ageing population and demography: the role of financial institutions josé luis escrivá

11st EPFSF Annual Conference

Ageing population and demography: the role of

financial institutionsJosé Luis Escrivá

Chief Economist

BBVA Banking Group

[email protected]

Europe’s competitiveness:

how financial institutions can help

deliver it1st EPFSF Annual

Conference

Brussels, May 15, 2007


Ageing population and demography: the role of financial institutions

1. The need for an European pension market

2. The need to address the risks of an asset “meltdown” effect

3. The need for more marked-oriented pension systems





3. The need for more marked-oriented pension systems


The challenges of demographic ageing: economic growth and public finances

Demographic ageing will accelerate in the coming decades as the baby-boom generation reaches retirement age… and will have a significant impact on European economic growth

Cause: reduction in the size of the labor force:… Holding

productivity growth,

participation rates and unemployment constant, GDP pc

growth will slowdown by 3 p.p. over the next two decades in Europe

They could be partially offset by higher participation rates, longer work life, and greater productivity…

Population aged 15-64. Average growth rate (% )

-5

-2

1

4

7

10

13

16

19

1950/55 1975/80 2000/05 2025/30 2045/50

Europe Northern America Latin America Africa World

Source. United Nations & BBVA


Ageing will require greater labor mobility across European countries

… This requires a more efficient use of the labor factor. The low labor mobility across European countries makes difficult to improve the efficiency

Currently 1.5% of EU-25 citizens live and work in a different member state form their country of origin. Interstate mobility rate in the US is three times bigger

Every year, 7.2% of EU-25 citizens change their place of residence, but only 1.1 p.p. due to a change in jobs (2.8 p.p. in the US) (Eurostat & US Department of Labor, 2002)

Are the current European pension systems a barrier for mobile workers?

Share of people moving depending on work-related reasons

0.0

0.5

1.0

1.5

2.0

2.5

3.0

B I P GR IRL E D L NL A UK S F DK FIN EU15 USA

1,1

2,8

Source. Coomans, G. (2002)


Portability of pension rights of migrant workers is essential to increase mobility

First Pillar

Although EU regulation ensure that pension rights are maintained when a European worker moves across European countries…

[EU Regulation 1408/71, implementing Regulation 574/72, and later Council and Commission Regulations]

… Most European countries do not refund pension contributions if worker moves to another EU country

Contribution records are kept until workers reach retirement age contributions paid in one country can neither be transferred to another country nor reimbursed to workers

This is a suboptimal solution: public pensions portability between European countries is very limited


Portability of pension rights of migrant workers is essential to increase mobility

Second and Third Pillars:

The European Commission Directive on Institutions for Occupational Retirement Provision (2003) has not been translated in most countries (14 out of 25 member states). Why?

The gap between EU regulation of pension institutions and the national regulation of pension products

Therefore, the development of Pan-European Pension Plans (PEPP) should be a priority

An alternative solution to this problem, focusing on 3rd pillar:

“Pan-European Pension Plans. Deepening the concept” (EFR Pensions Steering Group, 2005)





3. The need for more-marked oriented pension systems


Old-age dependency ratios in Europe will increase exponentially…

Holding macro and regulation constant, pension expenditure will rise as the old-age dependency ratio,

… European social security systems have a problem

Old-age dependency ratio(Population aged 65 and over / Population aged 15-64)

0

0.1

0.2

0.3

0.4

0.5

1950 1975 2000 2025 2050

Europe Northern America World Latin America Africa

Source. United Nations and BBVA

0.13

0.23

0.48

0.09

0.06

0.11

0.25

0.110.06


… giving rise to the risk of an “asset meltdown”

Higher dependency ratios mean lower overall savings, inducing potential capital losses to those who retire

The asset “meltdown” problem:

A massive liquidation of past savings by the retiring baby-boomers will cause a rise in interest rates and a fall in the price of bonds (“asset meltdown”)

Estimation Results. 70 - 80 basis points drop in bond prices spread over five decades (Krueger and Ludwig, 2006)

Is this problem manageable?What can the financial system do?


Asset meltdown problem is manageable. Financial institutions can help to provide more income security among the elderly

The problem is manageable with the involvement of financial institutions:

1. Older societies can transfer part of the burden to younger ones, if financial markets are integrated

2. Investment strategies for pension fund managers focused on lifetime earnings: Longevity Bonds

3. Development of instruments to make more efficient use of non-financial wealth after retirement: Reverse Mortgages

The “meltdown effect” may still be small and spread over a very long


Financial institutions can help to provide more income security among the elderly: longevity bonds and reverse mortgages

2. Coverage of longevity risks in private-DC pension markets,

Solution: to implement bonds indexed to life expectancy, i.e., longevity bonds

• Difficulties to implement since no obvious counterpart exists

• Difficulties to asses uncertainty and associated risks adequately

Comparing realized gains in life expectancy at birth with past projections (years)

A positive sign means that

life expectancy in 2003 has

already by-passed projected

life expectancy for the

average 2000-05 (UN) and

2005 (Eurostat)

Life expectancy

projections by international

orgs. and actuaries have

consistently underestimate

d improvements

United Nations EurostatOECD Average 0,8 -EU-15 Average 0,7 0,4Canada 0,2 -France 0,6 -0,3Germany 0,6 0,3Italy 1,1 0,7Japan 1,5 -Mexico 1,9 -0,1United Kingdom 0,5 -United States -0,2 -

Source: Antolín (2007)


The potential size of the RM market is huge...

3. Instruments to make more efficient use of non-financial wealth after retirement: Reverse Mortgages (RM)

A significant proportion of the wealth of individuals (especially in Southern European countries) is tied to housing

Home equity conversion products may be useful to all those

who are “house-rich but cash-poor” (not limited to the elderly) The development of RM could play a central role Demographic projections indicate that elderly people is the

fastest growing segment all over the world, especially in Japan and Europe

Literature on RM is unanimous on its huge market potential (Püntner & Röhrs, 2006). Reality has not been up to expectations though…


…but the actual size of the RM markets is nowhere near its estimated potential…

United States, Reverse Mortgages

0

15000

30000

45000

60000

75000

90000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2010

(p)

2015

(p)

2020

(p)

2050

(p)

0

20000

40000

60000

80000

100000

120000

Number of RM (left)

Pop. over 60 years in thousands (right)

Source. HECM, Census Bureau and BBVA

Assuming that the development of the RM market in Spain will be

similar to that of the U.S. and the population projections, in 2050 there will be 800 RM per million

inhabitants over 60 in Spain

United Kingdom, Reverse Mortgages

83728

122087

196148

105073

150952131716 139753

0

50000

100000

150000

200000

250000

2004 2005 2006 2010 (p) 2015 (p) 2020 (p) 2050 (p)

0

5000

10000

15000

20000

25000

Number of RM (left)


Source: CML Research, Census Bureau and BBVA

Spain, Reverse Mortgages

35921

1,474

8,818

11,528

0

2000

4000

6000

8000

10000

12000

14000

2007 (p) 2010 (p) 2015 (p) 2020 (p) 2050 (p)

0

2000

4000

6000

8000

10000

12000

14000

16000

Number of RM (left)


Source: Census Bureau and BBVA

Year United Kingdom United States Spain2004 6704 757 0

2050 (p) 9537 805 805

Number of RM/ Million Inhabitants over 60 years

Source: CML, HECM, Census Bureau and BBVA


... for a variety of reasons from the demand, supply and regulatoriy considerations

What are the reasons for the gap between potential and actual RM volumes?

Supply side RM complexity exposes a lender to several risks:

mortality, interest rates and real estate markets Moral hazard problems: once a RM loan is taken, the

homeowners may have no incentive to maintain the house to preserve or enhance it’s market value

Demand side It is an unusual product for a typical elderly

borrower, creating fears of debt burden, eviction and inability to bequeath property

Regulatory uncertainties Still novel (or non-existent) legislation in most

European countries





3. The need for more-marked oriented pension systems


First pillar, generally Pay-As-You-Go pension scheme, is the most important in Europe

Countries where private pension plans started decades ago have the largest pension markets (Anglo-Saxon countries)

The size of private-pension asset accumulation is reduced in countries where public pensions play a dominant role (France, Germany, Italy,…)

Expenditure (% of GDP)

ShareTotal investments

(% of GDP)Share

Italy 14.7 85.1 2.6 14.9Germany 13.3 77.9 3.8 22.1France 13.1 68.6 6.0 31.4United Kingdom 10.7 13.5 68.8 86.5Spain 9.2 50.5 9.0 49.5

EU-15 12.3 69.9 5.3 30.1

Public PensionsPension funds

(occupational & personal)

Source. Eurostat, OECD Global Pension Statistics,and BBVA

Evolution of the public pension expenditure and the size of pension funds, 2004


Increased longevity and falling fertility rates are major factors making pension systems unsustainable

From a fiscal perspective, system sustainability requires reforms of the public social security systems (parametric or structural)

Not-reformed PAYG pension systems accumulate commitments between one and three times the current GDP level

What will happen if European countries do not reform their pension systems? The Latin American experience

Central government debt, 1999-2000

Implicit pension debt (4% discount rate)

Germany 50 186Italy 129 207Spain 63 129France 48 112United Kingdom 46 92Brazil 33 330Polonia 43 261Hungary 59 203Argentina 53 85

Source. Holzmann, Palacios & Zviniene (2001)

Estimates of implicit pension debt and central government debt (% of GDP)


Countries that moved from PAYG to DC systems had to face large fiscal transition costs, but will benefit from lower pension debt

Counterfactual:

What if Latin American economies had not reformed their pension systems?

2001 2020 2001 2020

Argentina 74.6 89.1 87.3 125.1

Chile 40.3 10.1 22.0 44.0

Mexico 14.9 18.0 130.1 179.6

If not reformed…Reformed

Implicit pension debt (% of GDP)

Source. Zviene & Packard (2002)


Countries that gradually move towards DC schemes will make the pension system more sustainable

… Fiscal savings will make possible a

major upgrade of the solidarity pillar

Chile will have large fiscal savings in the future, despite persistent transition costs

Fiscal committments with civilian pensions

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

(% o

fG

DP

)

Old system deficit Recognition Bonds PASIS Minimum Pension

Fiscal committments with civilian pensions

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

(% o

fG

DP

)

Old system deficit Recognition Bonds PASIS Minimum Pension


Conclusions

Demographic ageing will have a significant impact on public finances and will put the European households under strain

Solutions: reforming pensions, improving the efficiency of pension systems, and developing home equity conversion products:

1. Improving the efficiency of European pension markets requires facilitating public and private pension portability between European countries. The development of Pan-European Pension Plans should be a priority

2. Financial institutions can contribute to address the pension challenge. They can help to provide more income security among the elderly by means of longevity bonds and reverse mortgages

3. A more marked-orientation of the European pension schemes, with more DC components, will make the system more sustainable over the long run

ageing population and demography: the role of financial institutions josé luis escrivá

Documents

european pension market2

pension contributions

european worker

european pension plans

markedoriented pension

european economic growthcause

european commission

greater labor mobility