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Pension Risk Management: ALM in Today’s MarketRobert Gardner, Partner, Redington Partners LLPDawid Konotey-Ahulu, Partner, Redington Partners LLP
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Executive Summary Non-Market FactorsMarket FactorsRisk Management is CriticalThrough the LensesPlanning the Long Term Flight PlanNon-Linear AssetsImplementationMonitoringConclusions
ContentsALM in Today’s Market
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Non-Market Factors
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RLAM
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RLAM
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RLAM
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RLAM
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RLAM
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RLAM
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Non Market Factors
• Changing Accounting Standards• FRS17• IAS19
• Pension Protection Fund• Risk Based Levy
• Changing Regulation• The Pensions Regulator• Financial Services Authority
• Rating Agencies
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Non-Market FactorsFactors Driving Behavioural Change
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The risk that a specific population will live longer than anticipated (Blake et al, 2006).Facts
• Life expectancy is increasing 5 hours a day.
• The most frequently used life expectancy by FTSE100 DB pension schemes for a 65 yr old man is 20 years.
• The Pension Protection Fund (PPF)’s latest S143 and S179 valuation assumptions set life expectancy for a 65yr old man as 22 years.
• “If the life expectancy for a male currently aged 60 is understated by two years, depending on the assumptions adopted, this could understate the value of his pension by around 5%.” The Purple Book (2007).
Longevity Risk
0
5
10
15
20
25
1920 1940 1960 1980 2000
Life
Exp
ecta
ncy
Increase in Life Expectancy65 year old in England & Wales
Male Female
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Non-Market FactorsImpact of Other Factors
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KIPPERS - Who is… What is… Generation Y?
Source: KPMG
Non-Market FactorsThe Longer Term Issue
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Market Factors
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Market Snapshot30 Year Inflation Swap Rates (steady increase above 3.20% “ceiling”)
Source: Bloomberg
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Market SnapshotHistorical 30 Year Interest Rate Swap (Volatile and Low)
Source: Bloomberg
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Market SnapshotReal Yield on 1.125% 2037 Index-Linked Gilt (Significantly below 2% “floor”)
Source: Bloomberg
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Market SnapshotHistorical Credit Spreads (Major Market “Distortion”)
Source: Bloomberg
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Market SnapshotHistorical 1 Year FTSE 100 Performance
Source: Bloomberg
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Market SnapshotBreakeven 30 Year Inflation (last 5yrs) (Up, up and away)
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Source: Bloomberg
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Market Snapshot30 Year Australian and Canadian Inflation (LDI goes Global)
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Source: Bloomberg
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Risk Management is CriticalLessons Learned from 2008
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Historical Performance of Brent Crude
Too expensive?
Source: Bloomberg
Why Risk Management is ImportantLessons Leaned from 2008
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To our dear customers,
When our inaugural flight took off in January 2007, we pledged to change the face of air travel. Your appreciation of our unique values and your belief in our product has allowed us to achieve this.
Your belief in us was shared by our investors ‐ but regrettably, due to unforeseen circumstances, they were unable to unlock the finance that we needed. As a result, we are very sad to announce that from 30 May 2008, we will cease operations and we are no longer able to honour flight reservations.
We extend our sincerest apologies to those of you who have travel plans with Silverjet in the future and at present. You are advised to seek alternative travel arrangements with other carriers, and contact your credit card company or travel agent directly for information on obtaining refunds.
We are working actively with new investors who are prepared to inject new funds so we can recommence operations. If we are able to achieve this, we will make an announcement as soon as possible and we hope to be able to bring you our very 'sivilised' flying experience again.
Thank you for your support ‐ it has meant everything. Yours sincerely,
Lawrence Hunt, CEO
Why Risk Management is ImportantLessons Leaned from 2008
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“Southwest owns long‐term contracts to buy most of its fuel through 2009 for what it would cost if oil were $51 a barrel. The value of those hedges soared as oil raced above $90 a barrel, and they are now worth more than $2 billion.”
Source: The New York Times, 27 November 2007
First Quarter 2008 Financial Highlights
•Record first quarter revenues of $2.53 billion, up 15 percent;•Net income, excluding special items, of $43 million, up 30 percent;•Net income per diluted share, excluding special items, of $.06, up 50 percent.
Source: Southwest, 17 April 2008
Why Risk Management is ImportantLessons Leaned from 2008
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"Unfortunately, the huge fuel price hike and the inability of the business to hedge all its fuel has increased our costs year on year by over $80m.
So where many people have been making hay with high oil prices, this is the repercussions of that hay -1,700 people potentially out of work today in the UK.
We've made every effort - myself and my fellow directors - to find new funding for the business, and it's a very sad day for me personally. I am totally devastated."
- Phil Wyatt, XL Chairman (12 September 2008)
Why Risk Management is ImportantLessons Leaned from 2008
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Why Risk Management is ImportantSpreads on 10 Year Goldman Sachs Credit Default Swap (CDS)
Collapse of Northern Rock
Withdrawal of liquidity in interbank
market
Bear Sterns bought out by JP
Morgan
Lehman Brothers file for bankruptcy.
Bank of America announces purchase
of Merrill Lynch
Source: Bloomberg
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Why Risk Management is ImportantOvernight GBP LIBOR
Source: Bloomberg
CDO crisis
Northern Rock nationalised
Bear Sterns bought out by JP
Morgan
Lehman Brothers file for
bankruptcy. Fed leave short term rates unchanged
Overnight GBP Libor
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Through the LensesMulti Dimensional Analysis
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Analyzing the Pension Scheme
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Risk Telescope Sensitivity Microscope Scenario Kaleidoscope
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Pension Fund Risk ManagementRisk Attribution
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Analyzing the Pension Scheme
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Sensitivity MicroscopeRisk Telescope Scenario Kaleidoscope
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Unhedged Inflation (PV01) Hedged Inflation (PV01)
Pension Fund Risk ManagementSensitivity Analysis (PV01) (“Delta Ladders”)
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Unhedged Interest Rate (PV01) Hedged Interest Rate (PV01)
Pension Fund Risk ManagementSensitivity Analysis (PV01) (“Delta Ladders”)
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Analyzing the Pension Scheme
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Sensitivity MicroscopeRisk Telescope Scenario Kaleidoscope
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Pension Fund Risk ManagementStress Testing (“What If?” Scenarios)
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Planning the Long Term Flight Plan
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Ongoing Monitoring
Redington / RiskMetrics Monitor Manager Performance Monitor Funding Trajectory Monitor Risk Budget
New Strategic Investment Strategy
Manager/Counterparty selection Strategy and Tactics Execution Pricing Due-Diligence
Funding “Flight Plan”
Benefit Optimization Sponsor Funding Investment strategy optimization Easy First Steps Asset Diversification Hedging Risk
Investment Objectives
Minimum Funding Level Long Term Funding Target Funding Trajectory Cone of Uncertainty Regulation / Accounting
Diagnostic ALM Review of Pension Fund
Component Risk Budget Current Risk Analysis Current Return Analysis
Establish Appropriate Risk Budget for Sponsor (B/S)
Employer Covenant Review Equity and CDS (Beta) Analysis Peer Comparisons
Road MapKey Milestones for Pension Funds
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Minimum Funding Level
Cone of Uncertainty
Cone of Uncertainty
FRS 17/IAS 19
BUYOUT S75
Cone of Uncertainty
Destination “Fully Funded”Flight Plan
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Achieving Risk Adjusted ReturnHedging Risk – VaR Road Map
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Non-Linear AssetsExpanding the Investment Universe
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Non-Linear AssetsAdding Options to the Asset Toolbox
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Non-Linear Assets Strategy Comparison – Current vs. New Strategy
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Mitigating downside risk
Maintaining Equity upside exposure
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Non-Linear Assets Strategy Comparison – Current vs. New Strategy
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Non-Linear AssetsStrategy Comparison
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Original Strategy New Strategy
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Alternative Investment AnalysisWhy add AI to the asset mix?
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ImplementationKey Steps
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Step 7: Counterparty selection and execution monitoring opportunistic hedging
Step 6: Accessing market “axes” and opportunistic hedging
Step 5: Appropriate Dealing costs
Step 4: Optimal transaction size(s)
Step 3: Optimal timing of execution
Step 2: Establish Appropriate Yield Bands as dealing / trigger points
Step 1: Framework to minimise market impact
Implementation FrameworkSeven Stages
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Monitoring
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Pension SchemeALM Risk Process
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Benchmark DesignHistorical Analysis
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Pension Scheme“Box and Whisker” analysis
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Pension Scheme“Box and Whisker” Graph
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Conclusions
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Understand pitfalls of risk managementBack test VaR calculations with different data inputs / different methodologies to understand the strengths and weaknesses of the VaR number generated.
Estimation errors
Always ask the “what if” questions.
Stress Test.
Use full arsenal of investment tool kit Diversification of assets to work throughout regime changes.Consider adding non-linear assets e.g. call options.Consider adding Alternative Investments to your portfolio.
Longevity bites once risk reduction is implemented Understand range of solutions.
Annuity/But-outIndex Linked Longevity Swaps.Scheme Specific Longevity Swaps.Longevity Annuity Option.
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Pension Fund Risk ManagementConclusion
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Pension Risk Management: ALM Modelling in Today’s MarketRobert Gardner, Partner, Redington Partners LLPDawid Konotey-Ahulu, Partner, Redington Partners LLP
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ContactsDawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 [email protected]
Robert Gardner | Partner Direct: +44 (0) 207 250 [email protected]
Redington Partners LLP13 -15 Mallow Street London EC1Y 8RDTelephone: +44 (0) 207 250 3331
www.redingtonpartners.com
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Contacts
Disclaimer
Disclaimer For professional investors only. Not suitable for private customers.
The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence .
Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees' actuarial advisors. Redington Partners will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in that estimation. Additionally, the client recognizes that Redington Partners does not owe any party a duty of care in this respect.
Redington Partners are investment consultants regulated by the Financial Services Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate.