Redington13-15 Mallow StreetLondon EC1Y 8RD
T. 020 7250 3331www.redington.co.ukhttp://twitter.com/redingtontweets
Engaged Investor / Pension Corporation Trustee Seminar De-Risking for Pension Schemes
Liability Driven Investments (LDI) Birmingham, 9th June 2011
Let’s start by getting creative!
Creativity exercise
Here’s one I made earlier
Pension Risk Management Framework (PRMF)
Flight Plan
Flight Plan for pension schemes
• a clear set of overall objectives that define your scheme’s goals and long term strategy
• designed to identify clear outcomes,define the target path of your assets and liabilities, and to assist in monitoring the journey
• Regular reporting with clear risk analysis that offers regular insight and is a “call to action” for trustees, sponsors and key stakeholders
“Our goal is to help clients
become fully funded with
the minimum level of risk”
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IntroductionPension Risk Management Framework (PRMF)
Overall
Objective
Risk
Targets
Aspirational
Targets
Scheme
Constraints
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The pension risk management framework is a market consistent, transparent and actionable tool which is key for any trustee, sponsor or member
Objective Triggers Performance Indicators
What is the overall objective? To reach full funding on self-sufficiency basis By 2020 on a Swaps +75bps with £50m of contributions p/yr
How will we measure the objective? Using the required return on the Scheme’s assets Required Return of assets is Swaps +160bps
What are the primary risk targets? Required rate of Return at Risk (RRaR)Contributions at Risk (CaR)
RRaR should be no more than 300bpsCaR should be kept below £50m
What is the secondary risk target? Value at Risk (VaR) VaR should not exceed 20% of the liabilities
What are the primary aspirational targets? To increase interest rate and inflation hedge ratios
Hedge ratios equal to funding level
What is the secondary aspirational target? Dynamic de-risking Based upon regular monitoring
What is the primary Scheme constraint? Liquidity Enough liquidity to pay pension payments
What is the secondary Scheme constraint? Collateral Requirements Enough eligible collateral to cover the 1yr derivative VaR95
Regular monitoring allows a call to action that enables trustees and sponsors to anticipate and recalibrate the investment strategy
ExamplePension Risk Management Framework (PRMF)
“„If a man knows not what harbour he seeks, any wind is the right wind‟”
Seneca
Flight Plan – Projected Cashflows
This is the expected path of the liabilities over the next 20 years.
...but the reality may look more like this.
Variation is a result of a number of factors, including:
• Nominal rates
• Inflation
• Change in the curve shape
• Valuation basis
• Longevity
• Change in benefits
• ETVs
This analysis takes account of
• Strategic Asset Allocation
• Expected Returns
• Current Deficit
• Funding Objective
• Sponsor Contributions
The Funding Objective implies requires returns of at least [Gilts + 80bps] p.a. on the asset portfolio.
Risk management, governance, markets and strategic asset allocation all play a part.
Objectives:
• Converge Asset and Liability lines at/ahead of objective date
• Reduce volatility
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Theory – Dynamic De-RiskingPension Risk Management Framework (PRMF)
From “set and forget” to “anticipate and recalibrate”
BackgroundThe Scheme had a VaR of [30%] of liabilities with a large proportion of equity risk and implemented dynamic de-risking in order to reduce their equity exposure as their funding level improved
Overall Objective To be self-sufficient by [2020] on a Gilts +[50bps basis]
Triggers Triggers are set to get tighter as they outperform the FlightPlan’s required return
GovernanceInvestment committee implemented the process on a recourse basis (the trustees wished to be consulted before a decision was taken) and then moved to an automated process later
Market Performance
Gilt yields increased leading to lower liability value
and equity markets rose resulting in a higher
funding level for the scheme
Senior Actuary and Co-Head ofALM, responsible for co-managingthe firm’s quantitative analystsand driving innovative clientsolutions.
•Ian Maybury, the lead consultant, worked
with the client to take advantage of the
improvement in the funding level and
reduced its equity exposure from 85% of
total assets to 40% of total assets as the
funding ratio increased from 80% to 91%.
• Significantly reducing downside risk by
over 30%
Funding Level
27 Sep 2010 28 Oct 2010 15 Dec 2010 04 Feb 2011
Funding Ratio 80% 86% 89% 91%
Equity Allocation 85% 65% 50% 40%
Total Risk (VaR) 33% 29% 25% [ ]
Case Study – Dynamic De-Risking in PracticePension Risk Management Framework (PRMF)
PRMF
Pensions Committee
Management Level
Investment Committee
Corporate Governance Structure
Pension SchemeGovernance Structure
Corporate Board
Trustee BoardExecutive Level
Importance of Structuring Good GovernancePension Risk Management Framework (PRMF)
“Flight Plan Consistent” Assets
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The Flight Plan: Long-Term Objective Setting and Risk Management Framework
£10.0bn
£12.0bn
£14.0bn
£16.0bn
£18.0bn
£20.0bn
£22.0bn
£24.0bn
£26.0bn
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
Example: Actual Asset and Liability Path (Actuarial Basis)
Projected Liabilities Projected Assets Actual Liabilties Actual Assets
Pension Risk Management Framework (PRMF)“Flight Plan Consistent” Assets
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Growth
• Equities
• Property
• Absolute Return/ Hedge Funds
• Private Equity
• Commodities
Traditional “Growth” and “Matching” Assets
Matching
• Nominal Gilts
• Index-Linked Gilts
• Nominal Swaps
• Inflation Swaps
?
Credit• Nominal/ index-linked
corporate bonds
• Loans
• Structured Finance Assets
• Other debt products
C
?
Flightplan Consistent Assets
• Long term secured leases
• Social housing
• Commercial mortgages
• Ground rents
• Equity release mortgages
• Social and economic infrastructure
Pension Risk Management Framework (PRMF)“Flight Plan Consistent” Assets
FPCAs Matching Growth Credit
High Correlation to Liabilities /
Contractual Cashflows
Senior Secured
Long Duration / /
Excess Returns
(Il)Liquidity Premium /
Potential for Upside Gain
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Pension Risk Management Framework (PRMF)“Flight Plan Consistent” Assets
Redington Publications
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Spring Collection Highlights: LDI 2.0, Secured Leases, Ground Rents, Equity Release Mortgages, Social Housing, Insurance-Linked Securities, Infrastructure
Spring Collection 2011 Collection Coming Soon: Enhanced Matching Assets, Socially Responsible Investing and Long-Term Growth Assets
Pension Risk Management Framework (PRMF)“Flight Plan Consistent” Assets
SECURED LEASES
• Take advantage of attractive yields on long-term secured property leases
• Yields may be in excess of yields on corporate bonds issued by same borrower
• Long-dated (up to 25 years) index-linked cashflows - helps hedge inflation risks
SOCIAL HOUSING• Low-cost rental housing provided for disadvantaged people in need of housing
• Generally provided by local councils and housing associations
• Offers long-dated, inflation-linked cashflows from secured borrowers (i.e. housing associations) with quasi-government guarantee
INFRASTRUCTURE• Investing in public sector projects through Private Finance Initiatives (PFIs)
• PFIs enable government to fund new infrastructure projects
• Long-term, potentially inflation-linked revenue streams
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Example Flight Plan Consistent Assets
Pension Risk Management Framework (PRMF)“Flight Plan Consistent” Assets
1. Secured Leases - long dated inflation-linked cashflows - can help match liabilities.
Library Retail – Banks Offices15
“Flight Plan Consistent” AssetsSecured Leases
LDI Characteristics of the Lease Component
Fixed Income
• Long-dated index-linked cashflows
Credit
• Rental cashflows typically guaranteed by investment grade borrower
• Unlike corporate bonds, leases are secured by underlying property
• Property provides some security, mitigating against default risk
Property
• Exposure to property prices
Similarities with other Asset Classes
Example: lease rental income streams received for 25 years,assuming no lessee defaults with annual RPI indexation
Inflation Hedge• RPI linked payments• Stream of [annual] real cashflows to match inflation-
linked liabilities
Interest Rate Hedge• Long dated nature lease• Can helps offset asset/liability duration mismatches
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Source: Redington
“Flight Plan Consistent” AssetsSecured Leases (II)
Tenant Services Authority (TSA)regulation of social housing providers
Homes and Communities Agency (HCA)funding and regeneration work
• RSLs now UK’s major providers of new social housing
• 2008 Regulatory and Statistical Return Factsheet(published by TSA) shows ~1700 RSLs
• 90% of social rented units are owned by 18% of RSLs
In England, RSLs are regulated by two agencies:
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The Facts
Traditionally funded by government grants and debt
Majority of lending came from UK Banks (e.g. Barclays, RBS) and provided over long-term horizons (e.g. 25 years)
Wholesale lending fell as banks were required to have higher capital ratios
The TSA reported a big increase in the cost of debt (loan margins were 20-30bps higher than before the credit crisis)
The coalition governmentwants to reduce social housing costs and has announced plans to replace lifelong council house tenancies with five to ten-year contracts
But Housing Associations need £20bn new money, £5bn refinancing by 2015
Previous Funding After the Credit Crunch The Situation Now
• Low cost, rental housing• Provided by local and non-profit organisations, e.g. housing associations and Registered Social
Landlords (RSLs)• Government grants and state support help RSLs build new homes and subsidise rents• RSLs also seek finance from other sources
“Flight Plan Consistent” AssetsSocial Housing
2. Social Housing- long dated inflation-linked cashflows - can help match liabilities.
Registered Social Landlords (RSLs)
Interest payments
Capital
Rent Payments (linked to inflation)
Capital used to fund and
maintain social houses
Investor
Property let to low income tenant (mostly on state subsidy)
By taking current policy covering rent increases (of RPI + 0.5%), linking these cashflows directly to cost of servicing its debt, Housing Associations can ensure projects are cash generative from completion
By linking debt to inflation, Housing Associations couldaccess new investors – UK pension schemes
How Can These Be Structured
Individual inflation-linked rents from tenants can be securitised
Issuers bonds can be individual Housing Associations, or THFC
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• Housing Finance Corporation plays keyrole, enabling smaller housingassociations to access public financing
• A+ rating with S&P
• Aggregating financial intermediary:
• diversifying risk
• reducing cost, standardisingloan terms for RSLs
Linking Debt to UK Inflation Opens New Investor Base
Matching Funding to Rental Income
2. Social Housing- long dated inflation-linked cashflows - can help match liabilities.
“Flight Plan Consistent” AssetsSocial Housing (II)
Key Benefits of Investing in Social Housing
• 2008 sector turnover >£10 billion
• Gross book value of properties £85.2 billion, up 10% on 2007
• Housing assets provide fundamental security for investors
Secured Lending
• Interest payments long-dated and inflation-linked
• Typically covered by rental income stream received by RSLs
LDI Hedging
• Strong government support and tight regulation by TSA
• Housing benefits make up large part of rental income
• Government sets annual rent increases, allocates grants to sector, sets qualitative targets for housing standards
• Powers of intervention
Government and
Regulatory support
• Interesting and attractive way to participate in Socially Responsible Investing
Socially Responsible Investment
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• Relatively illiquid
• Attractive illiquidity premium
Liquidity Perspective
• Currently limited access, only segregated solutions
• The sector developing rapidly -we expect imminent offering of products and solutions by fund managers
Accessibility
Potential Drawbacks
“Flight Plan Consistent” AssetsSocial Housing (III)
“Flight Plan Consistent” Assets: InfrastructureHow Does It Work?
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Schematic of Cashflows
PPP/PFI Projects
Pension Fund
Financing
0
5000
10000
15000
20000
25000
30000
1 4 7 10 13 16 19 22 25
An
nu
al C
ash
flo
w (£
mill
ion
)
Lease
Cashflow Structure for PPP/PFI
Inflation
Nominal
PFI Projects Provide Long-Dated Inflation-Linked Cashflows
Health: Queen Elizabeth Hospital, London
Defence: Future Strategic Tanker Aircraft
Transport: Skye Bridge, Scotland
ContactsDisclaimer
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Contacts
Direct Line: +44 (0) 20 7250 3416
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y 8RD
Robert Gardner
Founder & Co-CEO
www.redington.co.uk
THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT
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