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

robert.gardner@redington.co.uk

www.redington.co.uk

THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT

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