What Lies Beneath: The Hidden Cost of

Pension Equity Risk

March 2014

For Institutional Investors

2

For Institutional Investors March 2014

Contents

Situation

A recent change to banking regulation brings pension risk to the fore

3

Problem

Allowing for equity risk at a 99.5% 1-year risk level means reserving against quite extreme

shocks

4

Implication

Additional capital requirement can be lessened by capital protected equity strategies

5

Need

Using a volatility controlled benchmark greatly reduces the cost of protecting an equity

portfolio against large losses, while maintaining return expectations similar to a

conventional equity portfolio

6

Source Data 12

About the Author 13

What Lies Beneath: The Hidden Cost of Pension Equity Risk

March 2014 For Institutional Investors

3

Situation

A recent change to the banking regulatory landscape brought pension risk

to the fore…

On 29th November 2013, following a consultation, the Prudential Regulation Authority, responsible for

the prudential regulation and supervision of banks, building societies, credit unions, insurers and major

investment firms, announced1 changes to the capital framework applying to UK banks and building

societies, specifically with respect to defined benefit pensions risk.

“The PRA has decided that firms should meet all Pillar 2A risks (5), including pension risk, with

at least 56% CET1 capital from 1 January 2015 onwards. This matches the proportion of CET1

capital required for Pillar 1. In its consultation the PRA asked for views on whether Pillar 2A

should be met in full with CET1 capital from 1 January 2016. In light of consultation responses,

the PRA has decided that it will not require firms to meet Pillar 2A in full with CET1.”

Source: The Bank of England1

Here, “pension risk” means the 1-year 99.5% Value-At-Risk (“VaR”) of the scheme assets relative to the

liabilities. This is quite an onerous shock, for example for equities the 99.5% VaR would be around 2.5x

the annual volatility of equities. The historic annual volatility of equities varies depending on the time

period but is generally 16-20% per annum. The 99.5% VaR would also be nearly twice the 95% VaR which

many pension schemes use for risk modelling.

Pensions were already in the spotlight when it comes to banks’ accounting (see table 1) but the previous

regulations required only a figure relating to the accounting deficit and agreed contributions be covered

by tier 1 capital. Thus the risk of the scheme was not so important, this has now changed as a large

proportion (56%) of the risk in the pension fund must be covered by high quality (“CET1”) capital.

Table 1 : Number of times the word "pension" appeared in each bank's 2012 Annual report & Accounts

Barclays HSBC Lloyds RBS Santander

UK

Word count for

“pension” in 2012

report & accounts

59 107 183 163 199

This change signifies the latest in a series of efforts by regulators to tighten up banking capital regulations

in the wake of the financial crisis of 2008 onwards. This seemingly small change can have deep and

lasting effects on the way risk is measured and managed, and the capital banks must hold as a result.

In this paper we analyse the most recent2 publicly available data on five UK banks (Barclays, HSBC,

Lloyds, RBS and Santander UK).

1 http://www.bankofengland.co.uk/publications/Pages/news/2013/181.aspx 2 For all the banks analysed, the most recent report & accounts available were for 2012. The pension position may have changed

since this date

Source: Individual Company 2012 Report & Accounts (see “Source data” section). Calculations: Redington

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For Institutional Investors March 2014

Problem

Equity portfolios across the UK banks are considerable, and the 99.5% VaR

used to determine the capital requirement is a large shock…

Figure 1: Summary of Asset & Liability positions

The Capital Requirement for Equities

The capital charge is based on a 1-year 99.5% VaR estimate. There is no prescribed method for

calculating this by the regulator, with each banking using their own modelling approach and calibration

which are not publicised. The exact modelling approach and calibration used will affect the result of this

calculation but one independent and public guide is the Solvency II standard formula, which gives an

equity shock (base level) to determine the capital requirement of 39% for developed, quoted equities.

For comparison, this is roughly equivalent to an annualized volatility of 16%. Redington’s own modelling

produces a very similar result of a 38% equity shock.

While each of the banks’ pension schemes will have other diversifying risks which makes the overall

ALM VaR analysis more complicated, we can look at the new capital requirement arising solely from the

equity portfolio simply by multiplying the capital charge of 39% by the £ size of the equity portfolio and

then multiplying by 56%, that being the proportion of pension risk that is met with CET1 capital under

the new regulation.

Barclays HSBC Lloyds RBS Santander UK

% Equity 26% 13% 41% 41% 27%

Equity (£m) 6,265 2,129 12,450 10,812 2,026

Total Assets (£m) 24,096 16,380 30,367 26,370 7,503

Liabilities (£m) 25,407 17,999 31,324 30,110 7,554

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

£m

Source: Individual Company 2012 Report & Accounts (see “Source data” section”)

March 2014 For Institutional Investors

5

Implication

The high additional CET1 capital required to cover pension risk once equity

risk is allowed for can be lessened by capital protected equity strategies …

but these can often seem prohibitively expensive when applied to

conventional equity portfolios

Figure 2: Bank pension scheme equity holdings, VaR, current capital and pension adjustment

• The increased CET1 requirements for equity risk (item 3 above) are large compared to the previous

pensions adjustments to CET1 capital (for example those in the 2012 report & accounts).

3 Calculated as 39% of the amount held in equity 4 Calculated as 56% of the 1-year 99.5% VaR 5 Sourced from individual 2012 annual report and accounts – see source data section

Barclays HSBC Lloyds RBS Santander UK

1. Equity

holdings (£m)

6,300 2,100 12,500 10,800 2,000

2. Estimated

1-year 99.5%

VaR (£m)3

2,400 830 4,900 4,200 790

3. Estimated

CET1 Capital

requirement

equity-only

(£)4

1,400 500 2,700 2,400 440

4. 2012 total

CET 1 capital5

42,121 22,088 37,913 47,320 8,861

5. 2012

Pensions

Adjustment to

CET1 Capital

(£m)4

2,445 1,218 1,438 913 52

Source: Individual Company 2012 Report & Accounts (see “Source data” section). Calculations: Redington

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For Institutional Investors March 2014

Need

Using a volatility controlled benchmark greatly reduces the cost of

protecting an equity portfolio against large losses using put options, while

maintaining return expectations similar to a conventional equity portfolio

Enter Volatility Control

In previous papers we have introduced the idea of using a volatility controlled index to manage the

equity portfolio6.

This is an index that systematically adjusts its exposure to equity markets dynamically, in response to

changes in the realised volatility of equities. This means that the index has a lower, and more constant

level of volatility.

Both our own work, and external studies7 find that a volatility controlled equity benchmark has delivered

greater risk-adjusted returns than a static benchmark, over a wide variety of long-term time periods and

equity indices. This means we can reasonably expect a similar level of return as a static allocation for

a lower level of risk.

Another consequence of reducing and controlling the level of volatility in an equity investment is the

fact that put options on the value of the portfolio become much cheaper than on a static portfolio, which

means that credible investment strategies can be adopted which embed this “hard floor” protection of

the portfolio value on a rolling basis (see figure 3).

Figure 3: Comparison of protection costs

1-Year protection

level

Current cost of

protection on Global

Equity Index (%)

February 2014

Stressed market

conditions cost of

protection on Global

Equity Index (%)

Cost to Protect 10%

Volatility Control

portfolio (%)

90% 3.5% 6.5% 1.0%

85% 1.6% 4.8% 0.4%

80% 1.3% 3.5% 0.2%

6 Volatility Control : An Introduction http://blog.redington.co.uk/Articles/Dan-Mikulskis/September-2012/VOLATILITY-

CONTROL.aspx

Volatility Control Taming the Beast: A Tale of Two Crashes http://www.redington.co.uk/getattachment/172c962e-bd64-4adc-

8243-9bcfdcc62d5b/Taming%20The%20Beast%20-%20A%20Tale%20of%20Two%20Crashes.aspx

Volatility Control: The Hedgehog and the Fox http://redington.co.uk/getattachment/eea3dd74-37c8-446e-afa9-

fd8d1973f295/Taming%20The%20Beast.aspx 7 Guide Giese: The Optimal Design of Risk Control Strategy Indices (Journal of Indexes)

http://www.etf.com/publications/journalofindexes/joi-articles/12932-optimal-design-of-risk-control-strategy-indexes.html

Source: Redington, Investment Banks

March 2014 For Institutional Investors

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While the capital reduction of implementing a volatility controlled benchmark (without capital

protection) is model dependent (it does substantially reduce the 1-year VaR in our model as shown in

figure 4, but this depends on how it is modelled), the capital reduction associated with a benchmark

involving explicit downside protection should be much easier to demonstrate. Given the portfolio has

protection in place at a certain level (90% say), and as long as this protection is maintained throughout

the year and on a rolling basis, this level of protection should be reflected in a reduced capital

requirement (see figure 4).

Figure 4: Reducing Equity VaR using volatility control and put options

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

0% 10% 20% 30% 40% 50%

Exp

ecte

d R

etu

rn o

ve

r sw

ap

s (

bp

s)

1-year VaR 99.5% (% of notional exposure)

Stage 1: Developed

Market Equity

Source & Calculations: Redington

Stage 2: Developed

Market Equity with

Volatility Control

Stage 3: Volatility

Control with rolling

90% put option

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For Institutional Investors March 2014

Figure 5: Illustration of CET1 capital requirement reduction with volatility control + put option

Barclays Lloyds HSBC RBS Santander

UK

Equity holdings (£m) 6,300 12,500 2,100 10,800 2,000

Estimated New CET1

capital requirement,

equity risk only (£)

1,400 2,700 500 2,400 440

Estimated New CET1

capital requirement,

replacing equity with

volatility control + put

option (£m)8

350 700 120 600 200

Change in Equity Only

capital requirement

from implementing

volatility control (£m)

-1,050 -2,000 -380 -1,800 -240

8 Volatility controlled equity includes annual put option with a strike of 90%. Capital charge calculated as 10% of the value of

volatility controlled equity holding

• This example focuses on equity risk in isolation, and so approximates a situation where other

risks are either minimal or closely matched. In practice this will not be the case and the

interplay between the other risks in the scheme will be a significant factor in determining the

overall change in VaR, and hence capital requirement – this is discussed further below

• The reductions in equity-only CET1 capital requirement from adopting a protected volatility

controlled benchmark are substantial (the reduction is around 75%).

• Figures above may not sum due to rounding

Source: Individual Company 2012 Report & Accounts (see “Source data” section”). Calculations: Redington

March 2014 For Institutional Investors

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Accounting for diversifying risks

• So far, we have looked at the equity component of the capital requirement in isolation. In reality,

the diversifying effects of other risks in the pension scheme, particularly unhedged interest rate risk

will change the picture when viewed at the aggregate level

• The extent of this will be depend on the individual assumptions and models that the banks use,

which are not public. Further, it is not possible to tell exactly from the publicly available information

the level of interest rate hedging that each bank has implemented within the pension fund

• We can, however, make some approximate conclusions based on various assumptions. The most

important modelling assumptions are the level of the interest rate shock, and the level of interest

rate/equity correlation

• The chart below shows the approximate percentage reduction in the overall capital requirement,

for varying levels of liability hedge ratio. Each line depicts a different allocation to equities. The

change in capital requirement reflects moving the entire equity portfolio from conventional equity

to volatility controlled equity with put option

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For Institutional Investors March 2014

Figure 6: Reduction in capital requirement taking into account diversifying risks

-80.0%

-70.0%

-60.0%

-50.0%

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

Ch

ange

in o

vera

ll C

apit

al r

equ

irem

ent

Liability Hedge ratio

Approx. Overall Capital reduction from applying protected volatility controlled equity

15% Equity 25% Equity 40% Equity

How to read this chart:

Each line represents a different level of equity allocation. The vertical axis tells us the approximate reduction in the overall

capital requirement from implementing a capital protected volatility controlled allocation to equity (allowing for the diversifying

effect of interest rate risk) at different levels of liability hedge ratio (along the horizontal axis).

For example, for the 40% equity allocation, if the liability hedge ratio was 0% the overall capital requirement would be reduced

by roughly 20% if the equity portfolio was changed to a volatility controlled benchmark with put option (grey line, left hand end).

If the liability hedge ratio was then increased to 50%, for example by employing an increased interest rate matching overlay

(moving to the right on the grey line) the reduction in overall capital requirement – from moving to volatility controlled equity

plus put option - increases to around 35-40% (although the overall size of the capital requirement would also reduce).

Notes: analysis takes into account equity and interest rate risk only. Correlation between bonds and equity assumed -0.2.

Interest rate shock assumed to be a 1.2% fall in real yields. Assumed liability duration 20 years.

March 2014 For Institutional Investors

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Conclusions

• The latest change in regulatory landscape for banks and building societies brings pensions risk to

the fore, requiring a more significant CET1 capital requirement for risks being run in the pension

fund, including equity risk

• The five schemes analysed represent more than £100bn of liabilities. The level of risk in each

scheme is dependent on a number of factors, the most important being:

– The proportion of assets invested in equities or other growth assets;

– The level of liability hedging/matching undertaken

• Looking at the capital requirement from the equity portfolios only, the new regulation points to a

substantial increase in capital required, as the equity shock used to determine capital

requirement is likely to be relatively high (although each bank’s methodology is not public)

• In practice the interplay of the other risks in the scheme, particularly the unhedged liability interest

rate risk will play a role in determining the reduction in capital requirement from employing volatility

controlled equity

• This effect is hard to quantify exactly as the specific assumptions and calibrations used by each

banks modelling team will affect the result. We have however made an attempt to look at this

affect approximately for a range of equity allocations and liability hedge ratios

• We can draw two broad conclusions from this part of the analysis:

– The capital reduction from employing volatility controlled equity with put option is more

significant the greater the level of liability hedging already in place

– However for equity allocation greater than 40%, a significant reduction in overall capital

requirement can be obtained even at low liability hedge ratios

– For low equity allocations of 15% or less, the benefits of adopting a capital protected equity

strategy are likely to be small below liability hedge levels of 70%. Above this level the benefits

begin to increase quite rapidly

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For Institutional Investors March 2014

Source Data

Bank Source

Barclays Barclay Bank PLC Annual Report 2012 pages 66, 212

http://group.barclays.com/Satellite?blobcol=urldata&blobheader=application/pdf&

blobheadername1=Content-Disposition&blobheadername2=MDT-

Type&blobheadervalue1=inline;+filename%3D2012-Barclays-Bank-PLC-Annual-

Report-PDF.pdf&blobheadervalue2=abinary;+charset%3DUTF-

8&blobkey=id&blobtable=MungoBlobs&blobwhere=1330696635849&ssbinary=tr

ue

Lloyds Annual Report and Accounts 2012 pages 49, 189, 272-4

http://www.lloydsbankinggroup.com/media/pdfs/investors/2012/2012_LBG_Ran

dA_Interactive.pdf

HSBC HSBC Group 2012 Annual Report & Accounts pages 82, 120, 133

http://www.hsbc.co.uk/1/PA_esf-ca-app-

content/content/pws/content/personal/pdfs/hbeu-2012-ara-final-online.pdf

RBS

RBS Group Annual Report and Accounts 2012 pages 381 - 383

http://www.investors.rbs.com/~/media/Files/R/RBS-IR/documents/annual-report-

2012.pdf

Santander

UK

Annual Report and Accounts 2012 pages 84, 270

http://www.aboutsantander.co.uk/media/59517/santander%20uk%202012%20a

nnual%20report.pdf

March 2014 For Institutional Investors

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About Redington

Redington is committed to improving financial futures. We design, develop and deliver

investment strategies for pension funds and insurance companies to help them to define and

reach their goals, we work to help create a new pensions system for those currently saving

and planning for retirement, and we run a financial education programme for young people.

Our investment advice is more action-focused than many other consultancies, and we are not

afraid to be innovative in the types of strategies we deliver. We take our clients through a

rigorous 7 Steps to Full Funding™, and our three flagship clients are measurably better

funded with less downside risk as a result of working through this. We were named

Investment Consultancy of the Year by four separate award-giving bodies in 2013.

We advise 50+ clients, eleven of the top 30 pension funds in the UK, and have over £300bn

in assets under consulting.

About the Author

We would welcome the opportunity to discuss further. Please do get in touch to find out more.

Dan Mikulskis

Director, ALM & Investment Strategy

• Dan joined Redington in

June 2012 and is Co-Head

of ALM.

• Prior to this, Dan worked at

Deutsche Bank in their

Cross Asset Trading Group,

where he focused on

volatility trading and in-

house systems

development.

• Earlier, he developed and

tested quantitative tools to

support portfolio

management at Macquarie

Funds Group.

• Dan started his career as

an Investment Consultant

at Mercer.

• He is a fellow of the

Institute of Actuaries.

Contact:

+44 (0) 20 3326 7129

dan.miksulkis@redington.co.uk

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For Institutional Investors March 2014