road to the end game

Teach-in Road to the End Game 17 September 2013

Road to the End Game: Terminal

Portfolios and Buy-In / Buy-out

1


The End Game

The End Game describes the position that a scheme aims to be in as it reaches maturity:

• This may mean targeting a “Terminal Portfolio” i.e. a low-risk asset allocation or;

• a buy-out or buy-in with an annuity provider

The path to the End Game for most schemes will be a dynamic process: whilst a less mature scheme with a large

deficit (and strong sponsor) may run a high-risk / high-return strategy, as the scheme’s funding position improves, it

makes sense to take de-risking opportunities where the scheme can afford to do so

This presentation is in two parts:

• Road to the End Game and Terminal Portfolios

• Buy-ins and Buy-outs with an annuity provider

2


Setting the Scene

Open 33%

Closed to new

members 49%

Closed to future

accruals 17%

Winding up 1%

3

Source: Pension Protection Fund “Purple Book” 2012. Excludes hybrid schemes

Open 17%

Closed to new

members 52%

Closed to future

accruals 29%

Winding up 2%

More schemes are closing to new members and to future accruals...

Distribution of Scheme Status (% of Schemes)

2012

Distribution of Scheme Status (% of Schemes)

2006


Setting the Scene

4

Overall, schemes are moving to lower risk asset allocations (lower equities, higher fixed interest)...

Equities 61%

Gilts & fixed

interest 29%

Property 4%

Cash & deposits

2%

Other 4%

Source: Pension Protection Fund “Purple Book” 2012. Excludes hybrid schemes

Equities 39%

Gilts & fixed

interest 43%

Property 5%

Cash & Deposits

5%

Other 8%

Average Asset Allocation in Total Assets

2006

Average Asset Allocation in Total Assets

2012


Setting the Scene

5

-0.6

0.0

0.6

1.2

1.8

3,000

4,000

5,000

6,000

7,000

FTSE 100 30yr Real Yield (%)

Source: Bloomberg (chart 1), PPF “Purple Book 2012 (chart 2)

60% 65% 62% 58% 68% 67%

60%

0%

20%

40%

60%

80%

2006 2007 2008 2009 2010 2011 2012 2013

Funding Ratio – Full Buy out basis

?

But most schemes are nowhere near fully funded on a buy-out basis


What do we mean by a Terminal Portfolio?

• A Terminal Portfolio is a portfolio that enables a scheme to continue paying out member benefits without any

deterioration to the funding level, until the very last benefit payment is made, or a buy-out occurs.

• A Terminal Portfolio assumes the Scheme is fully funded on a prudent valuation basis

• In addition, a Terminal Portfolio:

• No longer requires deficit-repair contributions from the Sponsor;

• Is fully interest rate and inflation hedged;

• Will likely have exposure to liquid and/or illiquid credit to:

• Fund the spread to Gilts (or Swaps) on the liability discount basis; and/or

• Provide a sufficient buffer to underpin the residual risks in the scheme, for example longevity risk

• The Terminal Portfolio is not implemented once the Scheme reaches full-funding. Rather, the Scheme’s current

investment strategy should converge towards this Terminal Portfolio as the Scheme approaches full funding

6


Why think about the End Game now?

7

150

175

200

225

250

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Liabilities Assets Liabilities have risen Assets (Required Return after liability rise)

1. Required Return to reach full

funding in 15yrs: Gilts + 2.50%

3. After liabilities have risen, Required

Return on Assets is Gilts + 3.25% 2. Liabilities have risen

• If liabilities rise, all else being equal, Required Return on Assets to meet full funding will rise; the closer the target full

funding date, the greater the impact on Required Returns

• It therefore makes sense to adopt an investment strategy that de-risks dynamically through time to give greater

certainty around the path to full funding as the scheme matures:

• As funding ratio improves, reduce reliance on less predictable sources of return e.g. equities, and allocate to

assets with more predictable and less risky cashflows that better match the liability cashflows

£m

Illustrative Flight Plan

Time Horizon


Objective Measurement Performance Indicators Performance (30 Jun 13) Status

Primary Funding

Objective

To reach full funding by [2025] based

on discount rate of Gilts + 1.00%

(Technical Provisions basis)

Expected Returns (ER) > Required

Returns (RR)

RR: Gilts + 275bps

ER: Gilts + 200bps

Difference: -75bps

Secondary

Funding Objective

To reach full funding on a buyout basis

by [2035] based on a Gilts Flat

discount rate

Expected Returns (ER) > Required

Returns (RR)

RR: Gilts + 250bps

ER: Gilts + 200bps

Difference: -50bps

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: 30.0%

Hedging Strategy

Nominal/Inflation hedge ratio should be

maintained within +/- 5% of the funding

ratio.

Funding Ratio (Gilts + 1.00%) 60%

Nominal Hedge Ratio (Gilts + 1.00%) 20%

Inflation Hedge Ratio (Gilts + 1.00%) 25%

Collateral

Maintain sufficient eligible for meeting

collateral requirements that may arise

from the Scheme’s current derivative

positions over a 1 year period.

Total available eligible collateral £300m

Remaining collateral after VaR95 event £200m

Road to the End Game: Setting Clear Goals and Objectives

8

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

The first step is for all stakeholders to agree what the objectives are...


Constructing a Terminal Portfolio: What Required Returns should a Terminal Portfolio target?

9

1.Discount Rate

2.Buffer

Target Required Returns

Once a Scheme has reached full funding, the Required Returns

needed to maintain this position will be:

• The liability discount rate on which the Scheme has reached

full-funding plus;

• A buffer/margin to cover risks, such as:

• Longevity Risk: the risk that members live longer

• Underperformance of credit portfolio: risk that the credit

allocation underperforms i.e. defaults

• Reinvestment Risk: credit spreads tighten over time so the

scheme can not achieve the same credit spreads in the future

• Deflation: where a scheme has a large proportion of LPI

floored liabilities, it is exposed to sustained periods of

deflation

• Other: expenses (advisors, legal, admin etc.)


Constructing a Terminal Portfolio

The asset allocation of a Terminal Portfolio will depend on what the scheme is trying to achieve e.g. how certain does the

scheme need to be that it will have no further need for sponsor contributions?

• The higher the discount rate, the higher the returns needed to maintain full-funding; this implies more risk

• The lower credit spreads are when the Scheme reaches full-funding, the higher the allocation to credit will need to

be to generate sufficient expected returns

• Note that these are not suggested portfolios. A Terminal Portfolio may also hold other (non-fixed income) assets

10

Liquid credit 70%

Gilts / Swaps / Cash 25%

Illiquid credit 5%

Liquid credit 15%

Gilts / Swaps /

Cash 75%

Illiquid credit 10%

Illustration 1

- Full funding by 2035

- Credit spreads = 100bps

- Discount basis = Gilts+50bps

Illustration 2

- Full funding by 2035

- Credit spreads = 200bps

- Discount basis = Gilts+25bps

Illustrative Terminal Portfolio 1 Illustrative Terminal Portfolio 2


The Role of Credit

11

The Role of Credit Within a Scheme’s Asset Allocation


Illiquid Asset Universe

12

ILS: Insurance linked securities

CTA: Commodity Trading Advisors

ABS: Asset backed securities

CRE: Commercial Real Estate Debt

Illiquid Asset Considerations

• Do incremental returns

contribute to expected returns

> required returns?

• Interest rate / inflation hedge?

• Impact on overall Scheme

risk?

• Is there still sufficient collateral

to cover scheme requirements?

• Do the returns compensate for

the investment’s level of risk,

illiquidity, complexity and

governance?

• Are there less complex

opportunities available?

• How is liquidity affected at the

Scheme level? Can the

Scheme afford to hold illiquid

assets?

• Scheme tolerance for

fluctuations in funding ratio

due to valuation of illiquid

assets?

Note: Above chart based on responses to a Redington survey


Further Considerations for a Terminal Portfolio

13

Why ? Further Considerations

Liquidity In the absence of sponsor contributions, a scheme may

rely largely on coupon payments, maturing assets and the

disposal of assets to pay benefits; it is therefore important

to manage the level of illiquid assets held that may be difficult

to sell in the short-term

However, long-dated illiquid

assets will typically provide an

attractive illiquidity premium

while reducing reinvestment risk

Collateral Collateral requirements will increase if the scheme uses

unfunded instruments, such as swaps to reduce risk;

emphasis should be on effectively managing these collateral

requirements

Reinvestment

Risk

As traditional credit is typically shorter-dated than scheme

liabilities, where a scheme relies on credit for returns, it will

be exposed to reinvestment risk (the risk that a scheme

can not reinvest at the same credit spreads as when the bond

was initially purchased); this may result in the scheme’s

Expected Returns being lower than its Required Returns

Allocation to long-dated credit

reduces this risk (subject to no

defaults) as it locks into current

returns for longer

Buy-Out

Compatibility

If a Scheme wishes to consider a buy-out in future, it should

consider which assets are preferable to an insurer in the

event of a buy-out


Ideally, a Scheme’s investment strategy should converge towards the Terminal Portfolio as the Scheme

approaches full funding; this can be achieved systematically within a dynamic de-risking framework, for example:

1. Reduce interest rate and inflation risk by increasing hedging

• Could be time-based i.e. level of hedge increased incrementally over time and/or;

• Trigger-based i.e. increase hedge ratio as funding ratio rises to “lock-in” funding ratio improvements

2. Reduce allocation to “return-seeking” assets (e.g. equities) as and when funding level improves:

• Where funding level improves, “Required Return” will fall, so the scheme can afford to reduce the level of

Expected Return (by reducing return-seeking assets) – see chart below

Dynamic De-Risking

14

0

100

200

300

400

500

60% 64% 68% 72% 76% 80% 84% 88% 92% 96% 100% Required Return Expected Return

Spread over Gilts

Funding Ratio

Teach-in Road to the End Game 17 September 2013 15

Dynamic De-Risking Case Study: The Journey of a Small Scheme

Scheme 2008 2013 Comments

Clear Funding Objectives Pension Risk Management Framework

Risk Budget Reduced VaR from 30% to 15%

Monitoring Missed Buy-Out opportunity in 2008

Allocation to Equities 90% 0% Dynamic asset allocation

Hedge Ratio 5% 90% Funding Level immunised to rates & inflation


Considerations for Terminal Portfolio vs. Partial Buy-in vs. Buy-out

• What are the residual risks in the scheme? e.g.:

• Longevity risk, credit risk, basis risks (e.g. discounting using a Gilts basis but hedging using swaps)

• Counterparty risk of the annuity provider

• What are relative costs of the solutions?

• Dependent on level of risk being run

• Market prices for solutions change over time

• Does the scheme have an appropriate governance framework for the solution?

• A dynamic de-risking strategy requires additional governance bandwidth

• Implementation of buy-in / buy-out / longevity swap will require trustee / investment committee time

16


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

Contacts

17

Disclaimer

For professional investors only. Not suitable for private

customers.

The information herein was obtained from various

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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

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rates or other reference rates or prices which appear

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Building Pensions SuperTeams

18

About the event What’s the difference between a SuperTeam and an average one? Why does creating the right team set the conditions to produce the best outcomes? And how can understanding the success of the Rolling Stones help pension schemes to achieve their goals? Pinsent Masons and Redington cordially invite you to learn the secrets of stellar performance from leadership and teamwork advisor, Khoi Tu, author of ‘SuperTeams’. We all work in teams, both within and across organisations, to solve complex issues such as repairing DB pension deficits or designing robust investment strategies for DC members. With inspiration and insight from some of the greatest teams in the world, we hope to give you the guidelines and protocols for success with your trustee board, your sponsor and your advisors. Agenda: 4.00pm Registration and Refreshments 4.30pm Welcome Address (Pinsent Masons, Redington) 4.40pm Presentation, Q+A (Khoi Tu) 6.15pm Drinks and Canapes

http://www.redington.co.uk/Events-Seminars/Events/2013/Building-Pensions-SuperTeams.aspx

Building Pensions SuperTeams

Date: 14 Oct 2013 Time: 16:00 Venue: 30 Crown Place, Earl Street, London EC2A 4ES








19

ROAD TO THE END GAME: TERMINAL PORTFOLIOS AND BUY-IN / BUY-OUT – AN INSURER’S VIEW 17 SEPTEMBER 2013

Michael Abramson – Co-Head of Business Development for Bulk

Annuities and Longevity Insurance

INSURER PRICING FOR BUY-IN AND BUY-

OUT.

20

20

Investment

strategy

Mortality

Inflation

expectations

Reserving

requirements

Shareholder

demands

ANNUITY INVESTMENT STRATEGY.

21

• Strategy varies from one insurer to the next

• Credit LDI

• Funding trade

• Legal & General approach

• Predominantly credit

• Average rating: A

• Currencies: GBP, USD, EUR

• Appropriate duration

• Diversification

• Actively managed

• Some gilt holdings for collateral

• Increasing allocation to direct investments, e.g. sale and

leaseback, infrastructure

• Rates, inflation and fx hedging to match liabilities

DETERMINING SCHEME PRIORITIES.

22

• Hedge vs. Outperform annuity pricing

• Hedge: Investing like an insurer

• Which insurer?

• Credit LDI strategy

• Default risk; exposure to illiquid assets

• Outperform

• Requires a good knowledge of true market price

• Timing is critical

• Possible approaches: price tracking, “toe in the water”, pre-

approval of contracts

MINIMISING TRANSACTION COSTS.

23

• In specie transfer generally based on overall insurer investment strategy

• Gilts are generally simplest

• Can transfer corporate bonds, although pooled funds may be tricky

• Illiquid assets will require insurer due diligence

• Swaps – can they be novated?

• A hedged strategy with low exit costs may be more effective than

focussing on in specie transfer

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APPENDIX

FSCS

Statutory reserves (containing prudent margins above best estimate liability)

Regulatory Capital Requirements

Additional

shareholder capital

Regulator intervention

• UK insurers are required to hold

significant amounts of capital

– Life insurers hold statutory reserves,

which contain prudent margins above

best estimate liabilities

– Insurers must hold additional

Regulatory Capital Requirements

– Additional shareholder capital is held

above Regulatory Capital

Requirements

• Additional protections

– Regulator intervention to protect

policyholders’ benefits

– Financial Services Compensation

Scheme (the “FSCS”) protection

– FSCS covers at least 90% of benefits

• Layers of policyholder protections

Technical insolvency

(c. 110% of best

estimate)

Capital Resource Requirement

(c. 115% of best estimate)

UK INSURANCE REGULATORY REGIME.

25

Michael Abramson

Co-Head of Business Development,

Bulk Purchase Annuities and Longevity Insurance

direct: 020 3124 2978

mob: 07889 748927

email: [email protected]

CONTACT DETAILS.

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This presentation contains confidential and proprietary information of Legal & General Group Plc (“L&G”). The presentation, and any opinions on financial products it contains, may not be modified, sold, or otherwise provided, in whole or in part, to any other person or entity without L&G's written permission.

L&G makes no representations as to the accuracy or completeness of any of the information in this presentation and any liability on the part of L&G in relation to the inaccuracy or incompleteness of the information is excluded to the extent permitted by law. Nothing in this

presentation amounts to an offer or promise.

road to the end game

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