Demography, Capital Markets and Pension Risk Management Adair Turner IMF Seminar The views expressed in this paper are those of the author(s) only, and the presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the paper.

Washington, 7th February 2007

Demographic factors at work

•

Increasing longevity

•

Lower fertility

•

Retirement of Baby Boom

1

Estimates of cohort life expectancy: Male at 65 UK Government Actuary’s principal projections

Cohort life expectancy at 65

30

25

20

15

10 1950

1960

1970

1980

1990

2000

2010

2020

2030

Historical

Principal Projection

1983-based Projection

1992-based Projection

2040

2050

(2003)

2

Increasing longevity – The non-problem Possible problem

PAYG

Funded

Solution

Increased % of life beyond post retirement ages

Increase retirement ages proportionally to keep % stable

Increased ratio of pensioners to contributors

Unchanged affordability at unchanged contribution rate

Increased saving to fund longer retirement

No/minimal charges in K/L ratio for unchanged real income in retirement

• Long-term effect ¾ K/L rises ¾ Return on capital falls • Transitional effect: asset prices rise

3

From pyramids to columns Age Group 100 + 95 - 99 90 - 94 85 - 89 80 - 84 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

B

B

B

A

A

A

4

People over SPA to those aged 20 – SPA* 0.6 With SPA fixed at 65

0.5 0.4

With SPA rising proportionally (to 68.5 in 2050 and 70.2 in 2070)1

0.3 0.2 0.1 0 2006

2020

2030

2040

2050

2060

2070

* SPA: State Pension Age (1) This proportionate adjustment maintains the proportion of life over 20 years old which is spent in retirement at 27.5%

5

Lower fertility – The inherent challenge to pension systems PAYG

Increased ratio of pensioners to contributors

Lower pensions relative to average earnings Higher contribution rates Increase Pension Age more than proportionally with life expectancy

Funded

Savers of generation 1 have to sell accumulated assets to “smaller”* generation 2

Transitional asset price fall effect K/L rises: return on capital falls

* Smaller can mean either absolutely smaller than G1 (if fertility < 2.0) or “smaller than would be the case if fertility had not fallen”

6

Possible de facto demographic effects on funded systems and capital markets Lower Fertility

Transitional asset price fall effect (at sale)

Inherent effect of shift to lower fertility

K/L rises: return on capital falls

Increased Longevity

Transitional asset price rise effect Longer-term effect; K/L rises, return on capital falls

Not inherent but could occur if future pensioners do not adjust retirement ages but instead increase savings rate

7

Demographic impacts on returns to capital Model Results •

Garry Young:

Baby-boom generation Increased longevity Falling fertility

•

David Miles:

Given future actual trends in UK demographics, returns fall:

-0.1% -0.1% -0.3%

¾ 4.56% (1990) to 4.22% (2030) ¾ 4.56% (1990) to 3.97% (2060) if PAYG phased out

8

Real S&P500 price index and % of 40-64 year olds among total U.S population 1950-2003

Real S&P500 Price Index

34

1800

33

1600

32

1400

31

1200

30

1000

29

800

28

600

27

400

26

200

25

0 24 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 Real S&P500 (LHS)

Percentage of 40-64 Population

Forecast

2000

40-64 population/ total population (RHS)

Source:: Poterba (2004), with additional data to 2006

9

Theoretical & empirical approaches to measuring demographic effects “Given the limited amount of time series on returns and demographic variation, and the difficulty of controlling for all of the other factors that may affect asset values and asset returns, the theoretical models should be accorded substantial weight in evaluating the potential impact of demographic shifts”

Poterba: “The Impact of Population Ageing on Financial Markets”

10

Global glut of savings hypothesis In China and other East Asian countries • Fewer children enable higher savings rate • Awareness of greater longevity, fewer children and lack of social welfare net, require a high savings rate

Developed countries save more to cope with their demographic/pension challenges

Global glut of savings relative to investment Long-term, not just cyclical, fall in real interest rates Transitional positive asset price effects

11

01/01/2005

01/01/2004

01/01/2003

01/01/2002

01/01/2001

01/01/2000

01/01/1999

01/01/1998

01/01/1997

01/01/1996

01/01/1995

01/01/1994

01/01/1993

01/01/1992

01/01/1991

01/01/1990

01/01/1989

01/01/1988

01/01/1987

01/01/1986

Percent

Real yields to maturity on UK index-linked gilts

1986 – 2004

5

4.5

4

3.5

3

2.5

2 2.5 Year 5 Year 10 Year 20 Year

1.5

1

0.5

0

12

UK Long-term real interest rates 11% 9% 7%

Real interest rate Long-term average (1700-2004) Estimate for 2005

5% 3% 1% -1% -3% -5%

Estimate for 2005, as of 02 March 2005

-7% 1700 1716 1732 1748 1764 1780 1796 1812 1828 1844 1860 1876 1892 1908 1924 1940 1956 1972 1988 2004

Source: Morgan Stanley Research

13

Whole world gross savings rate 1981 - 2005

25

20

15 1981

1986

1991

1996

2001

2006

Source: IMF World Economic Outlook database

14

Gross savings rates: developing Asia and the US % of GDP 1981 - 2005 40 35

Developing Asia

30 25 20 15

USA

10 5 1981

1985

1989

1993

1997

2001

2005

Source: IMF World Economic Outlook database

15

Alternative hypothesis on global labour / capital balance Very long-term future increase in K/L driven by demography … but short/medium term massive increase in the economically relevant labour force … not matched by increase in global savings/capital stock

Low real wage growth in developed countries, driven by: • China and India in traded goods/services • Immigration in non-traded services

Buoyant profits and profit share of GDP: high equity returns

16

Profit share of GDP – U.S. % of GDP

1970 - 2004 35

30

25

20 1970

1980

1990

2000

Note: Gross Operating Surplus and Gross Mixed Income as % of GDP (Income approach) Source: OECD: www.oecd.org/statistics/national-accounts

17

So why are real interest rates historically low?

• Not Rise in the global supply of capital relative to labour

• But Particular asset allocation preference of major national savers

18

Demographic challenges to funded pension systems

•

Increasing longevity

Not inherent problem but possible de facto

•

Lower fertility

Overwhelmed in shortterm by globalisation effect

•

Uncertainty of longevity forecasts

19

Estimates of cohort life expectancy: Male at 65 UK Government Actuary’s principal projections

Cohort life expectancy at 65

30

25

20

15

10 1950

1960

1970

1980

1990

2000

2010

2020

2030

Historical

Principal Projection

1983-based Projection

1992-based Projection

2040

2050

(2003)

20

Mortality rate declines & UK G.A. principal 2003 projection

Cohort life expectancy at 65

40 35 30 25 20 15 10 1980

1990

2000

2010

2020

2030

1% pa Mortality Decline

2% pa Mortality Decline

3% pa Mortality Decline

Principal Projection

2040

2050

Historical

21

Male cohort life expectancy at 65 Uncertainty in 2003 forecasts if already apparent 1983 errors/changes are the maximum possible and if error potential is symmetrical

Cohort life expectancy at 65

30

25

20

15

10 1980

1990

2000

2010

2020

2030

Historical

Possible Maximum

Possible Minimum

GAD Principal Projection

2040

2050

22

Interpreting the range of uncertainty • Inherent uncertainty not quantifiable risk

• Total error potential unclear from past errors

• Are the uncertainties symmetric?

• Are future potential error rates likely to be as high as 2003 vs 1983 comparison?

23

Male cohort life expectancy at 65: range of possible uncertainty around 2004 - based principal projection 30

Years

25

20

15

10 1980

1990

2000

2010

2020

2030

2040

Historical

GAD Principal 2003-based

Upper 90% bound?

Lower 90% bound?

2050

GAD Principal 2004-based

Source: Government Actuaries Department (GAD) and Pensions Commission estimates, UK

24

Longevity risk in UK pension provision £bn of total liabilities – broad estimates at April 2005 Insurance Companies Annuities

80

Pension Funds

800

Unfunded Public Employee Pensions

450*

Legal liabilities or close to legal liabilities

State Pensions •

Basic

870

•

Earnings-related

260

Total

Political promises Can theoretically be changed

2460

* Latest figures (2006) suggest unfunded public employee liabilities now about £550bn

25

Longevity risk in UK pension provision £bn of total liabilities – broad estimates at April 2005 Pre-retirement

Post-retirement

Insurance Companies

10?

70?

Pension Funds

400?

400?

Unfunded Public Employee Pensions

260

190

State Pensions • Basic • Earnings-related

490 170

380 90

Total

1330

1130 26

Three factors driving increased overt annuitisation

•

Defined Benefit Defined Contribution shift ¾ Increased awareness of risks

•

Defined Benefit legacy risk management

•

¾

Bulk buyouts

¾

Latent demand for longevity bonds

Declining generosity of state PAYG annuities if private savings rise.

demand for post-retirement

27

Possible long-term annuity or longevity bonds stock? Present Stock £bn Overt Annuities (Life Companies) Post Retirement

Pre Retirement

70

10

Annuity Promises (DB Pension Fund)

400?

400?

Total

470

Required stock to replicate annuity promises given by final salary schemes

410

Required to manage legacy DB promises

28

Who should bear cohort longevity risk? Post-retirement: e.g. the risk that the cohort of 65 year olds living in 2005 will live for 20 years not current estimate of 19 years Long-Term pre-retirement: i.e. the risk that the cohort of 35 years old living in 2005 will live for 25 years after reaching 65 in 2035 rather than the current estimate of 21.2 years

• Social interest in a fairly priced annuity market • Longevity uncertainties moderate

• Natural offset exists in human capital / later retirement • Longevity uncertainties huge.

29

The search for yield uplift

•

Hedge funds: alpha without beta

•

Complex yield enhancing strategies: credit derivatives

•

Infrastructure finance

30

Conclusions Macro-Effects

Long-term potential demographic effects swamped by medium-term globalisation and asset allocation effects driving ¾ Falling K/L ratio, high capital returns ¾ Low real interest rates

Pension Fund Management Effects

Decreasing willingness of corporates / governments to absorb longevity risk ¾ Increased demand for liability matching assets ¾ Increased demand for yield enhancement at low (?) risk 31