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Manufacturing Inflation Risk Protection Manufacturing Inflation Risk Protection Prepared by Joshua Corrigan, Michael DeWeirdt, Fang Fang, Daren Lockwood Presented to the Institute of Actuaries of Australia Biennial Convention 10 - 13 April 2011 Sydney This paper has been prepared for the Institute of Actuaries of Australia’s (Institute) 2011 Biennial Convention. The Institute Council wishes it to be understood that opinions put forward herein are not necessarily those of the Institute and the Council is not responsible for those opinions. Milliman The Institute will ensure that all reproductions of the paper acknowledge the Author/s as the author/s, and include the above copyright statement: The Institute of Actuaries of Australia Level 7 Challis House 4 Martin Place Sydney NSW Australia 2000 Telephone: +61 (0) 2 9233 3466 Facsimile: +61 (0) 2 9233 3446 Email: [email protected] Website: www.actuaries.asn.au Manufacturing Inflation Risk Protection Abstract This paper examines various wealth management solutions, both existing and new, that provide inflation protected benefits designed to meet consumer’s wealth accumulation and post-retirement income needs. Section 2 discusses inflation risk in the context of these needs, across a number of developed markets. Section 3 examines existing vehicles and products that attempt to manage inflation risk, and discusses the evidence for various asset classes to mitigate inflation risk. New product designs are then explored in detail in section 4 that provide exposure to attractive investments, whilst at the same time protecting against market risk, inflation risk and for the post-retirement segment, longevity risk. Section 5 then explores the risk management requirements for such products to be offered, with particular focus on the availability and liquidity of inflation based derivatives to hedge inflation risks. A discussion of the operational and capital requirements to design and manage such products is provided in section 6. Keywords: inflation risk, inflation risk management, risk management, variable annuities, retirement planning, financial planning, personal wealth management Page 2 Manufacturing Inflation Risk Protection Table of Contents 1 EXECUTIVE SUMMARY ............................................................................................................................ 4 2 THE NEED FOR INFLATION RISK PROTECTION ......................................................................................... 6 2.1 LIFECYCLE CONSUMPTION ............................................................................................................................ 6 2.2 INFLATION ................................................................................................................................................. 8 2.3 INFLATION RISK .......................................................................................................................................... 9 3 EXISTING INFLATION LINKED INVESTMENTS AND STRUCTURES ............................................................ 17 3.1 DEFINED BENEFIT PENSIONS ....................................................................................................................... 17 3.2 INFLATION INDEXED ANNUITIES ................................................................................................................... 18 3.3 INFLATION GUARANTEED BONDS ................................................................................................................. 20 3.4 VARIABLE ANNUITIES OR INVESTMENT / UNIT LINKED WITH GUARANTEES ........................................................... 20 3.5 SOCIAL SECURITY RETIREMENT BENEFITS ....................................................................................................... 21 3.6 INFLATION PROTECTION CHARACTERISTICS OF VARIOUS ASSET CLASSES .............................................................. 22 4 POTENTIAL INFLATION PROTECTION PRODUCT DESIGNS ...................................................................... 30 4.1 MANUFACTURING INFLATION RISK ............................................................................................................... 30 4.2 PRE -RETIREMENT WEALTH ACCUMULATION AND GENERAL SAVINGS ................................................................. 31 4.3 POST -RETIREMENT INCOME GENERATION ..................................................................................................... 40 4.4 RISK PROTECTION DESIGNS ........................................................................................................................ 51 4.5 POTENTIAL PRODUCT DESIGN STRUCTURES ................................................................................................... 52 4.6 RELIANCES AND LIMITATIONS ...................................................................................................................... 52 5 RISK MANAGEMENT CONSIDERATIONS ................................................................................................ 54 5.1 MANUFACTURING INFLATION BENEFITS THROUGH REPLICATION ........................................................................ 54 5.2 INFLATION HEDGING INSTRUMENTS ............................................................................................................. 54 5.3 PRICING .................................................................................................................................................. 57 5.4 USE OF REAL RETURN ASSETS IN THE UNDERLYING PORTFOLIO .......................................................................... 58 5.5 LIMITATIONS AND RISKS ............................................................................................................................. 58 6 PRODUCT DELIVERY OPTIONS AND OPERATIONAL STRUCTURES .......................................................... 59 6.1 TO PROTECT OR GUARANTEE ...................................................................................................................... 59 6.2 INSURANCE RISKS ..................................................................................................................................... 59 6.3 ECONOMIC CAPITAL CONSIDERATIONS FOR GUARANTEE PROVIDERS .................................................................. 60 6.4 OPERATIONAL AND BUSINESS MODELS OPTIONS ............................................................................................ 62 7 APPENDIX A: PRICING ASSUMPTIONS ................................................................................................... 63 8 APPENDIX B: ECONOMIC CAPITAL ASSUMPTIONS ................................................................................ 66 9 APPENDIX C: BREAKEVEN VERSUS REALISED INFLATION ....................................................................... 68 10 ACKNOWLEDGEMENTS ......................................................................................................................... 70 11 REFERENCES .......................................................................................................................................... 71 Page 3 of 72 Manufacturing Inflation Risk Protection 1 Executive Summary Inflation plays a central role in the management of personal wealth to meet future consumption wants and needs. It is particularly important in the management of long terms savings to meet retirement related needs, which can span durations well in excess of 30 years. Over such periods of time, even low to moderate levels of inflation can have extremely large impacts on the ability of accumulated wealth to maintain purchasing power. A central part of any long term retirement investment plan should be a strategy of how wealth is invested and protected in order to maintain its purchasing power, and thus to secure and sustain adequate standards of living throughout retirement. This paper examines various wealth management solutions, both existing and new, that provide inflation protected benefits designed to meet consumer’s wealth accumulation and post-retirement income needs. Section 2 discusses inflation risk in the context of these needs, across a number of developed markets. For these markets, consumer price inflation has tended to range predominantly in the 0% to 5% levels over the last two decades, although there have been extended periods of both lower and higher inflation over long historical timeframes. The importance of providing inflation protected retirement solutions is clearly evidenced through the provision of social security provided by the state, as well as through the dependence on defined benefit occupational pension schemes provided by employers, both of which provide elements of inflation indexation of retirement income. However with the broad movement away from these vehicles over recent years towards private provision of retirement solutions, there has been little corresponding use of investment or insurance solutions which provide equivalent benefits. The use of retail products such as inflation indexed fixed annuities, inflation indexed variable annuities, and inflation guaranteed bonds has been extremely limited. Section 3 discusses these solutions in further detail. Traditional investment solutions have focused primarily around the use of traditional asset classes such as equities, fixed income and property to provide nominal returns that are correlated to inflation. However the analysis outlined and discussed in section 3.6 on this, shows that the performance of these assets can vary significantly
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