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Longevity Risk: Public and Private Sector Solutions and the Government’s Role

Ross JonesDeputy Chairman, Australian Prudential Regulation Authority

September 2010

The impact of the financial crisis

• Despite substantial recovery funding levels for pension funds at the end of 2009 was significantly lower than two years before.

• Funding levels for pension funds of OECD members had median funding deficit (gap between assets and liabilities) at 26 per cent at end of 2009.

• Decreasing band yields (which are used to calculate liabilities) in many countries meant that liabilities went up, offsetting the equities recovery.

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The impact of the financial crisis

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• Pension funds nominal investment rate of return in selected OECD countries, 2008-2009 (%).

Source: OECD Global Pension Statistics and OECD estimates.

Policy responses to the crisis (OECD and IOPS)

• Some governments are being pressured to retreat from private pensions but public PAYG systems have sustainability issues due to aging population and now higher levels of unemployment.

• Emphasis on long term nature. There has been a tendency in a number of countries to allow greater flexibility in access during crisis but this risks creating longer term deficits.

• Safety net should address issues of insufficient income at retirement e.g. ‘top ups; for DC accounts but incentives may be needed to deep people working and to increase non compulsory contributions.

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Policy responses to the crisis (OECD and IOPS)

• Improve the design of DC plans including default e.g. flexibility in timing of annuity purchase, guarantees for DC (but who pays).

• Improved pension fund governance and risk management.

• Improved disclosure, communication and financial education.

• Funding and solvency rules for DB plans should be counter-cyclical with greater flexibility in funding requirements.

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Three problems of longevity risk

Funding of DB plans

• Adequacy of retirement savings

• Lack of financial instruments for hedging

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Funding of DB Plans – extent of the problemdepends on the structure of retirement system

Public Private

Defined Benefit Austria, Belgium, Canada, Czech Republic, FinlandFrance, Greece, Hungary, Japan, Korea, Luxembourg, Portugal, Spain, Switzerland, Turkey, UK, US

Iceland, Netherlands, Switzerland

Defined Contribution, or Notional DC

Germany, Italy, Norway, Poland, Slovak Republic, Sweden

Australia, Denmark, Hungary, Mexico, Norway, Poland, Slovak Republic, Sweden

Source: OECD Pensions at a Glance 2009

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Australian system has reduced reliance on DB in the last decade

Source: APRA Data, Total Superannuation Assets includes APRA-regulated fundsand self-managed superannuation funds

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The GFC has highlighted investment risk in DBfunds and created severe underfunding problems

Source: Yermo and Severinson, OECD, July 2010

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OECD Policy Recommendations

• Need to strengthen regulation of solvency issues

• Focus on counter-cyclical funding– allowing over-funding in good economic times – Limiting contribution holidays and sponsor access

to surplus

• Stability of contribution patterns is important

• Regulators should incorporate flexibility into funding rules to reflect the overall volatility of funding valuations

Source: Yermo and Severinson, OECD, July 2010

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APRA’s focus

• Supervisory attention on recovery plans for under-funded DB plans

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Longevity Risk and DB under-funding

• Under-funding problems are larger than currently measured

• Netspar research suggests fully-funded DB plans need a surplus of 4-5% to cover longevity risk over five year period (De Waegenaere, Melenberg, Stevens, 2010)

• More countries moving from DB to Notional DC frameworks (Netherlands)

• [Role of Government Insurers (PBGC in the US, PPF in UK) – topic to be covered by Martin Clarke]

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Three problems of longevity risk

• Funding of DB plans

Adequacy of retirement savings

• Lack of financial instruments for hedging

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Australian context

• Three pillar retirement framework– Social security safety-net– Universal superannuation– Tax-advantaged voluntary additional savings

• Mandatory employer superannuation contributions introduced in 1992– 3% in 1992, 9% in 2002– Current proposal 12%

– Average balance of 55-64 year old is only $72,000 (ABS,2009)

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Relative size of retirement savings – Australiahas large assets compared to other countries

Source: OECD Global Pension Statistics

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Australian Treasury projections of adequacysuggest the system will provide for retirement

Source: Treasury Projections from the Henry Tax ReviewAustralia’s Future Tax System – The retirement income system: report on strategic issues, May 2009

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However projections of adequacy vary widely based on assumptions

Source: NATSEM microsimulation results from Keegan, Harding, Kelly (2010)

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What Retirement Products are used?

Lump sum only

Lump sum or PW

Lump sum, PW or annuity

Lump sum or annuity

Partial lump sum or annuity

PW or annuity

Annuity only

Hong Kong

India

Luxembourg (SEPCAV)

Phillippines

Indonesia

China

Malaysia

Australia

Brazil

Denmark

Japan

Luxembourg

Spain

Greece

Belgium

Czech Republic

Hungary (voluntary funds)

Switzerland (voluntary funds)

USA

Germany

Ireland

Italy

Portugal

South Africa

UK

Argentina

Canada

Chile

Costa Rica

Mexico

Norway

Peru

Austria

Belgium*

Colombia

Croatia

Germany*

Hungary*

Netherlands

Poland

Russia

Sweden

Switzerland*

UruguaySource: OECD * indicates mandatory funds

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OECD policy recommendations on adequacy and longevity risk

• Need to save for a long time– Contribution rates and length of contribution period

are primary importance in determining adequacy

• Increase retirement age as population ages

• If retirement phase focuses on annuities– Life cycle investing is optimal

• If retirement phase focuses on gradual/prescribed withdrawals– Maintaining a high allocation to equities throughout

retirement can provide higher retirement income

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Australian context

• Most lump sums are small (less than $60,000) reflecting the immature superannuation system

• Account-based pensions cover 88% of retirement products– Retirees still exposed to investment and longevity risk

• Government pension is main protection against longevity risk

• Annuity products not active– ING’s Money for Life, AXA North Guarantee, Macquarie

Lifetime Income Guarantee

• Barrier to pooled solutions: DC mentality in Australia, bequest motives, expensive products

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Three problems of longevity risk

• Funding of DB plans

• Adequacy of retirement savings

Lack of financial instruments for hedging

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Private Solutions

• Many papers at this conference are exploring this problem

• Private market solutions appear to be the best approach

• Not an immediate concern in Australia due to DC focus

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OECD Policy Recommendations

• Government can help by providing updated mortality tables that incorporates longevity risk

• Governments can play a role by developing a longevity index that can be used for pricing

• Governments can issue inflation-indexed long dated bonds to facilitate asset liability management

• [highlight APRA’s engagement with UNSW researchers?]

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Summary

• Public solutions to longevity risk problems– Reforming retirement industry structure– Regulations that encourage product innovation but

preserve safety of retirement assets– Investment in research

• Private solutions to longevity risk problems– Innovative products to hedge risks– Investment in research