Evaluation of The Measures Taken for Management of Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems Assist.Prof.Dr. Yılmaz BAYAR September 24, 2012 Congress Centre VŠFS, Prague

Longevity Risk Evaluation of the Measures Taken for Management of Longevıty Risk Conclusion Outline ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems *Blue: Men, Red: Women Source: United Nations, World Population Prospects: The 2010 Revision, CD-ROM Edition Male and Female Life Expectancy at Birth in the World (Years)*

The upward trend at life expectancy for men and women causes individuals, governments and private pension providers to face the longevity risk. Longevity risk is the risk that future outcomes in mortality and life expectancy will turn out higher than expected and accounted for. Longevity risk comprises individual and aggregate/cohort longevity risk. Individual longevity risk refers to the possibility of living longer than assumed in financial planning for the retirement of a single individual. Aggregate longevity risk refers to the possibility of a higher average number of years of survival than assumed in designing a retirement security system for the aggregate. Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Individuals, pension funds, annuity providers and governments are exposed to longevity risk directly or indirectly. The negative effects of longevity risks can’t be seen in short time, however if it is not taken into account and managed correctly in the financial planning stage, it can harm to the related parties in the future. It is very important to be aware of longevity risk and manage it in order to mitigate its negative effects. The sharing of longevity risk differs across countries depending on their existing pension systems. Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Governments all over the world bear a significant amount of longevity risk as main regulator. Government can be exposed to the longevity risk, - through public pension plans (such as Pay As You Go financed pensions and funded DB pension plans), - through social security schemes (indivuals who run out of resources in retirement will need to depend on social security schemes to sustain their living), and - as the holder of last resort of longevity risk of individuals and financial institutions (financial institutions or corporations face solvency threats from longevity exposure) Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Individuals bear the longevity risk in DC pension schemes, Corporations that offer DB schemes, insurance companies which are selling life annuities also bear the longevity risk. Since insurance companies and pension funds are interconnected with other financial institutions, the financial consequences of a longevity shock could propagate through the financial system. Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Individuals, governments and private pension providers are already becoming aware of longevity risk which are faced in different ways. Management of longevity risk is very hard and it requires a dynamic structure which monitors life expectancy attentively and reflect the changes to the financial planning. Increasing the retirement age or linking retirement ages to the developments in demography and tightening the early retirements, Reducing benefits and increasing contribution rates to social security schemes, Transition from DB schemes to DC schemes gradually, thusly transferring the risk to the pensioners, Establishing a pension system which consist of multiple pillars by increasing the share of private pension providers in pension system, Transferring longevity risk to investors in financial markets by securitization of longevity risk Evaluation of the Measures Taken For Management Of Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Evaluation of the Measures Taken For Management Of Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems Normal Pension Ages by sex, Source: OECD

While DC pension plans provide a clear and direct link between contributions and benefits, DB pension plans promise certain pension benefits. Therefore the link between contributions and pension benefits is far from straightforward. In DC pension plans, income at retirement depends on the contribution rate and rate of returns of these contributions. Therefore, the level of contributions would have a direct effect on retirement income and related replacement rates in DC pension plans. While any shortfall due for example to underperformance of investments or longevity changes in DB pension plans is the responsibility of plan sponsors, the individual bears all the risks and is responsible for any shortfall in DC pension plans. Evaluation of the Measures Taken For Management Of Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

The shift from DB to DC has also been implemented to reduce costs to sponsors or employers. In most cases, employers do not contribute to DC plans as much as they had to contribute to DB pension plans. During the last ten years DC assets have grown at a rate of 7,9% per year while DB assets have grown at a rate of 4,6%. The share of DC assets in total pension assets was increased to 43,1% in 2011 from 38,3 in This verifies the growing dominance of DC pensions. Evaluation of the Measures Taken For Management Of Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Evaluation of the Measures Taken For Management Of Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems Relative Shares of DB, DC and Hybrid/Mixed Pension Fund Assets in Selected OECD Countries (% of total assets) (2010) Source: OECD, Pension Markets in Focus No.8.

Governments have made reforms in order to increase the share of private pension providers in pension system for diversification and security. But the share of private pension schemes is still at low levels and public pensions dominated the system. The last global financial crisis has raised doubts especially about voluntary private pensions. It is very important to increase the share of the private pensions in the long term for the financial sustainability of public pensions, adequacy of retirement income and reducing the risk by diversification. Evaluation of the Measures Taken For Management Of Longevity Risk ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Longevity bonds, longevity swaps, buy-in and buyouts are the major instruments to transfer the longevity risk to the investors in financial markets. The longevity bonds are the first financial instruments which are developed to hedge aggregate longevity risk. Longevity bonds, which involve no repayment of principal, pay declining coupons that are linked to the survivorship of a cohort. If a higher-than-expected proportion of this cohort survived, the coupon rate would increase, off­setting some of the provider’s cost. BNP Paribas and the European Investment Bank issued the first longevity bond of GBP 540 million designed to protect pension schemes against the longevity risk in November 2004, but then withdrawn due to a lack of demand in late Swiss Re transferred USD 50 million of longevity trend risk to the capital markets by issuing its first longevity trend bonds on 23 December If this second issuance is accepted by investors, it will demonstrate that this type of risk can be packaged and sold. The longevity bond issuance has not been demand sufficiently until today. Evaluation of the Measures Taken For Management Of Longevity Risk-Longevity Bonds ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

A pension buy-in or a pension buy-out is another option which is offered by insurers or insurance vehicles in order to manage the longevity risk. The plan assets and liabilities are transferred from the plan sponsor to the insurer in pension buy-out, thusly enabling the sponsor to be fully discharged of liabilities and uncertainties of asset returns. The insurer receives an upfront premium and provides an individual annuity to each plan member. The existing assets of the plan are exchanged for annuities provided by an insurance company who assumes your plan’s longevity risk with a pension buy-in. In both cases liability and risk are outsourced and the longer term costs of administering the pension scheme fall. Evaluation of the Measures Taken For Management Of Longevity Risk-Pension Buy-in, Buy-out ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Longevity swaps are one type of the created instruments which are similar to interest rate or inflation swaps to hedge longevity risk. With a longevity swap, the counter party to the plan sponsor is typically an investment bank. If plan participants live longer than expected, the plan sponsor receives payments from the investment bank. If plan participants die sooner than expected, then the plan sponsor makes payments to the investment bank. Investment banks typically package and sell the longevity risk to institutional investors. A longevity hedge only allows the pension plan to transfer longevity risk, while other sources of risk remain and are managed separately unlike a pension buy-out or buy-in. Evaluation of the Measures Taken For Management Of Longevity Risk-Longevity Swaps ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

There are two types of longevity swaps: - Scheme experience swaps which are generally targeted at pensioner members and - Population index swaps which are based on a population longevity index. The effectiveness of the swap depends on the pension plan’s performance relative to this index. The world's first publicly announced longevity swap was realized between Swiss Re and the UK life office Friends' Provident in April Evaluation of the Measures Taken For Management Of Longevity Risk-Longevity Swaps ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

q-forward is a financial derivative that can be used to manage or actively take exposure to mortality risk. They are derivatives involving the exchange of the realized mortality rate of a population at some future date, in return for a fixed mortality rate agreed at inception. A portfolio of q-forwards can be used to provide an effective hedge of the mortality risk of a life assurance portfolio, or of the longevity risk of a pension plan or annuity book. The world’s first capital market derivative transaction, a q- forward contract between J. P. Morgan and the UK pension fund buy-out company Lucida took place in January Evaluation of the Measures Taken For Management Of Longevity Risk-q forward ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems

Life expectancy is steadily increasing in parallel with advances in standards of living and medicine and it is expected that life expectancy will be reached to 78,97 years old for men with a 17,7% increase and 83,33 years old for women with a 16,4% increase between The increases in life expectancy are becoming a serious risk to be managed for governments, pension funds, life insurance companies and individuals in order to sustain their pension systems healthfully. ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems Conclusion

Increase retirement ages in line with life expectancy, Limit early retirement or tighten eligibility criteria for early retirement schemes Reduce replacement rates by indexing pensions to prices and increasing the pensionable base to capture lifetime earnings Increase the efficiency of contribution collections, Transition from DB pension schemes to DC pension schemes gradually (thusly longevity risk is passed from governemt and private pension providers to households.), Set up a three-pillar pension system by increasing the share of private pension providers in pension system, Transferring longevity risk to investors in financial markets by securitization of longevity risk. ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems Conclusion

Some of the measures especially transition from DB schemes to DC schemes, increasing the share of private pension providers in pension system and increasing the trade of longevity-linked assets and liabilities in the capital markets have fallen short due to country specific conditions, global financial crisis and European sovereign debt crisis and pricing difficulty of longevity-linked securities. Although global capital markets are very developed, the financial instruments to tackle longevity risk remains limited and the developed financial instruments such as longevity bonds and longevity swaps have not met sufficient demand yet. Making progress in transferring longevity risk to the investors in capital markets and increasing the share of private pensions in pension system will have key roles in mitigating the negative effects of longevity risk arisen from increases in life expectancy. ERSJ Workshop 2012: Financial Management & Economics of Health & Pension Plan Systems Conclusion

Thank you for your attention!