Demography, Capital Markets and

Pension Risk Management

Adair Turner

IMF Seminar

Washington, 7th February 2007

2

Demographic factors at work

• Increasing longevity

• Lower fertility

• Retirement of Baby Boom

3

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

(2003)

10

15

20

25

30

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Coh

ort

life

expe

ctan

cy a

t 65

Historical Principal Projection

1983-based Projection 1992-based Projection

4

Increasing longevity – The non-problem

Increased % of life beyond post retirement ages

Increased ratio of pensioners to contributors

Increased saving to fund longer retirement

• Long-term effect K/L rises Return on capital falls

• Transitional effect: asset prices rise

Increase retirement ages proportionally to keep % stable

Unchanged affordability at unchanged contribution rate

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

PAYG

Funded

Possible problem Solution

5

From pyramids to columns

0 - 4

5 - 910 - 1415 - 1920 - 24

25 - 2930 - 3435 - 3940 - 4445 - 4950 - 5455 - 5960 - 6465 - 69

70 - 7475 - 7980 - 8485 - 8990 - 9495 - 99100 +

Age Group

B

A A

B

A

B

6

People over SPA to those aged 20 – SPA*

0

0.1

0.2

0.3

0.4

0.5

0.6

2006 2020 2030 2040 2050 2060 2070

* SPA: State Pension Age

With SPA fixed at 65

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

(1) This proportionate adjustment maintains the proportion of life over 20 years old which is spent in retirement at 27.5%

7

Lower fertility – The inherent challenge to pension systems

Increased ratio of pensioners to contributors

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

Lower pensions relative to average earnings

Increase Pension Age more than proportionally with life expectancy

Higher contribution rates

PAYG

Funded

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

8

Possible de facto demographic effects on funded systems and capital markets

Transitional asset price fall effect (at sale)

K/L rises: return on capital falls

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

Inherent effect of shift to lower fertility

Lower Fertility

Increased Longevity

9

Demographic impacts on returns to capital

• Garry Young: Baby-boom generation -0.1%Increased longevity -0.1%Falling fertility -0.3%

• David Miles: Given future actual trends in UK demographics, returns fall:

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

phased out

Model Results

10

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

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

0

200

400

600

800

1000

1200

1400

1600

1800

2000

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Rea

l S

&P

500

Pri

ce I

nd

ex

24

25

26

27

28

29

30

31

32

33

34

Perc

enta

ge

of

40-

64

Po

pu

lati

on

Real S&P500 (LHS) 40-64 population/ total population (RHS)

Forecast

11

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”

12

Global glut of savings hypothesis

• Fewer children enable higher savings rate

• Awareness of greater longevity, fewer children and lack of social welfare net, require a high savings rate

Global glut of savings relative to investment

Long-term, not just cyclical, fall in real interest rates

In China and other East Asian countries

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

Transitional positive asset price effects

13

Real yields to maturity on UK index-linked gilts

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

01

/01

/19

86

01

/01

/19

87

01

/01

/19

88

01

/01

/19

89

01

/01

/19

90

01

/01

/19

91

01

/01

/19

92

01

/01

/19

93

01

/01

/19

94

01

/01

/19

95

01

/01

/19

96

01

/01

/19

97

01

/01

/19

98

01

/01

/19

99

01

/01

/20

00

01

/01

/20

01

01

/01

/20

02

01

/01

/20

03

01

/01

/20

04

01

/01

/20

05

Pe

rce

nt 2.5 Year

5 Year

10 Year

20 Year

1986 – 2004

14

UK Long-term real interest rates

Source: Morgan Stanley Research

-7%

-5%

-3%

-1%

1%

3%

5%

7%

9%

11%

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

Real interest rate

Long-term average (1700-2004)

Estimate for 2005

Estimate for 2005, as of 02 March 2005

15

Whole world gross savings rate

1981 - 2005

Source: IMF World Economic Outlook database

15

20

25

1981 1986 1991 1996 2001 2006

16

Gross savings rates: developing Asia and the US% of GDP

1981 - 2005

Source: IMF World Economic Outlook database

USA

DevelopingAsia

5

10

15

20

25

30

35

40

1981 1985 1989 1993 1997 2001 2005

17

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

18

Profit share of GDP – U.S.

1970 - 2004

20

25

30

35

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

% of GDP

19

So why are real interest rates historically low?

Rise in the global supply of capital relative to labour

Particular asset allocation preference of major national savers

• Not

• But

20

Demographic challenges to funded pension systems

• Increasing longevity

• Lower fertility

• Uncertainty of longevity forecasts

Not inherent problem but possible de facto

Overwhelmed in short-term by globalisation effect

21

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

10

15

20

25

30

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Coh

ort

life

expe

ctan

cy a

t 65

Historical Principal Projection

1983-based Projection 1992-based Projection

(2003)

22

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

10

15

20

25

30

35

40

1980 1990 2000 2010 2020 2030 2040 2050

Coh

ort

life

expe

ctan

cy a

t 65

1% pa Mortality Decline 2% pa Mortality Decline

3% pa Mortality Decline Principal Projection

Historical

23

Male cohort life expectancy at 65

10

15

20

25

30

1980 1990 2000 2010 2020 2030 2040 2050

Coh

ort

life

expe

ctan

cy a

t 65

Historical Possible Maximum

Possible Minimum GAD Principal Projection

Uncertainty in 2003 forecasts if already apparent 1983 errors/changes are the maximum possible and if error potential is symmetrical

24

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?

25

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

10

15

20

25

30

1980 1990 2000 2010 2020 2030 2040 2050

Yea

rs

Historical GAD Principal 2003-based

Upper 90% bound? Lower 90% bound?

GAD Principal 2004-based

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

26

Longevity risk in UK pension provision

Legal liabilities or close to legal liabilities

Political promises

Can theoretically be changed

£bn of total liabilities – broad estimates at April 2005

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

State Pensions

• Basic 870

• Earnings-related 260

Insurance CompaniesAnnuities

Pension Funds

Unfunded Public Employee Pensions

80

800

450*

Total 2460

27

Longevity risk in UK pension provision

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

£bn of total liabilities – broad estimates at April 2005

28

Three factors driving increased overt annuitisation

• Defined Benefit Defined Contribution shift Increased awareness of risks

• Defined Benefit legacy risk management

Bulk buyouts

Latent demand for longevity bonds

• Declining generosity of state PAYG demand for post-retirement annuities if private savings rise.

29

Possible long-term annuity or longevity bonds stock?

Overt Annuities

(Life Companies)

Annuity Promises

(DB Pension Fund) Total

Post

Retirement 70 400? 470

Pre

Retirement 10 400? 410

Required stock to replicate annuity promises given by final salary schemes

Required to manage legacy DB promises

Present Stock £bn

30

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.

31

The search for yield uplift

• Hedge funds: alpha without beta

• Complex yield enhancing strategies: credit derivatives

• Infrastructure finance

32

Conclusions

Long-term potential demographic effects swamped by medium-term globalisation and asset allocation effects driving

Falling K/L ratio, high capital returns

Low real interest rates

Decreasing willingness of corporates / governments to absorb longevity risk

Increased demand for liability matching assets

Increased demand for yield enhancement at low (?) risk

Macro-Effects

Pension Fund Management Effects