SebastianSchich_Dec 0506

Developments regarding pension fund demand for government bonds

Presentation for GIC, 7 December 2006

Sebastian Schich, Principal Administrator Directorate for Financial and Enterprise Affairs

Reminder: (GIC presentation in 2005) “Special factors� contributing to low levels of long-term rates

Overview • Ageing populations in OECD countries and need for financing retirement income have led to tremendous growth of pension funds – which have a significant role in financial markets.

• Pension funds are focusing more on risk management. As a result they are changing their asset allocation strategies and increasingly choose their assets as a function of their liabilities matching.

• A sharper focus on asset-liability management typically will involve a shift of pension fund assets away from equity to bonds, especially to government bonds, given their limited credit risk.

Overview (continued) • Some argue that the shift is already happening and contributing to relatively low long-term interest rates.

• Another possible implication is pent-up demand for long-term government bonds by pension funds.

• Is there scarcity of investments that would allow pension funds to closely match their assets and liabilities?

• And this can lead to the policy question: if there is scarcity in suitable investments, should governments take any steps to respond?

Demographic developments and financial markets • Demographic developments and financial markets interact in various ways. – The investment characteristics of financial instruments are important for the provision of retirement income for an ageing population in systems with advance funding. – Changes in the age structure of the population affect the saving behaviour of an economy. Changes in the choice by households of saving vehicles, in turn, could have important implications for relative demand for financial assets and their prices.

Retirement savings and private pension funds • A large part of retirement savings are channelled through institutions, such as pension funds. • Pension funds in the OECD area have grown dramatically over the last decade, from about 6 trillion in the mid-1990s to more than 15 trillion by 2004, reflecting a growth of about ten per cent each year (OECD, 2006).

Importance of Pension Funds in selected economies, (2005, in percent of GDP) Netherlands (1) Switzerland (1) Iceland (1) United States United Kingdom (1) Finland Australia Canada (1) Ireland (1) (2) Denmark (1) Japan (1) Sweden (1) Portugal New Zealand Poland Hungary Mexico Spain Norway (1) Austria Czech Republic Belgium (1) Germany Italy Korea Slovak Republic Turkey Luxembourg (1) France (3) Greece (4)

108.7 108.5 108.0 98.9 68.8 66.1 58.0 48.9 42.6 29.8 14.2 13.1 12.9 11.3 8.7 8.5 7.7 7.5 6.6 4.7 4.1 4.1 3.9 2.6 1.9 0.6 0.3 0.3

0

20

(weighted average 90.2%)

40

60

80

100

120

Pension fund classification • There are two broad categories of private pension plans: defined contribution (DC) and defined benefit (DB) plans. • Corporate defined benefit pension plans are a very important part of the private pension fund universe. • Fixed nature of promises under DB plans implies that plan sponsors face risks, such as investment and longevity risks.

Sharper focus on risk management • As a result of changes in accounting, listed firms have to incorporate pension liabilities in their financial statements.

• To avoid that financial losses in their pension plan adversely affect their core business activity, a sharper focus is being placed on pension fund risk management.

• Two important effects: – Ongoing shift from DB to DC accelerating in several countries – Traditional focus on producing an asset portfolio return defined in relation to a benchmark is increasingly replaced by attempts to better match assets with liabilities.

Asset-liability matching at DB schemes • Implications of a sharper focus on asset-liability matching (ALM) for specific asset choices not clear a priori, but probably more “bond-like” than “equity-like”.

• Growing consensus that sharper focus on ALM typically involves a shift away from equity to bonds, especially to government bonds, given their limited credit risk.

• According to the specialised pension fund press, ALM is already triggering an increased demand from pension funds for bonds and, supply permitting, a shift in asset allocations away from equity into bonds.

Recent developments in supply of highquality fixed-income instruments Average term-to-maturity of total debt (years) 1996 - 2000

2001 - 2005

Change

United States

5.5

4.9

↓

Japan

5.6

5.0

↓

France

6.2

6.0

↓

United Kingdom

6.7

7.6

↑

Italy

5.2

6.1

↑

Canada

6.0

6.5

↑

Note: Preliminary. Do not cite.

Source: Replies to the questionnaire on long-term bonds by the Working Party on Debt Management of the OECD Committee on Financial Markets

“Scarcity” of investments?

• Many writers argue that pension fund managers will have difficulty implementing ALM strategies because there are insufficient quantities of suitable assets (“scarcity” of investments).

• While most of the discussion has been couched in qualitative terms, we thought we could gain insights from a quantitative investigation.

• To obtain a sense of the potential extent of “scarcity”, we compared the patterns over time of (estimates of) future pension fund payment promises with the cash flows that pension funds could obtain from investing in currently outstanding government bonds.

Measuring potential “scarcity” by comparing cash-flows (all liabilities assumed to be related to “passive” members) Matching Cash Flows 3700

Payments from G-10 government bonds outstanding (June 2005) Pension fund payout allocated to existing claims (2004) of today's "passive" plan members 2700

Difference in absolute values (100% of total pension fund assets allocated to bonds)

1700

700

-300

-1300

-2300 20 05 20 07 20 09 20 11 20 13 20 15 20 17 20 19 20 21 20 23 20 25 20 27 20 29 20 31 20 33 20 35 20 37 20 39 20 41 20 43 20 45 20 47 20 49 20 51 20 53 20 55

billions of US dollars

Difference in absolute values (75% of total pension fund assets allocated to bonds)

Alternative cash-flow comparison (liabilities related proportionally to „passives“ and „actives“) 3700

Matching Cash Flows Payments from G-10 government bonds outstanding (June 2005) Pension fund payout allocated to existing claims (claims in 2004 of passive and active plan members if DB scheme were closed) Difference in absolute values (100% of total pension fund assets allocated to bonds) Difference in absolute values (75% of total pension fund assets allocated to bonds)

1700

700

-300

-1300

-2300 20 05 20 07 20 09 20 11 20 13 20 15 20 17 20 19 20 21 20 23 20 25 20 27 20 29 20 31 20 33 20 35 20 37 20 39 20 41 20 43 20 45 20 47 20 49 20 51 20 53 20 55

billions of US dollars

2700

Potential pent-up demand?

• The estimated potential shortages vary noticeably across currency and maturity segments. According to our measurements, potential “scarcity” would be greatest in absolute values in the United States and in the maturity segment beyond ten years.

• Of course we cannot say whether these “scarcity” estimates measure pension funds’ pent-up demand for government bonds or to what extent part of this demand is already being met and, thus, already reflected in current bond prices.

• What is certain is that the potential pent-up demand could be very substantial.

• Given the current size of government bond markets, pension funds are sufficiently large that any significant changes in their asset allocations towards these instruments could have an effect on prices, even if such changes occurred in a gradual fashion, which appears to be a realistic assumption.

Policy Implications: Debt management implications • The potential demand for long-duration bonds could, in principle, be very substantial, sufficient in fact to result in a scarcity of such bonds in circulation. If a scarcity emerges, what steps, if any, governments should take in response?

• Should, for example, government debt managers shift the weight of their issuance toward the long-end of the maturity spectrum in order to help pension fund managers match assets and liabilities and ultimately increase benefit security?

• No. The OECD Committee on Financial Markets discussed this at its Spring 2006 meeting. Today there is no broad support among policy makers for such a strategy at present.

• The Committee felt that private, market-based solutions will emerge.