Major Issues of the 21st Century: Ageing and the Financial Markets

1
Major Issues of the 21st Century Ageing and the
Financial Markets

• Professor David Blake
• Pensions Institute
• Cass Business School

2
Ageing

• Worlds population is ageing rapidly
• Due to
• Increasing longevity
• Declining fertility
• Another critical factor is longevity risk
• Increasing uncertainty attached to length of life

3
(No Transcript)
4
Linear improvements in life expectancy since the
1840s
5
Consequences of ageing

• Big financial burden passed to next generation,
  via
• public pension system
• health care system
• Will next generation accept this burden?
• Or will it break the intergenerational solidarity
  pact and move to low tax countries?

6
Consequences of ageing

• Pension funds mature and move from accumulation
  phase to distribution phase
• Requirement for assets generating regular and
  reliable cash flows increase
• Demand for bonds increase
• Demand for equities falls

7
Consequences of ageing

• How will companies respond?
• Suppose companies respond by
• buying back shares
• issuing bonds in their place
• Modigliani-Miller Theorem tells us that this will
  not change total corporate risk
• Therefore the corporate bonds become as risky as
  the equity
• In aggregate pension funds cannot reduce risk by
  switching out of shares into bonds

8
Consequences of ageing

• Even worse, risk could increase
• Since corporate bond holders can force company
  into insolvency in a way equity holders cannot

9
Consequences of ageing

• How else might companies respond?
• To reduce risk of insolvency, they might engage
  in less risky investment projects
• Will global risk taking fall as the worlds
  population ages?

10
Stochastic nature of mortality improvements

• Evident for many years that mortality rates have
  been evolving in apparently stochastic fashion.
• Sequences do exhibit general trend, but changes
  have an unpredictable element
• not only from one period to next
• but also over the long run.

11
Mortality improvements over time

12
Mortality improvements over time

13
Longevity risk

• Large number of products in life insurance and
  pensions have mortality as key source of risk.
• Products exposed to unanticipated changes over
  time in mortality rates of relevant reference
  populations.

14
Longevity risk

• Eg annuity providers exposed to risk that
  mortality rates of pensioners will fall at faster
  rate than accounted for in pricing and reserving
  calculations
• Current pool of annuitants living 2 years longer
  than anticipated

15
Longevity risk

• Annuities are commoditised products selling on
  basis of price, profit margins have to be kept
  low in order to gain market share.
• If mortality assumption built into price of
  annuities turn out to be gross overestimate, cuts
  straight into profit margins of annuity
  providers.
• Most life companies claim to lose money on
  annuity business.

16
Longevity risk

• Yet life annuities are mainstay of pension plans
  throughout the world
• they are the only instrument ever devised capable
  of hedging longevity risk.
• Without them, pension plans will be unable to
  perform their fundamental task of protecting
  retirees from outliving their resources for
  however long they live.
• Real danger that they might disappear from
  financial scene.

17
Significant concern!

• Reinsurers (eg Swiss Re) have stopped reinsuring
  longevity risk of life offices!

18
Longevity bonds to the rescue!

• Life annuity bond coupon payments decline in
  line with mortality index
• Eg based on population of 65-year olds on issue
  date.
• As population cohort dies out, coupon payments
  decline, but continue in payment until the entire
  cohort dies.
• Eg, if after one year 1.5 of population has died
  out, 2nd years coupon payment is 98.5 of 1st
  years etc

19
(No Transcript)
20
Problem

• Natural shortage on supply side
• Very few institutions have natural longevity
  hedges in their balance sheets
• One example would be pharmaceuticals
• So is there a role for Government to issue
  longevity bonds?
• Government is Insurer of Last Resort
• By issuing longevity bonds, Government could help
  create a missing market

21
Conclusion

• Existence of longevity bonds
• will facilitate the development of annuities
  markets in the developing world
• and could well save annuities markets in the
  developed world from extinction.
• They will be the NEW product of the 21st century!