preparing for the end game

External Presentation Europe Institutional Pensions Training 31 January 2013

Preparing for the

End Game Robert Gardner

Europe Institutional Pensions Training

1


1. Transfer to members

Change benefit format, e.g. ETVs, Early

Retirement

2. Transfer to external entity

Buy-In/Buy-out

3. Preparing for the

End Game

A 7-Step Plan to Full Funding

What is the End Game?

2


Preparing for the End Game

3

The Seven Steps to Full Funding


Adjusting the sails

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The pessimist complains about the wind;

The optimist expects it to change;

The realist adjusts the sails.

- William A. Ward


Step 1 Description

• A strategic Pension Risk Management Framework that sets out funding objectives, risk budget

and other constraints such as liquidity and collateral requirements

• A Flight Plan that charts each plan’s path to full funding and generates required returns used

to set investment strategy

Setting Clear Goals and Objectives

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Objective Measurement Performance Indicators Performance (31 Jan 13) RAG

Primary Funding

Objective

To reach full funding by [2026] (based

on discount rate of Gilts + 0.75%)

Expected Returns (ER) > Required

Returns (RR)

RR: Libor + 300bps

ER: Libor + 200bps

Difference: -100bps

Secondary

Funding Objective

To reach full funding on a buyout basis

by [2032] (based on a discount rate of

gilts flat)

Expected Returns (ER) > Required

Returns (RR)

RR: Libor + 250bps

ER: Libor + 200bps

Difference: -50bps

Investment

Strategy

Actual Returns should exceed

Expected Returns

Actual Returns (AR) > Expected Returns

(ER)

AR: Libor + xxxbps

ER: Libor + 200bps

Difference: xxbps

Risk Budget

The investment strategy should not risk

the deficit worsening by [20%] of

liabilities over a 1 year period

VaR95 < [20%] of liabilities VaR95: 28.0%

Hedging Strategy

Nominal/Inflation hedge ratio should be

maintained within +/- 5% of the funding

ratio.

Funding Ratio (gilts + 0.75%) 60%

Nominal Hedge Ratio (gilts + 0.75%) 20%

Inflation Hedge Ratio (gilts + 0.75%) 25%

Collateral

Maintain sufficient eligible for the

purposes of covering margin calls that

may arise from the Scheme’s current

derivative positions over a 1 year

period.

Total available eligible collateral xx mn

Remaining collateral after VaR95 event yy mn

The Pension Risk Management Framework

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RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away


1,000

1,500

2,000

2,500

3,000

3,500

4,000

20

12

20

13

20

13

20

14

20

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20

15

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20

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20

23

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24

20

24

20

25

20

25

20

26

£m

m

Flight Plan

liability (swap flat) asset (swaps flat)

The Flight Plan

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100% - Swaps Flat by 2026

Required Returns Libor + 300bps

Expected Returns Libor + 200bps

Contributions & Asset Returns

Liability Basis

Time Horizon


Access to LDI Hub

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Step 2 Description

• Interest rate and inflation risk are typically one of the largest “unrewarded risks” for a

pension scheme

• Setting up an LDI hub which gives the scheme the ability to manage inflation and interest

rate risk efficiently and effectively


Step 3 Description

• Generating returns in highly marketable asset classes via risk premia and active

management

• Examples: volatility control, risk parity, equity, and CTA strategies

Liquid Alpha & Beta Strategies

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20%

80%

50%50%

85%

15%

40%

60%

Cash Asset Allocation Risk Contribution

Traditional

Risk Parity0%

10%

20%

30%

40%

50%

60%

An

nu

aliz

ed

Vo

lati

lity

(%)

FTSE 100 Rolling Volatility Vol Control Rolling Vol

Volatility Control Strategy Risk Parity Strategy


Liquid & Semi-Liquid Credit Strategies

Step 4 Description

• Credit consists of a range of sub-classes with different risk-return characteristics

• Bulk of excess returns are compensation for credit risk

Emerging Market Debt Investment Grade

10



11

LL

HY

EMD

IG

SF

ABS

LLHY

EMD

IG

SF

ABS0

100

200

300

400

500

600

0 100 200 300 400 500 600

GB

P C

red

it S

pre

ad

over

Sw

ap

s (b

ps)

Credit Spread VaR 95 (bps)

Leveraged Loans High Yield Investment Grade Sub Financials ABS Emerging Market Debt

Q1 2007

Q4 2012

Equity expected

return: 300bps

over swaps

Sources: Babson Capital, Redington 25



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Illiquid Credit Strategies

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Step 5 Description

• Long-dated, hold to maturity instruments that pay an illiquidity premium

• Usually for high-quality, inflation-linked cash flows

• Typically, these Flight Plan Consistent Assets (FPCAs) tend to fit well with the overall

objectives of pension schemes when assessed in the context of a scheme’s PRMF

• Careful consideration should be placed on ensuring the scheme invests in opportunities

providing the best risk-adjusted returns and offers better relative-value

Secured Leases Social Housing Infrastructure Ground Rents


Illiquid Alpha & Beta Strategies

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fd Step 6 Description

• Assets under this category provide attractive returns but are typically more complex and

illiquid e.g. private equity and PFI equity

• Inclusion of these asset classes in the scheme’s investments will depend on the overall

objectives and governance budget of the scheme as set out in its PRMF

• Examples: Private Equity, Property, Insurance Linked Securities

Insurance-Linked Securities


Step 7 Description

• Effective monitoring is key to measuring a scheme’s progress against its objectives

• Once you have set clear goals and objectives (step 1), the value of monitoring (step 7) is that

you can make better decisions by tracking where you are against your objectives.

• A scheme that regularly monitors understands the impact of their investment decisions and

can easily assess investment opportunities via-à-vis the liabilities

Ongoing Monitoring

Track scheme’s progress towards clear goals and objectives

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Case Study: 7 Steps in Practice

Background:

• The client is a scheme with assets less than £100m.

• In early 2008, the scheme was close to having sufficient funds to consider a full buyout. However, with a traditional

balanced portfolio and no robust monitoring in place, this was not known until it was too late.

• The scheme suffered during the financial crisis and by the end of 2008 the funding position had deteriorated and

a 10y recovery plan put in place. Redington were appointed as investment consultants in early 2010.

Step 1: Set up clear goals and objectives through Pension Risk Management Framework

• Funding objective: To be fully funded in 2022 on a self sufficiency basis

• Target asset allocation: 100% matching assets

• Risk Targets: To reduce risk as measured by Value at Risk

• Hedge Ratio: To increase the hedge ratio to equal the funding ratio

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60.0%

65.0%

70.0%

75.0%

80.0%

85.0%

90.0%

95.0%

100.0%

Fu

nd

ing

leve

l

Dynamic De-Risking

Original Strategy

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Re-risking and refresh of triggers Review investment strategy

Step 7: Daily monitoring of funding level to implement de-risking as funding level improves

Case Study: 7 Steps in Practice


13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk

Contacts

Robert Gardner

Founder & Co-CEO

Telephone: +44 (0) 20 7250 3331

[email protected]

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THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT

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 Ltd 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 Ltd does not owe any party a duty of care in this respect.

Redington Ltd 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.

©Redington Limited 2013. All rights reserved. No reproduction, copy, transmission or translation in whole or in part of this presentation may be made without permission. Application for permission should be made to Redington Limited at the address below. Redington Limited (6660006) is registered in England and Wales. Registered office: 13-15 Mallow Street London EC1Y 8RD

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preparing for the end game

Economy & Finance

required returns libor

funding ratio gilts

libor xxxbpser

funding objectives

required returns usedto

inflation hedge ratio

inflation risk

nominal hedge ratio