what to ask of your ldi manager?

P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012

What to Ask of your

LDI Manager? Pete Drewienkiewicz

27 September 2012

1


Asset/Liability Management: Recap (i)

2

£

Liabilities Assets

LDI

Manager

Asset

Manager 1

Asset

Manager 2

Asset

Manager 3

Asset

Manager 4


Scheme

LDI Manager

Advisor

Asset

Manager 1

Asset

Manager 2

Asset

Manager 3

Asset

Manager 4

Asset/Liability Management: Recap (ii)

3

£

Liabilities Assets


Good Governance: Ability to ACT

4

Agility

As markets can be volatile,

pension funds must have the

agility to implement

decisions quickly.

Good Governance

Control Transparency

Swift decisions are only

possible with a solid

framework which sets clear

and reasonable goals.

Setting a strong framework

requires a clear and

transparent understanding

of the fund’s current asset

and liability position.


Control:

The Pensions Risk Management Framework (PRMF)

5

Source: Redington.

Objective Performance Indicators Actual Performance

Funding strategy

To reach full funding

by 2020

Funding ratio on IAS19 basis 85%

Funding ratio on Gilts Flat basis 70%

Expected returns in

excess of required

returns

Expected returns from current

investment strategy Gilts + 300bps

Risk target

1-year 1-in-20

minimum worst-case

loss should not

exceed 15% of

liabilities

1-year 95% Value-at-Risk >[15]%

Aspirational target

To be fully inflation

and interest rate

hedged

Nominal hedge ratio <[80]%

Inflation hedge ratio <[80]%

Scheme constraint Liquidity & collateral

requirements

Liquidity: cash held sufficient to pay

two months of benefits £50m

Collateral: available eligible collateral

sufficient to meet potential collateral

calls on derivative positions

>£500m


The Flight Plan

6


Improving LDI Sophistication

Increasing Capacity to ACT

7

LDI 1.0

Liability Immunisation

LDI 2.0

The LDI “Manager”

LDI 3.0

Holistic ALM

• Interest rate swaps

• Nominal gilts

• Inflation swaps

• Index-linked gilts

• Gilt repo and TRS

• Swaptions

• Unfunded asset

exposures

• Corporate linkers

• Sophisticated option

overlays

• Flight-plan consistent

assets

• Forward starting CDS?

• Shift to fixed income

• Static liability matching

pools

• Focus on de-risking

• Some active management

• Much wider LDI toolkit

• Evolution of trigger rates

• Delegated opportunistic

trades

• Centralised collateral pools

& credit risk management

• Reinvestment risk?


Agility:

The LDI 3.0 Manager as “Quarterback”

8


Control:

Managing Assets Against Liabilities

9


LDI Strategy Case Study:

Agility and Control

Replicate physical equity exposures with

synthetic instruments

The client is a large UK DB scheme (£3bn in liabilities) with an overall objective to reduce its risk.

Purchase funded and unfunded hedging

instruments, including:

• Forward-starting index-linked gilts

• Index-linked gilts on asset swap

• Inflation-linked US treasuries (“TIPS”)

on asset swap

• Zero-coupon inflation swaps

• Index-linked gilt on TRS with nominal

exposure hedged out using a mixture of

swaps and long gilt futures

Review major LDI managers and select

most appropriate manager

Meet weekly with new LDI manager to

refine hedging strategy

Manage transition of assets

Client receives regular monitoring of hedge

ratio, level of collateral held, etc.

PR

OC

ES

S

Purchase long-dated assets with liability

matching and return-generating attributes:

• Long-lease property

• Social housing

• PFI debt

10


...Transparency?

Agility ?

11


IMA and Risk Limits

Counter-

parties

Leverage

Asset

Allocation

Counterparty diversification constraints

insufficiently robust

IMA provides inadequate risk framework

(e.g. based on simple tracking error limit)

Loose controls often originate from outdated IMAs, agreed when risk limits were less stringently negotiated.

Investment

Risk Limits

Poor sector/issuer diversification across

bond holdings and loose credit rating limits

Leverage limits of repurchase transactions

excessively high

Time

£

Liabilities

Hedging

Concentrating solely on tracking error can

result in a lack of understanding of how

liabilities are hedged over the entire curve (see

graph)

12


Gold Standard LDI Risk Limits

13

Much greater confidence can be

placed in LDI manager

Risk factor restriction for portfolio Maximum

Risk Limit

Minimum

Risk Limit

PV01 / IE01

Total PV01 relative to liability BM 100% 80%

Total IE01 relative to liability BM 100% 80%

Differential between total PV01 and

total IE01 20% -20%

LPI

Maximum overweight position in LPI

(0,inf) IE01 relative to liability BM 100% 90%

Maximum overweight position in LPI

(0,5) IE01 relative to liability BM 100% 90%

Z-Spread

Total z-spread PV01 relative to liability

BM 25% -10%

Iota positioning

Total Iota PV01 relative to liability BM 25% -10%

Sonia and basis restrictions

Sonia swap PV01 exposure relative to

liability BM 10% 0%

3 month vs 6 month basis PV01

exposure relative to liability BM 25% 0%

Repo and TRS

Market Exposure 25% 0%

Curve position relative to liability

benchmark

Maximum

Risk Limit

Minimum

Risk Limit

Maximum cumulative nominal PV01

differential between buckets

0 - 10 years vs 10 - 25 years 25% -25%

10 - 25 years vs 25 + years 25% -25%

25+ years vs 0 - 10 years 15% -15%

Maximum cumulative real rate PV01

differential between buckets

0 – 10 years vs 10 - 25 years 25% -25%

10 - 25 years vs 25 + years 25% -25%

25+ years vs 0 - 10 years 15% -15%

1

2

3

Managers to report regularly of their

positions within these limits

Reduces probability of large

unidentified or unintended risks

Source: Redington


Gold Standard Governance Framework

Gold standard

governance

framework

outlined in

consultation

with all three

parties.

The aim is not to impose

artificial restrictions on an

LDI manager or restrict

capacity.

The aim is to enhance

understanding of the risks

an LDI manager is

running.

Is the reporting framework

adequate to monitor

risks?

NO RISK LIMIT = NO REPORT

Scheme

LDI Manager

Advisor

14


Conclusion: ACT

15

Your LDI manager can enhance your agility to identify and

rapidly take advantage of market opportunities

Use of an LDI manager can allow for more efficient liability

control, using external asset managers and asset classes

Full transparency in the reporting and

monitoring framework ensures that LDI

risk limits are properly set and managed


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

Contacts

Pete Drewienkiewicz Director | Head of Manager Research

Direct Line: 020 3326 7138

[email protected]

Risk Management Firm

of the Year (2011, 2012) Pension Consultant of the

Year 2012

http://twitter.com/redingtontweets

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 (reg no 6660006) is a company

authorised and regulated by the Financial

Services Authority and registered in England and

Wales. Registered office: 13-15 Mallow Street

London EC1Y 8RD

16

http://twitter.com/robertjgardner


Appendix

17


Appendix 1:

Multi-Manager Structures

18

Early adopters of LDI

have often built up large

exposures to one

manager

Diversifying

operational risk can

lead to fresh problems:

• Inefficient use of

collateral

• Need for aggregated

reporting

• Managers using

different liability

models

• Managers compete to

execute trades

Scheme

LDI Mgr

2

LDI Mgr

1

Custodian

2

Bank

Counterparties

Custodian

1

Different LDI managers not netting off trades leads to trapped collateral


Appendix 2:

Counterparties and Collateral

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Downgrading of swap counterparties in

June 2012 places counterparty risk on

centre stage

Variety of opinions among LDI

managers regarding counterparty risk

Use of ATE clauses within ISDAs

Require sufficient collateral to meet margin

requirements, but inefficient use will drag on

performance

Impact of central clearing on collateral

requirements

Rehypothecation of collateral

Scheme Counterparty

Collateral

Cashflows


Appendix 3:

Credit Spread and Gilt Yield Evolution

20

-100

0

100

200

300

400

500

600

bp

s

Sterling IG 15+ Corporate Spread 20-Year Gilt Real Yield IG Spread + Real Yield

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