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Longevity Risk Transfer: A PPF Perspective Sixth International Longevity Risk and Capital Markets Solutions Conference 9 th & 10 th September 2010. Martin Clarke, PPF Executive Director of Financial Risk.

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Longevity Risk Transfer: A PPF PerspectiveSixth International Longevity Risk and Capital Markets Solutions Conference 9th & 10th September 2010

Martin Clarke,

PPF Executive Director of Financial Risk


Slide2 l.jpg
Pension Protection Fund (PPF) was established in April 2005 to protect members of defined benefit pension schemes

  • PPF pays compensation to members of DB pension schemes where the scheme sponsor becomes insolvent and there are insufficient assets to buy compensation on the open market

    • PPF compensation is 100% of pensions in payment and 90% of pensions in deferment

    • There is a cap in the case of deferred members and indexation/escalation is also capped

  • PPF is funded by:

    • A levy on eligible pension schemes currently £720 million per annum

    • The assets of schemes that it takes over

    • Recoveries from insolvent scheme sponsors

  • PPF is a public corporation established by Act of Parliament but it has no Government guarantee

Vision: Protecting people’s futures.

Mission: Pay the right people the right amount at the right time


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Its easy to see why we’re worried about longevity….. to protect members of defined benefit pension schemes

“For a 65 year old male today a 20% improvement in longevity will reduce his annuity by 9%”

Financial adviser

“Demographic picture very worrying – we face a pensioners crisis. Baby boomers reaching age 65 in the next three years – what will they live on?”

Ros Altmann 2009

“I've got all the money I need for my old age... provided I die before 4pm today”

Groucho Marx

“Sharply rising longevity adds urgency to pension review”

Financial Times June 2010

Nobody is disputing the evidence on mortality improvements – people are living longer and this will impact upon pension scheme costs”

The Pensions Regulator 2008


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…but how do you assess the available options? to protect members of defined benefit pension schemes

  • For a traditional carrier, risk is measured as cost of the economic capital required to cover extreme outcomes

    • Hedging solutions such as reinsurance can be judged by the net effect on risk adjusted profit

  • A UK pension scheme it is not required to hold a reserve against uncertain outcomes although its funding has to be based on prudent assumptions

  • Schemes can evaluate the cost of risk as threats to their funding objectives

    • Do they apply risk pricing techniques? Are they looking at all risks or just longevity?

  • There is still room for a qualitative overlay which may come from the sponsor’s overriding desire for stability/predictability

In PPF’s case the position is complicated by its potential to continue to

accrue additional liabilities as a result of future insolvencies


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PPF targets “self sufficiency” in 20 years’ time; off-balance sheet risks will then be limited and on balance sheet liabilities mature:

PPF claims as % of PPF liabilities

  • The impact of claims will decline over time

    • Scheme funding will improve

    • Risk mitigation trends continue including buy outs

    • Scheme closures to new entrants / accruals

  • Both UK DB & PPF liabilities will mature over the next 20 years

    • Average age of DB members will increase from 56 to 71

    • 70% of DB liabilities will be pensioner

    • Outstanding duration of PPF liabilities will fall from 21 to 12

  • The population of levy payers will continue to decline

    • Number of levy payers may halve

    • PPF liabilities become 10 to 15% of total DB

Age distribution of PPF members


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“Self sufficiency” means that the potential future burden on residual levy payers by 2030 remains affordable

  • PPF investment risk will be reduced to a minimal level

    • Scope to underwrite investment risk positions limited by capacity and appetite of levy payers

  • Residual interest rate and inflation risk will be hedged

    • Dependent on market for available instruments

  • Margin for “unhedgable” risks such as residual claims and longevity

    • Margin initially set at 10% to give a 90% certainty over the remaining period of the fund

    • Balances interests of levy payers and beneficiaries

    • Extreme longevity scenarios likely to prompt a policy reaction

    • But how do we decide to hedge and if so when?

The PPF Board believes that, given future uncertainty and the absence of any

external guarantee, a chance of success of 80% over 20 years is reasonable


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A good hedge for PPF is one that improves the funding success rate during the accumulation phase or that reduces the reserve for adverse experience in the decumulation phase

  • Base Case

  • PPF base case has 83% success percentage

  • 1.5% reduction to our funding target improves success rate by 1% (equivalent to a levy reduction of £50m)

  • Diversification effect

  • Over 20 years credit/market risk reduces by two thirds (in economic capital terms from £10 bn to £3bn)

  • Longevity risk rises from 0.8% of liabilities to 7.5%

  • Impact of stochastic vs deterministic mortality in accumulation phase is 1% to success rate

Note that PPF’s appetite for longevity risk transfer will progressively increase

PPF risk composition through time

100

Market risk

%

Credit risk

Longevity risk

0

2010

2030

2020

Decumulation phase

Accumulation phase


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Using our funding model we can evaluate the impact of our diversification effect on hedging strategies as shown in this example

  • Let base case assume that PPF will hedge when it becomes self sufficient in 2030

  • We also assume this will be at the current price points we have discovered

  • We can compare alternative strategies that hedge liabilities at an earlier date

  • Breakeven margin is price below which our probability of success improves on base case

Breakeven liability margin vs market prices

Price

100%

Forecast

margin

75%

2010

2020

2030

*Note that the numbers in this slide have been camouflaged to disguise actual price information in our possession.

The feature illustrated is however based on actual price information


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Supported by this analysis we can evaluate different strategies and, in principle, develop a hedging dashboard to reflect our appetite for business

PPF longevity risk dashboard*

  • Basic principle is to seek solutions that improve on our probability of success

  • Although we might eventually have an appetite to hedge, the diversifying effects of other risks suggests we might hold off for a while

  • A wait and see strategy incurs the hazard that market rates may trend adversely

*The ratings in the longevity risk dashboard are for illustration purposes only


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This theoretical model is subject to a number of questions and assumptions that must be understood to make any real world decision

  • Base mortality assumptions will differ between the PPF basis and the market

    • Data accuracy; up to date experience investigations; modern factorial analysis; sensitivity tests

  • Diversification benefits may be overstated

    • Sensitivities on key modelling assumptions: ESG calibration, pension scheme risk and behaviours

    • Scenario analysis (in this case a benign economic scenario with few claims and low market volatility)

  • Potential arbitrage of longevity model assumptions and methodology

    • Stress test model and assumptions

  • Robustness of PPF assumption to only fund to a 90% level of confidence on longevity risk


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Summary and conclusions and assumptions that must be understood to make any real world decision

  • A financial framework to evaluate hedging options objectively

    • Linked to funding objective and Board’s expressed risk appetite

    • Framework and criteria can be flexed to consider different hedging instruments and segments of portfolio

  • Decisions dependent on market pricing and risk composition

    • How will market pricing and capacity develop in future?

    • PPF is not alone in managing a maturing book of pension liabilities

  • The process is model and assumption dependent

    • The ideal-world solution is perfect knowledge or at least agreed assumptions that strip out any knowledge imbalances

  • Hedging all the risk may not be the best strategy

    • It is possible that market pricing makes some segments of the risk portfolio more attractive to hedge

    • If PPF has effectively hedged the risk above the 90% confidence kevel post 2030, is there more appetite in the market for capped risk?


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Longevity Risk Transfer: A PPF Perspective and assumptions that must be understood to make any real world decisionSixth International Longevity Risk and Capital Markets Solutions Conference 9th & 10th September 2010

Martin Clarke,

PPF Executive Director of Financial Risk