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Working Papers

2021Jul
Valuation of guaranteed minimum maturity benefits under generalised regime-switching models using the Fourier Cosine method

Boda Kang, Yang Shen, Dan Zhu and Jonathan Ziveyi

Abstract: This paper presents a flexible valuation approach for variable annuity (VA) contracts embedded with guaranteed minimum maturity benefit (GMMB) riders written on an underlying fund that evolves according to a general regime-switching framework. Unlike the classical regime-switching models which only allow model parameters to change upon regime switches, our framework allows, more importantly, model structures to vary. With mild assumptions on the characteristic function of the log-stock price, our model settings enable the study of fundamental features of the market dynamics, such as stochastic volatility and jumps, on the underlying fund value of GMMB in a unified framework. This novel idea is illustrated by a three-regime model whose environments can be characterised by either the geometric Brownian motion process, double exponential process or the Heston (1993) stochastic volatility process. Two versions of the GMMB riders are considered; a fixed or roll-up guarantee and a ratchet geometric average guarantee. With the Fourier Cosine (COS) method which utilises characteristic functions, explicit valuation expressions for various contracts are derived, and numerical illustrations are performed to analyse the efficiency of the approach in terms of computational speed and accuracy. The paper makes a unique contribution by presenting regime-dependent bounds and an algorithm for determining the optimal grid points required for the COS method to achieve a specific level of accuracy. Numerical experiments for the valuation framework reveal that as the likelihood of regime shifts increases, the price difference of VA contracts with different initial regimes diminishes, which is consistent with financial intuition.

Keywords: Variable annuity contracts; GMMB; COS method; Generalised regime-switching model; Ratch-et options

 

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2021Jul
Economy
Determinants of Early-Access to Retirement Savings: Lessons from the COVID-19 Pandemic

Hazel Bateman, Isabella Dobrescu, Junhao Liu, Ben R. Newell & Susan Thorp

Abstract: The Australian COVID-19 Early Release Scheme (ERS) allowed people in financial hardship immediate access to up to $A20,000 of their ‘preserved’ retirement savings between April and December 2020. Using data from a large Australian pension fund, we examine what drives people’s decisions to take advantage of the ERS. We find that while the majority of survey respondents withdrew money for immediate consumption needs, a substantial proportion of them were concerned about future needs. Most withdrawers thought about the decision for less than a week and many appeared to use the $A10,000 per round limit as an anchor in choosing their withdrawal amount. Conditional on eligibility, the probability of withdrawal was significantly higher where respondents (i) were more concerned about future needs, (ii) did not think about the long-term impact, and (iii) under-estimated or did not estimate the fall in their retirement savings. Our results suggest that many people who withdrew under the scheme did not fully understand the consequences of their choice. These findings raise the question of whether the framing of ‘mandatory’ retirement savings as a mental account to finance retirement has been irrevocably damaged.

Keywords: pension early access, retirement savings, mental accounts, COVID-19

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2021Jun
Mike Sherris CEPAR
On Sustainable Aged Care Financing in Australia

Michael Sherris 

Abstract: The Final Report of the Royal Commission into Aged Care Quality and Safety (2021) highlighted the challenges in developing a sustainable financing system for Aged Care in Australia. The Report recommended additional funding both in the short term and longer term, to provide an adequate level of aged care quality for older Australians including exploring an actuarially based contributory social insurance scheme for aged care. Sustainable financing of aged care requires a balance between government tax-based financing, individual contributions during working life through an aged care levy, co-payments for aged care costs for those receiving aged care and means testing for these co-payments. There should be a role for private market insurance and financing to supplement government financed aged care support.

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2021May
China
Delay the Pension Age or Adjust the Pension Benefit? Implications for Labor Supply and Individual Welfare in China

Yuanyuan Deng, Hanming Fang, Katja Hanewald and Shang Wu

Abstract: We develop and calibrate a life-cycle model of labor supply and consumption to quantify the implications of alternative pension reforms on labor supply, individual welfare, and government budget for China’s basic old-age insurance program. We focus on urban males and distinguish low-skilled and high-skilled individuals, who differ in their preferences, health and labor income dynamics, and medical expense processes. We use the calibrated model to evaluate three potential pension reforms: (i) increasing the pension eligibility age from 60 to 65, but keeping the current pension benefit rule unchanged; (ii) keeping the pension eligibility age at 60, but proportionally lowering pension benefits so that the pension program’s budget is the same as under Reform (i); and (iii) increasing the pension eligibility age to 65 and simultaneously increasing the pension benefits so that individuals of both skill types attain the same individual welfare levels as in the status quo. We find that relative to the baseline, both Reforms (i) and (ii) can substantially improve the budgets of the pension system, but at the cost of substantial individual welfare loss for both skill types. In contrast, we find that Reform (iii) can modestly improve the budget of the pension system while ensuring that both skill types are as well off as in the status quo. We find that Reforms (i) and (ii) slightly increases, but Reform (iii) slightly decreases, the overall labor supply.

Keywords: pension reform; labor force participation; welfare; life-cycle behavior; China

 

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2021May
Life Insurance: Decision States, Financial Literacy and Personal Values

Hazel Bateman, Paul Gerrans, Susan Thorp and Yunbo Zeng

Abstract: We administered an online survey to elicit consumers’ subjective assessments of their decision state for the purchase of life insurance - from pre-aware to purchase decision - in a setting of both active choice and default cover. We find that household formation and financial assets are associated with higher decision states, but not always with being capable and ready to choose. The financially literate are more likely to be in a higher state, but the less financially literate are spread across several states. We also find that personal values matter for readiness to make a choice about life insurance with respondents who place more value on benevolence and self- determination more likely to be aware of life insurance and capable to choose. We conclude that personal values help consumers choose suitable cover and that interventions to increase cover and improve suitability of life insurance should target progression through the decision states.

Keywords: Life insurance, decision states, personal values, financial literacy, defaults.

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2021May
Flexible insurance for informal long-term care: A study of stated preferences

Shang Wu, Hazel Bateman, Ralph Stevens and Susan Thorp

Abstract: We collect and analyze stated preferences for long-term care insurance that pays income in poor health states instead of reimbursing formal care costs. Around 75% of the sample of 1008 pre-retirees chose to purchase at least some long-term care income insurance from a menu that also included liquid wealth and a life annuity. Our results show that long term care income insurance is complementary to informal care and is attractive to seniors who plan to rely on family members for extensive care. Those who have access to extensive informal care demand 25-37% more health- contingent income per year than those who do not. Females who expect to rely exclusively on extensive care from family members are willing to buy more cover than males. We also find that if long-term care income insurance were available, many healthier seniors would release funds set aside to self-insure long-term care risk and purchase additional longevity insurance.

Keywords: Long-term care insurance; longevity insurance; aged care; informal care; retirement incomes; social care.

Online Appendix: online-appendices-flexible-insurance-for-informal-long-term-care-2021.pdf (cepar.edu.au)

 

 

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2021May
A New Perspective on Weak Instruments

Michael Keane and Timothy Neal

Abstract: It is well-understood that 2SLS has poor properties if instruments are exogenous but weak. We clarify these properties, explain weak instrument tests, and study how behavior of 2SLS depends on instrument strength. A common standard for acceptable instruments is a first-stage F-statistic of at least 10. But we show 2SLS has poor properties in that context: Besides having little power, 2SLS generates artificially low standard errors precisely in those samples where it generates estimates most contaminated by endogeneity. This problem persists even when instruments are very strong, causing one-tailed 2SLS t-tests to suffer from severe size distortions unless F approaches 10,000. The Anderson-Rubin test alleviates this problem, and should be used even with strong instruments. A first-stage F of 50 or more is necessary to give reasonable confidence that 2SLS will outperform OLS. Otherwise, OLS combined with controls for sources of endogeneity may be a superior research strategy to IV.

Keywords: Instrumental variables, weak instruments, 2SLS, endogeneity, Anderson-Rubin test, F-test, size distortions of tests

 

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2021May
Content pensioners enjoying a stroll
Pension Policy in Emerging Asian Economies with Population Ageing: What do we Know, Where Should we go?

George Kudrna, Philip O'Keefe and John Piggott

Abstract: This paper reviews the current state of knowledge about pension policy and pension policy formulation in emerging economies undergoing demographic transition, and, with this background, indicated possible directions for future policy development. The countries we consider are primarily located in East and Southeast Asia, a region which is home to more than 30% of the world's population, and are characterised by increasing life expectancy, falling and /or low fertility ratios, immature social protection policy structures, high rates of informal employment, and in many cases, high rates of co-residency.

These features point to the relevance of strands of research which do not normally sit together in thinking about the evidence base for pension policy formulation and its impacts. They include fiscal implications; impacts on economic growth and intergenerational affordability; the relationship between alternative pension models and labour market (in)formality; the role of public benefits in the context of multi-generation households and intergenerational transfers; and the limitations of pension administration for older people who have worked in the informal sector for most or all of their lives.

The paper documents what we know about these various aspects of the issue and identifies knowledge gaps. On the basis of the evidence we do have, we indicate policy reform directions, in particular regarding development of social pensions directed to older people who have worked in the informal sector.

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2021Apr
Global Economic Impacts of Climate Shocks, Climate Policy and Changes in Climate Risk Assessment

Roshen Fernando, Weifeng Liu and Warwick J McKibbin

Abstract: This study assesses the global economic consequences of climate-related risk in three broad areas: (1) the macroeconomic impacts of physical climate risk due to chronic climate change associated with global temperature increases and climate-related extreme shocks; (2) the macroeconomic effects of climate policies designed to transition to net zero emissions by 2050 (transition risk); and (3) the potential macroeconomic consequences of changes in risk premia in financial markets associated with increasing concern over climate events.

We consider four widely used climate scenarios (Representative Concentration Pathways, or RCP), and identify the physical damage functions due to chronic climate risks. The chronic climate risks include sea-level rise, crop yield changes, heat-induced impacts on labor, and increased incidence of diseases. We also estimate the future incidence of climate-related extreme events, including droughts, floods, heat waves, cold waves, storms and wildfires, based on climate variable projections under the climate scenarios.

After translating physical climate shocks into economic shocks to labor force and sectoral productivity, we investigate the macroeconomic consequences under the climate scenarios using the G-Cubed model. The results demonstrate that physical climate risk is likely to cause large economic losses in all RCP scenarios, both through chronic climate change and extreme climate shocks.

We then explore the impact of country-specific economy-wide carbon taxes as a representative policy action to drive the global economy to achieve net-zero emissions by mid-century. Transition risks vary according to the ambition and the design of policies to reduce emissions. The results demonstrate that there can be potentially significant costs associated with policies to reduce emissions, and the costs differ across sectors and across countries.

We also address whether changes in climate risk perceptions can significantly impact the real economy through changes in risk premia in financial markets. We calculate shocks to financial risk premia based on relationships between historical climate shocks and changes in financial market risk premia. We apply these shocks to risk premia under the RCP scenarios and find that the cost of rising risk premia can be of a magnitude consistent with historical experience. The cost appears to be smaller than the economic costs of changes in physical climate risk and transition risk.

Keywords: Climate change, Extreme events, Climate shocks, Climate risk, Macroeconomics, DSGE, CGE, G-Cubed

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