dashboard to reflect our appetite for business

• Basic principle is to seek solutions that improve on our probability of success

• Although we might eventually have an appetite to hedge, the diversifying effects of other risks suggests we might hold off for a while

• A wait and see strategy incurs the hazard that market rates may trend adversely

Current pricing (relative to PPF liabilities)

Current pricing (relative to breakeven margin)

Market capacity(assessment of appetite amongst buyers)

Deal activity(assessment of appetite amongst sellers)

Pricing outlook(is pricing going to soften or harden?)

PPF longevity risk dashboard*

*The ratings in the longevity risk dashboard are for illustration purposes only

This theoretical model is subject to a number of questions and assumptions that must be understood to make any real world decision

• Base mortality assumptions will differ between the PPF basis and the market

– Data accuracy; up to date experience investigations; modern factorial analysis; sensitivity tests

• Diversification benefits may be overstated– Sensitivities on key modelling assumptions: ESG calibration, pension scheme risk and

behaviours– Scenario analysis (in this case a benign economic scenario with few claims and low market

volatility)

• Potential arbitrage of longevity model assumptions and methodology

– Stress test model and assumptions

• Robustness of PPF assumption to only fund to a 90% level of confidence on longevity risk

Summary and conclusions

• A financial framework to evaluate hedging options objectively– Linked to funding objective and Board’s expressed risk appetite– Framework and criteria can be flexed to consider different hedging instruments and segments of portfolio

• Decisions dependent on market pricing and risk composition– How will market pricing and capacity develop in future?– PPF is not alone in managing a maturing book of pension liabilities

• The process is model and assumption dependent– The ideal-world solution is perfect knowledge or at least agreed assumptions that strip out any knowledge

imbalances

• Hedging all the risk may not be the best strategy– It is possible that market pricing makes some segments of the risk portfolio more attractive to hedge– If PPF has effectively hedged the risk above the 90% confidence kevel post 2030, is there more appetite

in the market for capped risk?

Longevity Risk Transfer: A PPF Perspective

Sixth International Longevity Risk and Capital Markets Solutions Conference 9th & 10th September 2010

Martin Clarke,PPF Executive Director of Financial Risk