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					                               Ageing population and
                              demography: the role of
                                financial institutions
                                         José Luis Escrivá
                                          Chief Economist
                                        BBVA Banking Group
                               bbvaresearch.department@grupobbva.com




                                                           Europe’s
                                                      competitiveness:
                                                   how financial institutions
                                                      can help deliver it
                                                   1st EPFSF Annual Conference
                                                      Brussels, May 15, 2007
1st EPFSF Annual Conference                                                  1
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




1st EPFSF Annual Conference                                  2
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




1st EPFSF Annual Conference                                  3
    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:
          Population aged 15-64. Average growth rate (%)
19                                                                                            … Holding
16                                                                                       productivity growth,
13                                                                                        participation rates
10                                                                                        and unemployment
 7                                                                                         constant, GDP pc
 4                                                                                            growth will
 1                                                                                       slowdown by 3 p.p.
-2                                                                                        over the next two
-5                                                                                        decades in Europe
1950/55            1975/80            2000/05                2025/30          2045/50


       Europe      Northern America      Latin America           Africa        World
                                                         Source. United Nations & BBVA

     They could be partially offset by higher participation rates, longer
                   work life, and greater productivity…
    1st EPFSF Annual Conference                                                                                 4
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
                       Labor, 2002)
        Department of Share of people moving depending on work-related
                                                  reasons
               3.0                                                                    2,8

               2.5

               2.0

               1.5
                                                                            1,1
               1.0

               0.5

               0.0
                     B   I   P GR IRL E   D   L   NL A UK S   F DK FIN     EU15      USA
                                                                 Source. Coomans, G. (2002)



Are the current European pension systems a barrier for mobile
  workers?
1st EPFSF Annual Conference                                                                   5
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


1st EPFSF Annual Conference                                             6
    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)




    1st EPFSF Annual Conference                                          7
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




1st EPFSF Annual Conference                                         8
      Old-age dependency ratios in Europe will increase
      exponentially…

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

                         Old-age dependency ratio
               (Population aged 65 and over / Population aged 15-64)
0.5
                                                                                0.48
0.4


0.3                                                                                      … European social
                                             0.23                                        security systems
                                                                                0.25
0.2                                                                                       have a problem
       0.13
                                             0.11
0.1    0.09
                                                                                0.11
       0.06                                  0.06
 0
      1950               1975               2000            2025                2050

              Europe     Northern America      World     Latin America        Africa
                                                       Source. United Nations and BBVA




      1st EPFSF Annual Conference                                                                            9
… 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?

1st EPFSF Annual Conference                                   10
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


1st EPFSF Annual Conference                                       11
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)

                                                     United Nations   Eurostat
                            OECD Average                  0,8             -
A positive sign means that EU-15 Average                  0,7           0,4
life expectancy in 2003 hasCanada                         0,2             -        Life expectancy
                           France                         0,6           -0,3        projections by
already by-passed projectedGermany                        0,6           0,3
                           Italy                          1,1           0,7
                                                                                 international orgs.
life expectancy for the                                                              and actuaries
                           Japan                          1,5             -
average 2000-05 (UN) and Mexico                           1,9           -0,1      have consistently
2005 (Eurostat)            United Kingdom                 0,5             -        underestimated
                            United States                 -0,2            -         improvements
                            Source: Antolín (2007)




1st EPFSF Annual Conference                                                                        12
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…



1st EPFSF Annual Conference                                                 13
      …but the actual size of the RM markets is nowhere near its
      estimated potential…
                                       United States, Reverse Mortgages                                                                                                                             United Kingdom, Reverse Mortgages
90000                                                                                                                                                                120000   250000                                                                                25000
                       Number of RM (left)                                                                                                                                                    Number of RM (left)
75000                                                                                                                                                                100000                                                                                196148
                       Pop. over 60 years in thousands (right)                                                                                                                200000          Pop. over 60 years in thousands (right)                               20000
60000                                                                                                                                                                80000                                                                      150952
                                                                                                                                                                                                                          131716     139753
                                                                                                                                                                              150000                                                                                15000
45000                                                                                                                                                                60000                                     122087
                                                                                                                                                                                                    105073
30000                                                                                                                                                                40000    100000     83728                                                                      10000

15000                                                                                                                                                                20000
                                                                                                                                                                               50000                                                                                5000
     0                                                                                                                                                               0
         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                                                                               0
                                                                                                                                                                                          2004       2005          2006   2010 (p) 2015 (p) 2020 (p) 2050 (p)
Source. HECM, Census Bureau and BBVA
                                                                                                                                                                              Source: CML Research, Census Bureau and BBVA

         Number of RM/Million Inhabitants over 60 years
    Year                      United Kingdom                                    United States                                                  Spain
                                                                                                                                                                                                            Spain, Reverse Mortgages
    2004                             6704                                              757                                                         0                          14000                                                                                 16000
                                                                                                                                                                                                                                                         11,528
                                                                                                                                                                                            Number of RM (left)                                                     14000
    2050 (p)                                  9537                                              805                                                  805                      12000
                                                                                                                                                                                            Pop. over 60 years in thousands (right)     8,818                       12000
    Source: CML, HECM, Census Bureau and BBVA                                                                                                                                 10000
                                                                                                                                                                                                                                                                    10000
                                                                                                                                                                               8000
     Assuming that the development of                                                                                                                                                                                                                               8000
                                                                                                                                                                               6000
       the RM market in Spain will be                                                                                                                                                                                                                               6000
                                                                                                                                                                               4000
     similar to that of the U.S. and the                                                                                                                                                                                   1,474
                                                                                                                                                                                                                                                                    4000
                                                                                                                                                                               2000                          921                                                    2000
    population projections, in 2050 there                                                                                                                                                   35
                                                                                                                                                                                   0                                                                                0
          will be 800 RM per million                                                                                                                                                     2007 (p)       2010 (p)          2015 (p)      2020 (p)         2050 (p)

         inhabitants over 60 in Spain                                                                                                                                         Source: Census Bureau and BBVA



      1st EPFSF Annual Conference                                                                                                                                                                                                                                       14
... 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

1st EPFSF Annual Conference                                       15
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




1st EPFSF Annual Conference                                  16
First pillar, generally Pay-As-You-Go pension scheme, is the
most important in Europe


       Evolution of the public pension expenditure and the size of pension funds,
                                         2004
                                                                         Pension funds
                              Public Pensions
                                                                    (occupational & personal)
                       Expenditure                            Total investments
                                            Share                                          Share
                       (% of GDP)                                (% of GDP)
      Italy                14.7                 85.1                  2.6                   14.9
      Germany              13.3                 77.9                  3.8                   22.1
      France               13.1                 68.6                  6.0                   31.4
      United Kingdom       10.7                 13.5                 68.8                   86.5
      Spain                 9.2                 50.5                  9.0                   49.5
      EU-15               12.3                  69.9                  5.3                  30.1
                                                Source. Eurostat, OECD Global Pension Statistics,and BBVA



 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,…)
1st EPFSF Annual Conference                                                                                 17
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
                     Estimates of implicit pension debt and central
                             government debt (% of GDP)
                                  Central government Implicit pension debt
                                   debt, 1999-2000    (4% discount rate)
                 Germany                    50                   186
                 Italy                     129                   207
                 Spain                      63                   129
                 France                     48                   112
                 United Kingdom             46                    92
                 Brazil                     33                   330
                 Polonia                    43                   261
                 Hungary                    59                   203
                 Argentina                  53                    85
                                  Source. Holzmann, Palacios & Zviniene (2001)
What will happen if European countries do not reform their pension
systems?  The Latin American experience
1st EPFSF Annual Conference                                                      18
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?

                         Implicit pension debt (% of GDP)

                                Reformed            If not reformed…
                              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
                                           Source. Zviene & Packard (2002)




1st EPFSF Annual Conference                                                  19
             Countries that gradually move towards DC schemes will make the
             pension system more sustainable

             Chile will have large fiscal savings in the future, despite persistent
                                        transition costs
                        Fiscal committments with civilian pensions
             4.0%

             3.5%

             3.0%
                                                                                    … Fiscal savings will
             2.5%
                                                                                    make possible a major
(% of GDP)




             2.0%                                                                  upgrade of the solidarity
             1.5%
                                                                                            pillar
             1.0%

             0.5%

             0.0%
                2005    2010    2015        2020   2025   2030    2035    2040   2045      2050
                       Old system deficit    Recognition Bonds   PASIS   Minimum Pension



             1st EPFSF Annual Conference                                                                       20
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


1st EPFSF Annual Conference                                                 21