As mentioned earlier, Intech’s Michael Monaghan is basing his future business strategy on a bet that investment banks – with their ability to provide collateral, to understand risk and evaluate reference portfolios – will be huge players in the retirement draw-down phase, which he expects super funds will dominate in the years ahead. “Twenty years ago, it was defined benefit funds and insurance companies which pooled and carried all the risk. Now of course, it’s all of us who are carrying it. But opportunities [for investment banks] will be created as that begins to reverse,” he predicts. As a baby boomer himself, Monaghan knows that his generation will in retirement demand a different kind of product to what’s come before, as they have at every other stage of their development. “When the baby boomers start to understand that they will live a long time, there will be a clamour for products that can sustain a high living standard, but have some kind of guarantee as well. My observation is that most people don’t know a lot about investments, so they want security more than anything else,”
Monaghan says. The post-retirement products currently on the market will not be acceptable to most baby boomers, he believes. Baby boomers want the high returns which market-linked allocated pensions currently offer, but will not want to bear their downside risk, or the risk they may outlive them. Meanwhile, the current crop of ‘lifestyle’ products draw down too quickly and require too much upfront capital commitment, Monaghan contends, providing a poor deal for those who live either much longer or much shorter than statistically expected. Then there are the ethical concerns around reverse mortgages. A product with a more sophisticated approach to longevity risk will be needed, Monaghan argues, which may incorporate the responsible use of leverage and “mismatching” to support the higher returns and downside protection being sought.
Citigroup’s Irfan Khan agrees that products which pool risk are set for a comeback, but unlike the old insurance policy model, where premiums keep coming in and actuaries could manage the risks over a long period of time, the new-style products will have finite inflows and will need to work harder to meet expectations. Monaghan thinks Australian investment banks are best placed to provide such a solution. He actually contends that BASEL 2, far from being a compliance burden, has sped up IT development and improved banks’ portfolio construction and risk management techniques in time to meet the retirement incomes challenge. “BASEL 2 means that if you’ve got poor risk management techniques, you’ve got to carry more capital, so it’s really sharpened them up. Super funds need to have risk statements and a few bits and pieces that ASIC require, but their risk management regime is nothing like what the banks face,” Monaghan says. Indeed in Europe, two investment banks have already been the first to produce what many are saying could be a panacea for pension funds and pensioners grappling with mortality issues – the longevity bond. Longevity bonds The Australian pensions market has been much slower to tackle the challenges of longevity risk and liability matching than have its US and UK equivalents. The reasons are understandable, according to Watson Wyatt’s Tim Unger. “Australian defined benefit funds are generally in a healthier position than their counterparts overseas, because our market did not go down as much,” he says. “Also, the new international accounting standards ended up allowing companies some scope to smooth their defined benefit liabilities on their profit/loss statements, which means firms have been more willing to carry some investment risk.” However, as Australia’s biggest population segment retires in earnest over the next 10 to 15 years, pension funds will have to consider products which seriously tackle the risks associated with the longevity of this group. Enter the longevity bond. First academically proposed in 2001, longevity bonds are annuity bonds whose annual coupon payment is tied to the mortality of a specific reference population. As members of this reference population die off, the coupon payments gradually fall. The academics who proposed the longevity bond, David Blake and William Burrows, suggested such bonds would be a suitable hedge for the annuity book of a life company or the liabilities of a defined benefit pension fund – after all, if cancer was cured after they bought such a bond, their coupon payments would stay high as a result, allowing them to service longer-living members. Blake and Burrows proposed the obvious counterparties for a longevity bond would be capital markets investors – most obviously, investment banks – who would view longevity exposure as a low beta diversifier from their more conventional risk factors. In late 2003, the investment banking arm of Swiss Re was first off the mark with a three year mortality bond, raising $400 million so that Swiss Re’s insurance arm could lay off some of its extreme mortality risk. Similar to the ‘catastrophe bonds’ issued by general insurers, the bond offered 1.35 per cent above LIBOR, but the final principal payment would be reduced if a mortality index, based on the number of ensuing deaths in five major countries, went above a predetermined level of ‘normal’ experience. An event similar to the Spanish flu pandemic of 1918 was actually conjured in the bond’s marketing material. That bond was quickly subscribed, chiefly by UK pension funds. After all, they face risks which are exactly the opposite to those of Swiss Re – while the insurance company would suffer financially if many people died, pension funds suffer financially if too many people live too long. The next longevity bond to appear, a 25-year issue released by the European Investment Bank and BNP Paribas in November 2004, had a structure more closely resembling something that would appeal to Australian super funds and post-retirement members, according to Watson Wyatt’s Unger. Launched with the aim of raising £550 million, the banks had promised to pay bondholders an annual coupon of £50 million multiplied by the percentage of English and Welsh males aged 65 in 2003 who were still alive in the given year. For example if 50 per cent of the men were still alive 10 years after issuance, that year’s coupon would be £25 million. Ultimately, that bond failed to reach subscription and was withdrawn, pending remodelling work. Two problems were blamed – one was the high level of upfront capital required for the income provided, something which could be solved, as Michael Monaghan suggests, with the increasingly sophisticated leveraging techniques available to investment banks. The second problem was the relatively narrow reference population of English and Welsh males, which UK pension funds were reported at the time as saying made the bond less correlated to their particular longevity liabilities. Another investment bank, Credit Suisse First Boston, went some way to solving this problem last December, when it launched the CFSB Longevity Index, with the stated aim of providing a benchmark against which a range of longevity derivatives could be calibrated. The Index only references the US population at present, but the bank says data on further countries will be forthcoming – global actuarial firm Milliman is working on providing this, from publicly available sources. Unger says that Australian study on the potential uses of longevity bonds is in its infancy. However, he foresees that a longevity bond ‘choice’ option could be made available to post-retirees in a particular fund, who might then form their own reference population off which the actual bond was constructed. As in the UK experience, well-constructed longevity bonds would be a natural investment for Australian defined benefit funds, Unger adds. Intech’s Monaghan points out that a trend in investment banking has been rapidly improving technology, allowing greater flows of data and greater compartmentalisation of data. He argues that if investment banks can now easily isolate the mining royalties or drug patent royalties from a parcel of stocks and securitise them, it is no great leap to effectively securitise the longevity of Australia’s superannuants, and take risk out of the equation for everyone.
