Liability-driven solutions for pensions

When Bonds are not enoughPresented by

Vincent de Martel, Director, Structured & Alternative Investments

2 April 2004

2

A changing world for DB pensions...

IAS 19 – marked-to-market valuations of assets and liabilities

Falling equity markets

Pension fund no longer considered a separate entity – direct impact on sponsor's ratings

A move towards higher bond allocations is observed

Yes, but is that enough?

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DB Risks - Common Misconceptions

Perception Reality

Liability risk

Asset mix risk

Active Risk

Source: Leo de Bever, Ontario Teachers' Pension

4

In a DB world, bond-matching is challengingUK longest Government bond 2036Netherlands 2028Germany 2034France 2035

With inflation-linkage, even greater rarity...UK Govt Inflation-Linked Bonds Maturity

DateNominal

Amount £

4% Index-linked Treasury Stock 2004 Oct-2004 1,3382% Index-linked Treasury Stock 2006 Jul-2006 2,0372 ½% Index-linked Treasury Stock 2009 May-2009 3,0982 ½% Index-linked Treasury Stock 2011 Aug-2011 4,3422 ½% Index-linked Treasury Stock 2013 Aug-2013 5,5972 ½% Index-linked Treasury Stock 2016 Jul-2016 6,4552 ½% Index-linked Treasury Stock 2020 Apr-2020 5,0932 ½% Index-linked Treasury Stock 2024 Jul-2024 5,7514% Index-linked Treasury Stock 2030 Jul-2030 3,1712% Index-linked Treasury Stock 2035 Jan-2035 3,775

Source: DSTA, Deutsche Bundesbank, DMO, 30 March 04

Only 6 countries with significant (>100m$ oustanding) inflation programmes - Canada, France, Italy, Sweden, UK, US

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Pension funds are significantly mismatched in interest rate sensitivity

0%

5%

10%

15%

20%

25%

30%

2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24Liability Duration

Frequency

Duration of UK Defined Benefit plans (FTSE 350 companies)

Duration of most commonly used benchmarked indices

Bond Benchmark ConstituentDuration

(Years)FT-SE 5-15 Yr Gilts 6.3FTSE UK Gilts All Stocks 8.0Merrill Lynch Corp Bond 8.3FTSE 5-15 Yr UK Gilts Indexed 9.2FTSE UK Gilts All Stocks Indexed 10.8FTSE > 15Yr UK Gilts Indexed 16.2

Over 70% of funds have a duration of liabilities that

exceed the longestduration index

Source: Barrie & Hibbert, AXA IM, February 2004, WM Research September 2003

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Duration mismatch can cause large changes in solvency levels

Duration measures the average remaining life of a stream of bond or pension fund cash flows. Duration measures the price sensitivity to interest rate changes:

Examples :

Duration Barclays Sterling Gilts 15+ = 13.2 years

Typical pension fund duration = 20 years

-2% -1% +1% +2%Barcap Sterling Gilts over 15 years +26.4% +13.2% -13.2% -26.4%

Pension Scheme +40.0% +20.0% -20.0% -40.0%Difference (negative means surplus for the scheme) 13.6% 6.8% -6.8% -13.6%

Change in interest rates

For simplification purposes, the effect of convexity has not been shown - the order of magnitude remains the same however

Source: Bloomberg, AXA IM

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Using swaps to achieve the right matchingPrinciple: the duration of a traditional fixed income portfolio is adjusted by entering into an interest rate swap, in order to match the duration of the liabilities

X

X X

XX

X

Pays variable rate

Receives fixed rate

Diversified bonds portfolio

Market counterparty(e.g. investment bank)

Application: UK Pension Scheme - matching portfolio

Bondsduration

Swapsduration

Schemeduration+ =

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Thanks to the swaps, the scheme can be immunised against changes in rates

2 5 0

3 0 0

3 5 0

4 0 0

LiabilitiesMarketvalue

Bondsportfolio

AA rate unchanged AA rate - 1%AA rate + 1%

Surplus

DeficitWithout swaps

2 5 0

3 0 0

3 5 0

4 0 0

AA rate unchanged AA rate - 1%AA rate + 1%

LiabilitiesMarketvalue

Bondsportfolio+ swaps

Matched

MatchedWith swaps

Based on an actual solution for a UK pension schemeActively managed corporate bond portfolioSwap overlay: 8 forward starting interest rate swapsPortfolio duration increased from 9 to 19 years

For illustration purposes only

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Asset-Liability Management is a risk management tool

BEFORE ALM AFTER ALM

Interest rates

Inflation

Longevity

Sponsor default ?

Source: The Times 27 June 2003

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Now and beyond...

Forget the herd – each scheme is different and requires a different asset mix

Asset-Liability matching does not necessarily imply a 100% allocation to bonds

Pension fund management evolving towards an ALM approach – match the liabilities and earn a spread

Liability-driven solutions for pensionsWhen Bonds are not enoughA changing world for DB pensions...DB Risks - Common MisconceptionsIn a DB world, bond-matching is challengingPension funds are significantly mismatched in interest rate sensitivityDuration mismatch can cause large changes in solvency levelsUsing swaps to achieve the right matchingThanks to the swaps, the scheme can be immunised against changes in ratesAsset-Liability Management is a risk management toolNow and beyond...