Asia-Pacific Journal of Risk and Insurance

Asia-Pacific Journal of Risk and Insurance Volume 6, Issue 1 2012 Article 3 Demographic Shift and Financial Markets in APEC: New Age Solutions to Age Old Challenges John R. Piggott, University of New South Wales Renuka Sane, University of New South Wales Recommended Citation: Piggott, John R. and Sane, Renuka (2012) "Demographic Shift and Financial Markets in APEC: New Age Solutions to Age Old Challenges," Asia-Pacific Journal of Risk and Insurance: Vol. 6: Iss. 1, Article 3. DOI: 10.1515/2153-3792.1053 2012 Asia-Pacific Risk2 and Insurance Association. All rights reserved.

Demographic Shift and Financial Markets in APEC: New Age Solutions to Age Old Challenges John R. Piggott and Renuka Sane Abstract The paper reviews the link between demographic shifts and financial products and markets, focusing especially on Asian based APEC economies. It argues that newly developed and emerging APEC economies will need to nurture private sector institutions, which, in partnership with government, can deliver the financial services that the elderly will need. We offer metrics that provide guidance as to whether the required governance and private business competence exist in these economies and suggest measures for improvement. We discuss financial innovation, especially in the arena of products and markets dealing with risks confronted by the elderly, which may provide opportunities for easing the burden of population aging. Finally, we ask what APEC as an organization might be able to achieve through co-operative international agreements. KEYWORDS: APEC, financial markets, retirement, insurance Author Notes: An earlier version of this paper was presented at the APEC-IMF High Level Seminar Ageing and Financial Markets, Seoul, Korea, May 2008. The authors acknowledge financial support from the Korea Institute for International Economics Policy and the Australian Research Council. Without implicating them, we would like to thank Cagri Kumru and seminar participants for comments on an earlier draft, which improved the current manuscript. All opinions remain the authors own. Piggott and Sane, 2011. All Rights Reserved John Piggott (corresponding author): Professor of Economics, Director, ARC Centre of Excellence in Population Ageing Research, Australian School of Business, University of New South Wales, Sydney 2052, Australia, e-mail: j.piggott@unsw.edu.au Renuka Sane: Research Economist, Indira Gandhi Institute of Development Research, Mumbai 400065, India, e-mail: renukas@gmail.com Journal of Economic Literature Classification Numbers: D91

Piggott and Sane: Demographic Shift and Financial Markets in APEC 1. Introduction This paper explores the implications of demographic transition for the development of financial markets and products, with special reference to APEC- Asia economies. Interestingly, although there is a large literature focused on population aging and its economic and social implications, as well as a large literature on financial markets and products, their regulation and innovation, little has been written about how these two strands of study are linked. The maintained hypothesis is that the demographic shift, which is now upon us and which most nations on the planet will experience in some form over the next several decades, will be managed well only if appropriately developed financial markets and products are available. Financial and health needs of the elderly in the past have been largely met either through the informal sector, especially family, or through government support. But the simultaneous arrival of increased longevity and declining fertility confronting many emerging economies means that the public sector will not be able to shoulder the burden alone, or at least not in an efficient manner. It follows that new financial products must be developed, and financial markets must innovate in these jurisdictions to cope with the unprecedented requirement for investment and insurance driven by the rapid aging of the population. This is not to suggest that governments, in their roles both as policy makers and as the crucibles for a robust regulatory environment, will not be critical players in this evolution. They will need to modify their policy and regulatory stance to nurture public-private partnerships in providing support for the retired and the aged. Creating a benign legal and regulatory infrastructure for financial markets and products, especially those built around contractual saving, is one of the most challenging tasks of the next 20 years in almost all of the APEC (Asia- Pacific Economic Cooperation) economies located in the Asian region. Transfers to the elderly, public health insurance and provision, and government subsidized long-term care will probably be important domains for policy development as populations age and their needs mushroom. In this paper, we spend as much time discussing how governments might respond to demographic transition as we do focusing on financial markets and products per se. APEC economies constitute one of the most diverse groups of economies in any significant regional association. The US is the world s richest large economy, measured on either aggregate or per capita income terms; Papua New Guinea ranks 129th in terms of total GDP (Gross Domestic Product; World Bank World Development Indicators Database, GDP tables 2006). Japan is the world s most aged large economy; Papua New Guinea is one of the youngest (UN Population Database). New Zealand ranks in the 96th percentile on regulatory quality; Vietnam sits at 31.2 (World Bank Governance Index). We therefore begin this Published by The Asia-Pacific Risk and Insurance Association, 2012 1

Asia-Pacific Journal of Risk and Insurance, Vol. 6, Iss. 1 [2012], Art. 3 review with a comparison of APEC economies on several national metrics. These cover not only standard measures, such as income and population age, but we also report metrics reflecting the maturity of the financial environment, the strength of its legal structure, the level of its business sophistication, and its potential for innovation. This exercise allows us to arrive at a five way division of APEC economies developed, developed Asia, emerging Asia, emerging other, and developing a schema that allows us to focus our discussion more meaningfully on the Asian groups. We use the (non-asian) developed group of countries as our reference benchmark because these countries, although falling far short of ideal, do have the most sophisticated finance and insurance frameworks and markets. 1 The emerging economies of Asia face a much more rapid demographic transition than developed countries and will need to develop their financial and insurance systems correspondingly rapidly. With this context, we turn to the question of the role of financial and insurance markets in meeting the needs of an aging population. These comprise accumulation and investment markets and services, retirement and aging insurance products and markets, and institutional products and markets that might support retirement insurance products. Central to their operation is an environment in which long-term contracts are credible and enforceable, and in which there is what might be termed prudent prudential supervision: a regulatory framework that offers the prospect of an acceptable degree of safety, along with the prospect of products priced to be attractive to consumers. Additionally, there is some consensus that governments have a role to play in considering the nature of the financial instruments they issue and in accepting some risk-sharing in domains where insurance markets struggle. This may be facilitated through stop-loss arrangements to provide some form of guarantee against major systematic longevity improvements, longevity bonds, and long-term inflation indexed bond issues. We also explicitly examine reverse mortgages. Although data are surprisingly difficult to come by, owner-occupied housing is the major private sector asset for many mature households in many APEC economies. The role of housing as collateral for retirement income streams is clear and requires separate consideration. Finally, we speculate about how APEC as an organization, or agreements between APEC members, might help meet the challenges of population aging. We ask what potential there might be for gains to be realized through international cooperation between economies confronting very different aging profiles, which are also differentiated in their financial sophistication and their age. It is fair to ask why a paper on this topic should be written at this time. The simplest answer is the demographic one by 2050 the number of people over the 1 APEC economies in Latin America tend to follow each other in their social security policies. Therefore, it seemed appropriate to leave them out for this analysis. 2

Piggott and Sane: Demographic Shift and Financial Markets in APEC age of 60 years in APEC economies will have increased from approximately 291 million to 884 million, an increase of almost 204%. 2 However, there are at least five other motivations for the paper: i. Although demographic shift is a global phenomenon, developed countries have had a much slower transition than currently emerging economies will have, and aging will confront emerging economies at a much lower level of per capita income. It is likely that these economies will not be able to cope with the fiscal stress as well as currently developed nations are, and we know that the oldest of these, such as Japan, are struggling with the issues they now confront. ii. It seems likely that pace of change in regional migration, especially urbanization, is greater for emerging economies than for the currently developed nations. We may well witness a transformation from predominantly informal sector support for the retired and aged to privately based support, without passing through the intermediate stage of predominantly public support. 3 To the extent this occurs, the efficacy of finance and insurance markets, at least as they operate in the arena of aging, will be critical. iii. The existence of a regional association as tight-knit and diverse as APEC raises the possibility of cooperation around facilitating factor flows and pooling risks between countries with disparate demographic profiles, and more generally sharing expertise and establishing common governance protocols. iv. Although there is a substantial literature on governance in the corporate world (well summarized by Schleifer and Vishny, 1997) and the economics of financial regulation, there is relatively little analysis on what the preconditions are for strong markets in retirement risk products. v. A changing international regulatory environment makes it timely to revisit these issues. Solvency II is coming into play, laying out appropriate regulation for insurance products. The idea of risk-based supervision, espoused in Solvency II, is central to the sensible prudential oversight of retirement products. 2 Source: United Nations Population database. 3 Informal sector support refers to support from family, mostly found in multi-generation households. Privately based support refers to retirement products sold in the financial markets in different countries. Published by The Asia-Pacific Risk and Insurance Association, 2012 3

Asia-Pacific Journal of Risk and Insurance, Vol. 6, Iss. 1 [2012], Art. 3 2. An Overview of APEC Economies APEC is a loose regional grouping of countries around the Pacific Rim. It includes economies at all levels of the income, economic development, and financial markets sophistication spectrum. To understand this group better, we have divided members into five groups based on both per capita GDP and geographic location: (i) developed world APEC economies with per capita incomes above $25,000, which include the United States, Canada, Australia, and New Zealand; (ii) developed-asia economies, which include Japan, Singapore, Chinese Taipei, Hong Kong, and South Korea; (iii) emerging Asia, consisting of Malaysia, with the highest per capita GDP of this group at $5704, Thailand, China, Indonesia, Philippines, and Vietnam, with the lowest per capita GDP at $673; 4 (iv) emerging other, comprising Mexico, Russian Federation, Chile, and Peru, with per capita incomes higher (except for Peru where it is comparable to the emerging Asia group) than that of the emerging Asia group; and (iv) the developing group, which consists of Brunei Darussalam and Papua New Guinea, with Papua New Guinea having one of the lowest per capita incomes in the world. This paper focuses principally on the two Asia groups because of their geographic contiguity, their dynamic importance in the global economy, and the contrast in maturity that they encompass, and it largely ignores economies outside the Asia region. 2.1. Demographics and Per Capita Incomes APEC economies are at different stages of the demographic transition. The developed-world group is expected to have an 11.33% change in the proportion of elderly above the age of 60 years by 2050. By contrast, the change is 23.66% and 19.86% for developed-asia and emerging-asia, respectively. The average dependency ratio in developed-asia is projected to be as high as 70.72% by 2050, whereas the developed- and the emerging-asia groups are similar at 35.4% and 36.08%, respectively (Table 1). 5 Table 1 reveals two types of differences in the APEC region. The developed-world group and the emerging-asia group will confront similar population structures, but at very different levels of per capita income. And within Asia, not only is the rate of change in the population structure somewhat varied, there is considerable divergence in what is projected for 2050. The other significant intergroup difference to note is the rate of change of population aging 4 The per capita GDP numbers are derived from the UN database. See http://unstats.un.org/unsd/demographic/products/socind/inc-eco.htm. 5 Comparable estimates were not available for Chinese Taipei, and for this reason it is excluded. 4

Piggott and Sane: Demographic Shift and Financial Markets in APEC in the three groups. Although developed- and emerging-asia may find themselves at similar dependency ratios in 2050, the rate of change in emerging Asia is much faster: emerging Asia has to confront older populations not only at lower per capita incomes, but also at much faster rates of demographic change. 2.2. Existing Social Security Arrangements Increasing old age dependency 6 has a direct impact on the provision of income security to the elderly. Pension provision in Asia and in emerging Asia in particular is usually structured around employment. There are pension schemes for those in the civil service and those in the organized work force. The civil service schemes are usually defined benefit plans (often PAYG), paying out a pension that is a function of the number of years in service and a benefit formula. The occupational pension schemes are usually provident funds (PFs), with contributions from the employee as well as the employer. Table 2 provides a brief summary of retirement protection in the emerging-asia group. Although the occupational schemes are Defined Contribution (DC) in nature, their investment regulation and administration is often poorly managed, resulting in low rates of return. Withdrawal rules are not strict, with members withdrawing from PF money for other things such as buying a house or the education of children. The outcome is small member balances at the time of retirement. Even if this were not so, the member is allowed to take the PF accumulation as a lump sum at retirement, leaving the member subject to the risk of outliving the balance. 2.3. The Importance of Coverage Rates Not only are the existing forms of support not well-structured but coverage is also patchy. Emerging-Asia economies have a significant section of the workforce that is in the informal sector and outside the purview of any formalized pension program. According to Holzmann et al. (2000), pension scheme coverage (publicly mandated and government schemes) in 1994 was approximately 17.6% in China, 15.5% in Indonesia, 28.3% in the Philippines, 25.1% in Thailand, and 9.1% in Vietnam. In Malaysia, Heller (2006) reports coverage of approximately 58% of the population. Recent research from Thailand reports a slight increase in coverage since 1994: Kobsak (undated) reports that 13.9% of the overall population and 25.7% of the labor force was covered in 2007. Heller (1999) estimates that, if the governments in the developed-asia and emerging-asia 6 Old age dependency ratio is defined as the number of people above the age of 65 years divided by the working population between ages 15 and 64 years. Published by The Asia-Pacific Risk and Insurance Association, 2012 5

Asia-Pacific Journal of Risk and Insurance, Vol. 6, Iss. 1 [2012], Art. 3 groups were to extend pension provision with a replacement rate of 30% to people not covered, then fiscal outlays would be higher by approximately 1% to 1.5% of GDP by 2010 2025 and another 1% of GDP between 2025 and 2035 with further additional increases thereafter. It does seem reasonable to conclude that many APEC economies in both Asia groups will confront fiscal stress stemming from the unfunded nature of their pension liabilities. This casts into doubt the feasibility of predominantly public support. The private sector and financial markets in particular will therefore have a greater role to play. 2.4. Governance and Regulatory Performance A necessary condition for well-functioning financial markets is an environment that allows for innovation and contract enforcement under a general acceptance of rule of law. The relationship between governments and financial markets is particularly fraught with conflicts of interest as governments are often regulators of the very financial institutions they own and participate in direct operations as competitors with private sector financial institutions. Schleifer and Vishny (1997) point out that corporate performance is directly related to regulatory and governance quality, and we assume that this same relationship will hold for financial institutions. Lack of transparency, accountability, and due-diligence in the working of governments and financial institutions will inhibit the growth and effectiveness of markets so crucial to dealing with the demographic transition that is occurring now and will continue over the next few decades. As with other indicators, the APEC region exhibits a wide variety of standards on the governance and financial sophistication front. As presented in Tables 3 and 4, the United States ranks first on global competitiveness, and Australia and New Zealand rank among the top ten on financial sophistication and quality of their institutions. Hong Kong and Singapore in the developed-asia group compete with the developed-world group on these indices. Apart from Malaysia, most economies in emerging-asia rank between 50 and 70 on various scales, reflecting a lower level of financial sophistication as compared to the developed group. The emerging-asia group has actually fallen in the rank on governance indicators such as rule of law, regulatory quality, and voice and accountability between 1996 and 2006, although there is improvement between 1996 and 2000. This disparity between the APEC economies points to the need for considerable reform by the emerging- and developed-asia groups before they develop standards comparable to the developed group. Moreover, there is potential for focused knowledge sharing between these economies on this critical issue. 6

Piggott and Sane: Demographic Shift and Financial Markets in APEC 3. Life Cycle Accumulation and Decumulation: What Finance and Insurance Products Are Needed? Population aging, which is occurring most rapidly across Asian economies, means that more people will be exposed to the various risks associated with retirement and old age. The response of the developed countries in Europe and America was to set up pay-as-you-go plans to provide for old-age income security. Traditional pay-as-you-go social security works well when populations are growing. However, demographic shift has meant that society can no longer rely on an ever-increasing younger labor force to generate contributions to meet the benefit entitlements of contemporaneous retirees. Demographic transition, and especially the decline in fertility rates, leads such arrangements to fall into deficit, as has been the case in the US and Europe. One response to this has been to establish fully funded retirement pension arrangements, usually promising some defined contribution accumulation at retirement. Standard examples of comprehensive funded income replacement accumulation plans include Chile, which introduced its policy in 1981, and Australia, which progressively adopted a mandatory accumulation policy through the 1980s and early 1990s. More recently, Hong Kong has introduced a credible and comprehensive accumulation policy. The individual risks at this stage in the lifecycle relate to employment and investment employment allows contributions and investment performance determines the overall return. Mandatory plans of this type lead to rapidly accumulating pools of assets that must be managed efficiently and professionally. This requires sophisticated financial institutions, markets, and products. Appropriate financial supervision is also necessary. However, management of investment funds being accumulated to finance retirement is only half the story. Retirement and old age bring with them a set of significant risks that are either non-existent or not significant at earlier ages. Of these, the primary risks relate to uncertainties around longevity and morbidity along with their associated costs. It is important to recognize that these risks have traditionally been covered by the family or community, and it is still the case, even in developed economies, that much care for the elderly is provided by children. A second major source of risk among the elderly stems from the fact that, by the time of retirement, individual assets have been transformed from human capital to financial or at least physical capital. In the absence of insurance, these cohorts confront income risks associated with investment return and inflation, against which they were largely immunized at earlier ages when wages formed Published by The Asia-Pacific Risk and Insurance Association, 2012 7

Asia-Pacific Journal of Risk and Insurance, Vol. 6, Iss. 1 [2012], Art. 3 the major part of income. 7 The retiree would like to have enough retirement income on average, would like it to last throughout his/her life, and would like to insure against major variations in that flow, probably on an inflation-adjusted basis. Insuring against these risks constitutes the most intractable financial challenge of demographic shift. Such insurance is hard to find, expensive to buy, and difficult to guarantee. We therefore devote some space to explaining the products and strategies that have the potential to deliver such insurance. In what follows, we first discuss the financial market developments associated with accumulations and then the corresponding developments which are more closely related to insurance markets and products that would be necessary to deliver market-based decumulation insurance. 3.1. Accumulations From a financial product perspective, accumulation for retirement is the easier phase to discuss. Asset allocation and portfolio choice have been much analyzed, and the analysis finesses many of the insurance issues that complicate decumulation strategies. From a household viewpoint, the questions to be answered are: how much to save and how to invest? Yet neither of these questions is straightforward to answer. Even in the US, a relatively financially mature economy, Moore and Mitchell (2000) found that only 30% of pre-retirees are fully prepared for retirement at age 65 years. More recent market developments have seen many people delaying retirement to offset accumulation shortfalls. Given that pension investments accumulate over long horizons of 20 to 30 years, investment policy plays an instrumental role in determining the savings accrued over the period. The issue of consequence is that of the permissible asset allocation and includes the question of international diversification. In the Asian region in APEC, there are usually quantitative limits on the asset classes that funds can be invested in, with maximum restrictions on investments in domestic and international equity. Investment portfolios of pension funds and PFs in these countries are concentrated on government securities (Asher, 1998; Holzmann et al., 2000). There is a general wariness about the risk of investing in international markets, without perhaps appreciating the risk of a portfolio that is heavily skewed to government debt or one that is heavily invested only in domestic instruments. For example, some years ago Japan's Government Pension Investment Fund (GPIF) 7 During working life, the predominant financial uncertainty revolves around employment and disability. 8

Piggott and Sane: Demographic Shift and Financial Markets in APEC suffered when the investment quality of Japan s government bonds were downgraded. The result has been PFs performing only marginally better than bank deposits (Holzmann et al., 2000). Policy makers need to develop a better understanding of the nature of risks involved in various instruments to allow financial institutions the flexibility to determine the point on the risk-return frontier they are comfortable with, conditional on meeting all the compliance requirements of the regulator. A second issue relates to voluntary saving for retirement. Typically, mandatory schemes generate income streams in retirement below the level of comfort, relative to income in working life. Although the foresightful rational consumer has dominated economic models of consumer behavior, there is mounting evidence that, when the consequence of a choice is far into the future, or when once-off choices are made where revision is costly or impossible, serious errors are made. Perhaps the best-known is myopia, a term used to describe decision-making that is short term in nature. This has been formalized by, for example, Laibson (1997) in his model of hyperbolic discounting, with high discount rates to the near term and lower discount rates to the future, thus placing a lower value on future benefits and overvaluing the present (Mitchell and Utkus, 2004). 8 The pertinent question for accumulation products then is how to encourage people to save. 9 There is now general acceptance that many people accept a default position if it is set for them and respond differently to the same set of alternative choices. It is becoming clear that providers and regulators should be responsive to these aspects of human behavior in framing policies, strategies, and products. Behavioral finance research points out that plan design decisions emit signals about appropriate behavior, and such design specifications trump independent decision-making. Policy has an important role in motivating and facilitating retirement savings. Tax incentives are usually seen as an effective mechanism for channeling public savings to retirement products. As the Asian economies in the APEC region develop, and a greater proportion of the population progresses into the tax-paying bracket, this will probably be a policy response. Other accumulation issues relate to high administration costs, commissions, and loadings. These are typically expressed as a percentage of asset value. Rather small variations in these loadings can have major impacts on a life cycle accumulation. Under plausible assumptions, a one percentage point 8 Most behavioral finance research has focused on the US, but recent research on developing economies also shows similar problems. For example, see Ashraf et al. (2004). 9 Although it is true that countries in Asia have a higher saving rate than the US, these savings do not generally translate into retirement savings. Often, the most important stated motive for saving is children s education. Published by The Asia-Pacific Risk and Insurance Association, 2012 9

Asia-Pacific Journal of Risk and Insurance, Vol. 6, Iss. 1 [2012], Art. 3 difference in charges translates into a 30% difference in the accumulation value over 40 years. Well-designed financial markets require cost-effective systems of administration and distribution. Financial education and adequate reputation requirements for financial advisors to be licensed can help in this process. Finally, in many countries with a large informal sector, the notion of retirement is not as clearly defined as in developed Western countries. Often, civil service pensions are the predominant employment-related retirement finance vehicle, with many in the private sector having little or no access to formal retirement provision plans. 3.2. Retirement Income Streams and Life Annuities We pointed out above that retirement risks longevity, investment, and inflation confront individuals at a point in their life cycles when human capital is depleted, and financial and real capital, along with government transfers and family assistance, constitute their remaining resources. Decumulation rules for private pools of assets that have been accumulated for retirement have proved among the most serious challenges for policy makers concerned with retirement issues. Strategies range from paying out a lump sum, through requiring that the accumulation be drawn down over some extended period of time, to complex annuitization rules. We briefly review these options below and explore some alternatives which may help with policy formulation. 10 3.2.1. Phased Withdrawals In many national DC type retirement provision arrangements, phased withdrawals are used. These effectively provide the retiree with an individual account, which he (or she) may draw down within limits, which are frequently set to a lifeexpectancy exhaustion target. Phased withdrawals do not provide longevity insurance coverage. A drawdown targeted at life expectancy will leave approximately half the participants alive, with their funded accumulations exhausted. Although ensuring more provident use of accumulations than a lump sum payout, limited self-insurance against outliving one s resources is all they offer. This limitation of phased withdrawals is well-recognized, and some analysts (e.g. Walliser, 2000) have for this reason argued against their use in national DC plans. 10 We have not covered inflation risk in what follows. Although a standard income stream product with constant nominal payments offers no coverage against this risk, inflation indexed streams can be purchased, and various risk-sharing arrangements are offered around the world. 10

Piggott and Sane: Demographic Shift and Financial Markets in APEC 3.2.2. Life Annuities By contrast, the standard financial instrument to provide full insurance against longevity risk is the standard life annuity. Yet typically, these markets do not work well when annuities are purchased on a voluntary basis. The standard explanation for this is adverse selection. Because annuitants know more about their own life expectancy than insurers, the assumption of common information necessary for a well-functioning market breaks down, and only the expected long-lived will purchase life annuities. This in turn affects price, thus driving marginal purchasers from the market. There are, however, other reasons why a standard annuity may be unappealing. Retirees might be discouraged from purchasing this type of insurance because it involves surrendering capital control. Annuity purchase implies forgoing precautionary wealth that may be needed if, for example, a medical emergency were to arise. In addition, purchasing a standard life annuity typically involves an implicit allocation of underlying assets into safe securities. Because the annuity contract guarantees a fixed dollar payout per period, the underlying assets are invested in bonds, with an associated low rate of return. 11 For this reason, annuities are frequently seen as a poor investment choice, not because of the insurance they offer but because of the implied asset allocation. Other explanations for low annuity demand include a bequest motive, crowding out from government-provided income streams such as social security, and administrative loadings, which reduce the money s worth of the annuity. 12 Creighton et al. (2006) take a rather different approach, emphasizing supply side issues. Exposure to systematic longevity risk has the potential to ruin an insurer, and information about improvements in life expectancy among cohorts of potential annuity purchasers is very uncertain. In fact, estimates about how uncertain are themselves very poor. Annuity issuers find it difficult to spread their exposure through reinsurance; perhaps appropriate products do not exist because so little is known about the evolution of longevity change. Below, we consider institutional mechanisms that might facilitate effective reinsurance of longevity risk. There have been several categories of policy response to annuity market failure. Other than resorting to phased withdrawals, these include mandating 11 It is possible to design an instrument that provides longevity insurance with payouts varying with investment return: the so-called variable annuity. These are rarely encountered as genuine retirement income stream products. 12 For money s worth calculations, see, for example, Mitchell et al. (1999), Finkelstein and Poterba (2002), and Doyle et al. (2004). For a comparative analysis of the relative importance of some of these deterrents, focused on Japan, see Purcal and Piggott (2008). Published by The Asia-Pacific Risk and Insurance Association, 2012 11

Asia-Pacific Journal of Risk and Insurance, Vol. 6, Iss. 1 [2012], Art. 3 annuity purchase and risk sharing. Mandatory annuitization removes adverse selection; risk sharing with the annuity purchaser allows more attractive terms to be offered. 3.2.3. Mandating Annuities Given that individual tailoring of annuity contracts is infeasible, and that market failure is therefore prevalent in voluntary markets, there is a strong case for mandating life annuities. Adverse selection is very limited when everyone must buy an annuity, and compulsion may reduce the costs of marketing annuities. In addition, if the tendency to save suboptimally has been anticipated by mandatory saving, then mandating a decumulation plan is a natural extension. Within national DC plans, this aspect of the policy design has until recently received surprisingly little attention, perhaps because of the natural tendency to postpone consideration of this aspect until accumulations reach significant levels. 13 This policy, however, has been adopted by APEC nations such as Chile, and there is now a small but developing literature devoted to assessing its efficacy (e.g. Rocha and Thorburn, 2007). Mandatory annuitization carries with it a range of operational and implementation challenges. On the supply side, genuine competition is difficult to guarantee in a captive market, even with multiple suppliers, and loadings are therefore likely to be higher. 14 Second, annuity buyers face unpredictable risks around the annuity factor prevailing at the point of retirement, stemming primarily from interest rate variations. Third, although more or less eliminating adverse selection, mandatory annuitization does not address the other negatives around standard life annuity purchase listed above. 3.2.4. A Hybrid Possibility The popularity and relative simplicity of phased withdrawals has considerable appeal, especially in economies where insurance markets are not well developed. However, their adoption leaves the retiree exposed to longevity risk. It may be possible to manage this through mandatory or tax-preferred deferred annuities, with payouts beginning in late life, contingent on survival. This potentially removes the largest uncertainty in retirement how long an accumulation needs to last. In the UK, annuitization was until recently mandatory from age 75 years, although the annuity was typically bought as an immediate, rather than a deferred, 13 See, however, Brunner, Hinz and Rocha (2008) for a collection of studies on this topic. 14 An innovation to deal with high loadings has been the quotation system in Chile, which allows the customer direct access to a full range of annuity quotations, driving up competition and keeping the industry competitive. 12

Piggott and Sane: Demographic Shift and Financial Markets in APEC instrument, and the policy has now been discontinued. Another example is the Temporary Withdrawal (TW) combined with a deferred annuity in Chile. A TW is a fixed drawdown for a predefined number of years (most commonly 1 year) followed by a deferred annuity. The TW payout cannot be lower than the minimum pension guarantee or the eventual annuity and cannot be higher than twice the level of the eventual annuity (Rocha and Thorburn, 2007). Mandating a phased withdrawal in combination with a (mandatory or concessionally treated) deferred annuity purchase has considerable intuitive appeal, combining capital drawdown flexibility with partial longevity insurance. Until life expectancy, the annuitant has considerable flexibility in arranging drawdown patterns. On an actuarially fair basis, the deferred annuity need not be expensive because of the combination of the probability of death before payouts begin (a form of survivor bonus), and the compounding of investment returns in the period prior to the first payout. In addition, life expectancy at the time the annuity commences payment is relatively low. In spite of their apparent virtues, however, it should be recognized that such products involve very long-term contracts, and, where governance and legal process are not robust, may not be practical. Counterparty risk is relatively high for these products because of the long-term horizons involved. They pose a challenge in governance and supervision for all economies. 3.2.5. Group Self-Annuitization (GSA) Two reasons why standard annuities end up being expensive is that insurers are nervous of systematic longevity improvements and regulators require substantial capital reserves, which raise the cost of the product. If a longevity insurance product could be developed that would separate idiosyncratic and systematic longevity risks, these sources of high annuity price could be potentially overcome. GSA tries to operationalize this idea. It is not itself new, 15 and a variant is actually offered as an option by the US pension fund TIAA-CREF (Teachers Insurance and Annuity Association and College Retirement Equities Fund). However, the first formal analytic treatment is that of Piggott et al. (2005). Its appeal is based on allocating risk efficiently across stakeholders. Although insurers and regulators are concerned about systematic longevity risk, annuitants are much more concerned with idiosyncratic risk. An administrative arrangement that offers idiosyncratic longevity risk pooling, while leaving annuitants exposed to systematic risk, but offering a higher payout, may be appealing. It could, for example, be offered by major pension funds. 15 It is mentioned by Wadsworth et al. (2001) and Lunnon (2002). Published by The Asia-Pacific Risk and Insurance Association, 2012 13

Asia-Pacific Journal of Risk and Insurance, Vol. 6, Iss. 1 [2012], Art. 3 3.2.6. Reverse Mortgages 16 In many countries, including several APEC economies, the most important personal wealth among mature households is the family home. This suggests that instruments designed to unlock housing equity may become popular. There is much variability around owner-occupier ratios for older consuming units, but in many countries it is very high, often exceeding 80% (Mitchell and Piggott, 2004). It has proved rather difficult to locate accurate home ownership data for the emerging Asia group of APEC economies, although in China it is reported that in 2000 75% of the urban elderly own their own homes (National Bureau of Statistics), with higher ownership in rural areas. 17 Gwin and Ong (2008) report that average home-ownership is around 65% in Asia and close to approximately 63% in North America. Elderly occupancy rates are expected to be higher Reverse mortgages are a natural product to trade in this environment. A reverse mortgage is a non-recourse loan, where debt accrues at a predetermined (sometimes variable) interest rate, and the timing of debt repayment is triggered by tenure surrender, typically death. If the debt exceeds the value of the securing asset at the time of closure, then the insurer loses the difference. But there remain issues of transparency in these contracts, especially around tax liability, conditions under which tenure surrender can be enforced, and security in the event of issuer bankruptcy. This is a clear case where sensible regulation could facilitate the market. Figure 1 provides an intuitive guide to the operation of a reverse mortgage. Reverse mortgage issuers face three sources of long-term risk. Interest rates may vary over the life of the contract, thus altering the cost structure of the contract; house price appreciation may vary; and longevity may not evolve as expected. All three of these risks are captured in Figure 1. Variations in interest rate will change the timing and therefore the probability of passing the crossover point, as shown by the dotted line. However, movements in the house price appreciation schedule will also vary the crossover point, and movements in the termination date of the loan, assumed to be triggered by the death of the borrower, will alter the chance of reaching crossover before exposure. Reverse mortgages are also interesting in another dimension. If the mortgage is taken as an annuity, then the debt gradually increases with the annuity benefit, along with the accruing interest. This contrasts sharply with the cash flow 16 The material on reverse mortgages is taken from Mitchell and Piggott (2004) and Piggott et al. (2007). 17 What is not clear is the incidence of multi-generation living. If younger generations of the family have occupancy along with their elders, then closure of a reverse mortgage contract becomes problematic. 14

Piggott and Sane: Demographic Shift and Financial Markets in APEC profile of a conventional annuity, where the annuitant pays a non-refundable premium at the start of the contract. Table 5 compares the essential characteristics of a conventional annuity with a reverse mortgage annuity. The reverse mortgage pattern is thus very similar to that generated by implicit annuities within families (Kotlikoff and Spivak, 1981). Note that, although altruism is not required in an implicit family annuity contract, trust is necessary. As family ties loosen with migration and other forces, inducing a higher incidence of family breakdown, reverse annuity mortgages provide a possible market substitute for implicit annuity contracts. 4. What Products and Markets for APEC Economies In Section 2 we divided the APEC economies into five groups and have focused on three of these: developed, developed-asia, and emerging-asia. Each group comprises members having common characteristics relevant to our study, which make this a convenient partition. However, these groups have much in common. First, all are, at least to some degree, undergoing population aging now, and all anticipate increasing rates of aging over coming decades. Second, these governments have taken on, to at least some degree, a caring role for the elderly and aged across both financial and health care domains. Third, all are concerned about the fiscal stress that is being or will be generated from the demographic shift. And finally, although the most developed of these economies embody some of the world s most sophisticated financial systems, financial and insurance markets and products focused on meeting the demands of demographic shift are poorly developed. As Mitchell et al. (2006) put it: In general, there are many product ideas that could help allocate risk more efficiently across stakeholders. Product innovation could include reverse mortgages, annuities linked to long-term care needs, survivor and mortality bonds, and mortality derivative securitization. Yet financial and insurance markets thus far have been thin. This may be partly accounted for by myopia on the part of consumers, but is almost certainly partly due to supplier reluctance, based on uncertainties about future mortality trends, and more general information asymmetry in these insurance markets, leading to moral hazard and adverse selection against which it is difficult to price attractively. (p. 331) In the developed economy group, events such as the shortfall in Enron employee pensions resulting from a heavy concentration on company stock, only point out the deficiencies in these markets. It should be simple to regulate a ceiling on the holdings of own-stock in a corporate pension plan, yet this has not Published by The Asia-Pacific Risk and Insurance Association, 2012 15

Asia-Pacific Journal of Risk and Insurance, Vol. 6, Iss. 1 [2012], Art. 3 been done for DC plans in the US. 18 It is easy to find other examples of gaps in regulatory coverage or inconsistencies existing in regulation, which will have the effect of impeding these market developments. In Australia, for example, deferred annuities are never offered, partly because of a requirement that a death prior to the payout phase requires a surrender payment to be made to the deceased s estate, thus blocking the most important value of such instruments the long-term mortality bonus. Reverse mortgages do not fall within the regulator s purview even though their feasibility is directly linked to longevity insurance. And the capital requirement on life annuities is so high that the market is more or less nonexistent. This is in a country that lies in the top five globally for the value of funds under management and has possibly the richest mandatory DC style pension fund in the world. These comments are directed at the most sophisticated economies in APEC. These economies are striving to improve their performance in these domains, but find the task challenging. This perspective needs to be borne in mind in considering what more might be achieved in less sophisticated economies. Regarding the developed-asia group, the governance and financial sophistication scores suggest that these economies have some distance to go before long-term private contractual saving instruments incorporating products spanning decades can be relied upon. Within Japan s own social security system, it has been revealed that records of social security contributions have not been correctly attributed to individuals over a period of decades. Some 50 million records are involved, and it is estimated that between 5 and 10 million individuals are affected. Singapore gains a very low score on Voice and Accountability one of the most important explanatory factors of good governance. 19 Even a brief examination of governance and business practice scores lends support to the idea that these economies fall short of the standards of the developed group. Therefore, it seems likely that emerging APEC economies, which are destined to confront these challenges at lower levels of per capita income, also have a less sophisticated financial sector as well as a less developed regulatory framework. Thus, a natural question to ask is what might be done. We do not have answers that will deliver immediate solutions, but we do have some recommendations about the process that might strengthen the contractual saving sectors of these economies over the next period. 18 Limitations do apply in Defined Benefit (DB) plans because these are partly guaranteed by a government entity, the Pension Benefit Guaranty Corporation. 19 See Mitchell et al. (2008). 16

Piggott and Sane: Demographic Shift and Financial Markets in APEC 4.1. Communication and Information Sharing Within APEC, and Between APEC and Other Countries There is much to be gained by effective communication of international experience in both regulation and practice. One simple way in which APEC members could improve communication about regulation of financial products directed towards the elderly is either to join the International Organization of Pension Supervisors (IOPS) or to set up an APEC variant. Currently, only 8 of the 21 APEC members are also governing members of IOPS. 20 This would function as a conduit through which contractual saving regulators can share experience and knowledge. Information about national policy initiatives could also be shared between APEC economies. For example, the Japanese government has embarked on a comprehensive long-term care (LTC) insurance plan in recent years (Mitchell et al., 2004). Their experience would be valuable to other APEC economies concerned about the increase in LTC needs with population aging. 4.2. Government Debt Issues Debt issued by government could be structured to provide some immunization against risks faced by retirees or by organizations offering long-term retirement saving products. Longevity bonds, 21 whose payouts depend on variations from a mortality index, have been mooted, but have yet to become firmly established. 4.3. Formalized Arrangements for Mutual Financial Risk Sharing Risks to which the elderly are especially exposed might be shared across APEC economies in formalized agreements analogous to the Asian Premium bond fund agreement. Just as there is now a collective APEC grouping for issuing premium bonds, a similar entity could be set up to encourage use of longevity insurance products, either at the wholesale or retail level. Reinsurance markets, which are just getting started in developed countries, may well expand rapidly where substantially differential mortality across nations could be mediated. Governments can help here in providing some guarantees around tail risk, perhaps based on some agreed mortality expectation. 20 These include Australia, Chile, China, Hong Kong, Korea, Mexico, Peru, and Thailand. 21 Blake and Burrows (2001). Published by The Asia-Pacific Risk and Insurance Association, 2012 17