outline 2012
TRANSCRIPT
OUT LINE
December 2012
ContentsIntroduction................................................................................................................2
7.Steps.to.Full.Funding............................................................................................3
The.Thief.of.Time.......................................................................................................4
What.Should.I.Ask.My.LDI.Manager?.................................................................5
Volatility.Control.and.Pension.Fund.Assets.....................................................6
Central.Clearing:.What.it.means.for.Pension.Funds......................................7
Pensions.Risk.to.the.Corporate.Sponsor...........................................................8
Illiquid.Credit.–.PFI.loans........................................................................................9
Index-linked.Utility.and.PFI.Swaps................................................................... 10
Models.on.Models.................................................................................................. 11
Escaping.“Friction”.–.Pension.Fund..Governance.and.the.Eurozone.Crisis.............................................................. 12
Further.Information.and.Disclaimer................................................................ 13
1O U T L I N EDecember.2012
Introduction
2O U T L I N EDecember.2012
Gurjit DehlVice President, Education and Research
Welcome.to.the.first.edition.of.Outline,.Redington’s.quarterly.collection.of. thought-pieces.designed.to.help. institutional.investors.make.smarter.and.more.informed.decisions..
Over.the.next.ten.pages.you’ll.find.articles.on.the.key.topics.we.think.institutional.investors.should.be.addressing.as.we.enter.the.New.Year.
We.hope.you.find.the.articles.interesting.and.helpful.as.you.consider.how.best.to.manage.the.risk-adjusted.return.profile.of.your.portfolios.
For.more. information.on.these.or.any.other. topics,.please.contact.your.Redington.representative,[email protected].
Best.wishes.for.2013,
Gurjit.Dehl
OUT LINE
The.7.Steps.to.Full.FundingTM
Struggling.to.tie.all.those.moving.parts.together.in..one.cohesive.strategy?.Take.the.7.Steps.to.Full.FundingTM
to.achieve.your.goals..
The.challenges.of.the.pensions.industry.are.well.known...People.are.living.longer;.historically.the.industry.has.placed.too.strong.a.focus.on.assets.and.failed.to.pay.adequate.attention.to.liabilities;.there.has.been.an.obsession.with.return.but.scarce.heed.paid.to.risk..Defined.benefit.pension.schemes.remain.vulnerable.to.falling.funding.levels.from.several.sources:.low.interest.rates,.inflation,.volatile.market.conditions,.and.an.uncertain.economic.outlook.that.renders.returns.uncertain.too..
Therefore,.the.risk.of.generating.insufficient.real.returns.to.meet.liabilities.and.to.pay.pensioners.has.never.been.greater..So.how.should.pension.schemes.be.acting.in.the.face.of.this.uncertain.environment?.How.can.a.pension.scheme.be.prudently.managed.today,.so.that.it.hedges.its.risks.and.still.achieves.the.return.it.needs.to.survive.and.succeed?
Our.7.Steps.to.Full.FundingTM.approach.places.control.of.assets.and.liabilities.back.into.the.hands.of.the.pension.scheme,.allowing.them.to.control.risk.and.return.and,.ultimately,.pay.their.pensioners.and.avoid.insolvency.through.these.uncertain.times.
STEP ONE: Pensions.Risk.Management.Framework.Document
Define.the.situation.clearly.by.laying.out.goals..and.objectives.that.are.written.into.a.robust.PRMF....The.document.includes.the.required.rate.of.return,.risk.budget,.and.other.goals.and.constraints.of.both.trustees.and.sponsor.
STEP TWO: Set.up.an.LDI.Hub
Construct.an.LDI.hub.that.allows.you.to.manage.interest.rate,.inflation.and.longevity.risk.dynamically.and.using.the.right.tools.
STEP THREE:.Liquid.Active.(alpha).and.Market.(beta).Strategies
When.it.comes.to.risk-based.asset.allocation,.look.to.invest.across.a.range.of.risk.premia;.liquid.alpha.and.beta.strategies.include.any.liquid.strategy.across.equity.risk-premia.through.active/passive.equities,.as.well.as.equity.overlay.strategies,.volatility-controlled.equity.strategies,.and.hedge-fund.strategies.
STEP FOUR: Liquid.and.Semi-Liquid.Credit
Credit.consists.of.a.range.of.sub-classes.with.different.risk-return.characteristics.and.liquidity.profiles..This.includes.alpha-oriented.mandates.where.the.manager.can.operate.in.the.entire.fixed.income.universe.
STEP FIVE: Illiquid.Credit
We.believe.there.are.a.number.of.opportunities.available.which.can.provide.“long-dated,.inflation-linked”.cash.flows.at.a.higher.yield.than.traditional.matching.assets.(for.example,.infrastructure.debt.and.social.housing).
STEP SIX:.Illiquid.Alpha.and.Beta.Strategies
Assets.under.this.category.provide.attractive.returns.but.are.typically.more.complex.and.illiquid.(for.example,.private.equity.and.PFI.equity).
STEP SEVEN:.Monitoring
Accurately.measure.where.you.are.along.the.path.to.full-funded.status,.constantly..Re-evaluate,.consider.new.opportunities.and.change.direction..
Robert GardnerFounder.&.Co-CEO
3O U T L I N EDecember.2012
The.thief.of.time
Procrastination.is.an.accomplished.thief.. You.believe.you.have.plenty.of.time,.but.just.when.you.need.it,.it’s.gone.-.stolen.by.a.practised and.dextrous.artiste.-.you..And.as.you.leave.“it”.undone,.it.becomes.exponentially.harder.to.get.“it”.done..Leave.it.long.enough,.and.the “cost”.of.getting.“it”.done,.starts.to.rise.
Welcome.to.the.concept.of.theta.Imagine.you.buy.a.one.year put.option to.protect.yourself.against.a.fall.in.the.value.of.your.equities.portfolio..After.purchase,.the.value.of your.put.option.decreases.by.a.certain.amount.each.day.that.passes.(since.there.is.less.time.within.which.you.can.receive.a.pay-out)..You can.quantify.this.daily.loss..In.the.markets,.this.erosion.of.value.(or.“time.decay”).through.the.passage.of.time.is.known.as.“theta”..The higher.the.theta,.the.more.you.lose.each.day.that.goes.by..Passing.time.costs.you.money!
Pension.Fund.Risk.Management
Nowhere.is.theta./.time.decay.more.in.evidence.than.when.it.comes.to.the.failure.to.manage.risk.in.the.pension.fund..This.is.where.the price.of.procrastination.comes.into.its.own.
The.problem.is,.the.sands.of.time.are.sinking.and.theta.is.rising.
One.pension.fund.I.met.recently.is.due.to.pay.out.an.increasingly.large.stream.of.members’.benefit.cash.flows.scheduled.to.peak.around 2035,.from.which.point.they.will.slowly.diminish.steadily,.until.the.final.benefits.are.paid.out.to.the.last.surviving.pension.fund.members circa.2090.
Except,.in.the.real.world.that.won’t.actually.happen..The.pension.fund.is.badly.underfunded..Unsurprisingly,.it.has.no.risk.management framework.
On.any.prudent.view,.the.pension.fund.now.has.insufficient.assets.to.make.pension.benefit.payments.past.about.2028..The.pension.fund would.need.to.earn.over.8%.on.its.assets.every.year.until.2090.to.pay.all.its.pensions.out.
Unfortunately,.the. pension.fund’s.younger.members.(now.in.their.late.30s).are.still.dutifully.paying.in.their.hard-earned.contributions, unaware.that.by.the.time.they.come.to.draw.their.benefits.in.30.years.time,.the.assets.will.almost.certainly.have.dwindled.to.nothing. They.are.unwittingly.funding.the.full.benefits.of.current.pensioners.but.will.themselves,.in.all.likelihood,.be.left.compromised..
Come.to think.of.it,.there’s.an.Italian.word.for.when.your.money.gets.paid.out.of.a.scheme.to.other.people.–.“ponzi”.
To.conclude.on.a.less.downbeat.note;.although.time.is.running.out,.there.are.key.steps.you.can.still.take.to.manage.pension.plan.risk.in.these.increasingly.uncertain.times.
Dawid Konotey-AhuluFounder.&.Co-CEO
“Let’s not hedge the real yield right now. Yes, it is far and away the biggest risk facing the pension fund, and yes we’ve known that for years, but there’s bound to be a better time to deal with it.”
4O U T L I N EDecember.2012
What.Should.I.Ask.My.LDI.Manager?.
An.LDI.manager.isn’t.just..another.asset.manager…..
How.much.time.do.you.spend.interacting..with.your.LDI.manager?.A.quarterly.report,..a.conference.call.or.two,.a.semi-annual.face...to.face.update?.Many.trustees.may.believe.that..an.LDI.manager.is.“just.another.asset.manager”,.but.an.LDI.manager.can.provide.a.valuable.extension.of.a.scheme’s.ability.to.dynamically.de-risk.and.access.market.opportunities,.as.well.as.informing.a.better.understanding.of.scheme.risks,.if.brought.within.an.enhanced.governance.framework..
An.LDI.mandate.enables.much.more.than.just.liability.hedging..Your.LDI.manager.serves.as.a.“derivative.hub”.which.allows.access.to.strategies.outside.the.scope.of.passive.liability.hedging..Today’s.LDI.manager.is.able.to.identify.and.exploit.market.opportunities.on.behalf.of.the.pension.scheme.client.to.allow.rapid.reaction.to.evolving.markets.that.would.otherwise.simply.not.be.possible..
Moreover.the.LDI.manager,.as.a.“hub”.for..de-risking,.can.give.you.access.to.unfunded.market.exposures.and.tactical.opportunities..Want.to.rapidly.de-risk.equity.exposure.without.the.hassle.of.managing.down.a.segregated.active.equity.manager?.The.LDI.manager.can.achieve.this,.through.equity.futures,.total.return.swaps..or.options..Want.to.lock.in.a.range.of.funding.levels.at.a.particular.valuation.date?.Again,.the.LDI.manager.can.assist,.with.customised.equity.options.and.swaption.strategies..Want.the.LDI.manager.to.take.into.account.the.cash.flows.from.a.portfolio.of.social.housing.debt.or.long.dated.commercial.property.leases?.Again,.the.LDI.manager.can.do.this.and.put.in.place.a.“completion”.hedge.
But.of.course,.as.we.all.know,.unless.you.ask..a.manager.to.report.on.compliance.of.a.particular.risk.limit,.they.are.unlikely.to..It.is.vital.to.expect.reporting.from.the.LDI.manager.that.allows.for.effective.monitoring.of.the.strategies.and.enhances.the.scheme’s.awareness.of.what.is..going.on.“under.the.hood”..
A.gold.standard.governance.framework.demands.regular.reporting.from.the.manager,.with.updates.on.performance.within.the.clearly.defined.risk.limits..This.will.improve.the.understanding.of.the.risks.being.taken.and.allow.for.greater.confidence.to.be.placed.in.the.LDI.manager..
For.trustees,.this.kind.of.enhanced.reporting..can.be.crucial.in.building.the.trusting.relationship.that.this.framework.requires..
A.gold.standard.LDI.governance.framework.requires.tri-partite.buy-in,.from.the.pension.scheme,.the.LDI.manager,.and.the.advisors...With.an.effective.framework.like.this.in.place,..a.pension.fund.can.achieve.the.ability.to.ACT:
A. .Agility:.an.LDI.manager.can.enhance.the.scheme’s.agility.in.identifying.and.quickly.taking.advantage.of.evolving.market.opportunities.
C.. .Control:.a.closely.monitored.LDI.framework.can.give.the.pension.scheme.the.control.over.their.dynamic.de-risking.path.via.access.to.a.wide.toolkit.of.instruments.and.asset.classes.
T.. .Transparency:.with.an.effective.monitoring.and.reporting.system.in.place,.pension.schemes.can.have.confidence.in.their.ability.to.dynamically.de-risk.as.part.of.a.flight.plan.
Pete DrewienkiewiczDirector,.Head.of.Manager.Research
5O U T L I N EDecember.2012
Volatility.Control.and..Pension.Fund.Assets.
Volatility.Control.is.a.simple.investment.approach.advocated.by.banks.and.asset.managers.for.some.time,.but.it.has.failed.to.gain.significant.traction.among.pension.funds..
We.believe.this.could.be.about.to.change..
Volatility.Control.may.have.a.role.to.play.within.the.mainstream.approach.to.pension.fund.equity.asset.management...
Volatility.Control.as.a.concept.is.the.management.of.an.equity.allocation.through.continual.rebalancing.between.equity.and.cash.holdings..At.any.given.point.in.time,.the.volatility.of.the.portfolio.measured.on.a.trailing.basis.should.remain.roughly.constant:.if.the.trailing.volatility.of.the.equity.holding.goes.up.(usually.associated.with.an.equity.market.fall),.then.the.allocation.to.equity.will.decrease.in.favour.of.cash..
The.underlying.idea.is.to.keep.the.overall.amount.of.risk.(as.measured.by.volatility).coming.from.the.total.equity.plus.cash.portfolio.roughly.constant..This.contrasts.the.conventional.approach.of.making.a.fixed.allocation.in.monetary.terms.to.equities.and.allowing.the.risk.to.vary.widely.through.time.
Despite.the.simplicity.of.the.concept,.a.study.of.returns.since.1998.shows.that,.across.equity.markets.and.time,.the.strategy.has.delivered.equity-like.returns.with.substantially.lower.volatility..The.results.are.robust.to.changes.in.the.rebalancing.frequency.and.precise.calculation.of.volatility.measure.
The.July/August.issue.of Insurance Risk.featured.an.article.entitled.“The.Volatility.Challenge”,.highlighting.the.possible.Solvency.II.capital.
savings.that.could.be.realised.as.a.result.of investing.in.equities.via.this.Volatility.Control.framework.as.opposed.to.via.“straight”.equity...The.article.cites.examples.of.Fund.Managers.running.mandates.for.insurers.targeting.a.capital.charge.of.15-20%,.compared.to.the.Standard.Formula.capital.charge.of.c40%.for.developed.market.equity.
Although.the.two.seem.similar,.the.Volatility.Control.approach.is.different.to.the.ill-fated.Constant.Proportion.Portfolio.Insurance.(“CPPI”),.which.has.been.popular.at.various.points.in.the.past.but.which.has.come.out.with.a.less.than.favourable.reputation..The.main.difference.is.that.CPPI.looks.to.replicate.the.delta.of.an.option,.which.can.involve.a.much.sharper.deleveraging.out.of.equity.in.the.case.of.a.market.fall...The.Volatility.Control.approach,.by.contrast,.rebalances.as.the.trailing.measure.of.equity.volatility.increases.
Although.Volatility.Control.is.a.new.concept.for.many.pension.funds,.it.is.an.established.approach.that.has.been.applied.with.success.within.hedge.funds.and.other.asset.managers.for.some.time..Indeed,.there.is.a.broad.category.of.“Diversified.Beta”.funds.that.broadly.use.a.Volatility.Control.methodology.to.control.their.allocation.to.a.broad.set.of.market.risk.factors.such.that.a.constant.amount.of.risk.comes.from.each.factor.
As.we.look.to.the.past,.we.see.many.of.the.major.shifts.in.pension.funds’.activities.stemming.from.successful.approaches.used.within.the.traditional.banking.or.asset.management.space;.it.may.be.that.Volatility.Control.offers.pension.funds.a.new.approach.to.managing.assets.that.helps.them.to.be.aware.of.and.react.to.changes.in.risk,.volatility.and.reward.
Dan MikulskisDirector,.ALM.&.Investment.Strategy.
6O U T L I N EDecember.2012
Central.Clearing:.What.it..means.for.Pension.Funds
Derivative.regulations.are.changing.globally.to.improve.transparency.and.reduce.counterparty.risk..Pension..funds.must.act.now.to.make..sure.they.take.the.necessary..steps.to.prepare.
In.the.aftermath.of.the.financial.crisis.of.2008,.the.G20.called.for.global.reforms.of.the.Over.The.Counter.(OTC).derivative.markets...The.existing.system,.the.G20.suggested,.failed.to.engender.proper.counterparty.risk.management.and.provided.inadequate.transparency..As.a.result,.they.suggested.some.wholescale.reforms.in.this.space.that.it.has.now.come.down.to.European.Securities.and.Markets.Authority.(ESMA).to.implement:
•. .all.standardized.OTC.derivative..contracts.should.be.traded.on.exchanges..or.electronic.trading.platforms,..where.appropriate;
•. .all.standardized.OTC.derivative.contracts.should.be.cleared.through.central.counterparties.by.end-2012.at.the.latest;
•. .OTC.derivative.contracts.should.be..reported.to.trade.repositories;.and
•. .non-centrally.cleared.contracts.should.be.subject.to.higher.capital.requirements.
These.reforms.have.been.agreed,.and.now.they.will.be.implemented.over.the.course.of.the.next.year..For.pension.funds,.one.of.the.key.points.is.that.their.new.derivative.contracts.will.all.be.subject.to.initial.margin.in.order.to.mitigate.close-out.risk..Calculations.of.this.margin.will.likely.be.based.on.a.VaR.model,.but.exactly.what.constitutes.acceptable.collateral.is.still.to.be.determined..
Usually.for.variation.margin.only.cash.is.accepted,.but.there.are.calls.for.greater.flexibility.for.pension.funds.considering.their.need.to.put.every.available.resource.to.work.in.the.quest.to.close.their.funding.gap..Some.market.participants.are.calling.for.variation.margin.to.be.extended.to.include.G7.government.bonds.
These.changes,.then,.could.have.serious.effects.on.not.just.asset.allocation.and.risk.management.for.pension.funds,.but.also.on.liquidity.requirements..On.the.upside,.though,.the.new.system.will.engender.an.upgrade.in.counterparty.quality.(a.central.clearing.house.rather.than.a.corporate),.and.can.lead.to.a.release.of.collateral.if.swaps.are.novated..
The.new.system.will.seriously.affect.any.pension.funds.that.have.derivatives.in.place.or.plans.to.put.them.in.place..Given.that.implementation.of.the.new.regulations.is.imminent,.now.is.the.time.to.consider.whether.the.changes.will.have.positive.or.negative.effects,.on.the.whole,.and.what.to.do.about.them..
Derivative.contracts.in.place.before.the.regulations.change.will.be.grandfathered.and.exempt.from.the.new.regulation;.so.it.could.be.valuable.for.some.pension.funds.to.move.forward.their.derivative.activities..Those.pension.funds.that.act.now.to.understand.this.issue.fully.will.certainly.be.better.off.later.
Tom McCartanAssociate,.Manager.Research
7O U T L I N EDecember.2012
Pensions.Risk.to.the.Corporate.Sponsor
The.risk.imposed.by.defined.benefit.pension.schemes.on.their.corporate.sponsors.is.now,.with.good.reason,.under.greater.scrutiny.than.ever.before..
Once.viewed.as.little.more.than.a.footnote..to.the.accounts,.pension.scheme.exposure.has.been.a.source.of.growing.attention.and.anxiety..for.many.UK.corporates.in.recent.years.
Falling.real.yields.have.driven.up.liability.valuations,.leading.to.sharp.declines.in.the.aggregate.funding.positions.of.UK.pension.schemes..This.has.forced.many.sponsors.to.substantially.increase.deficit.repair.contributions,.serving.as.a.drain.on.scarce.corporate.cash...At.the.same.time,.the.introduction.of.new.accounting.standards.over.the.past.decade..and.tougher.regulations.have.made.pensions..and.the.risks.they.pose.to.companies..significantly.more.visible.to.shareholders,..equity.analysts.and.rating.agencies..
The.difficult.market.environment.has.made.it.increasingly.important.for.corporate.sponsors.
to.put.in.place.a.clear,.strategic.framework.to.measure,.monitor.and.address.pensions.risk..We.call.this.the.“Pension.Risk.Management.Framework”.(PRMF)..The.PRMF.serves.as.an.excellent.governance.tool.by.focusing.the.minds.of.sponsors.and.trustees.on.core.objectives,..which.can.be.used.to.guide.investment.strategy.over.time..
One.of.the.considerations.that.may.be.used.to.help.construct.the.PRMF.is.how.to.“right-size”.the.pension.scheme.risk.relative.to.the.sponsor’s.key.corporate.metrics,.for.example.“Additional.annual.deficit.repair.contributions.in.a.downside.scenario.(Contributions-at-Risk).should.be.less.than.half.of.free.cash.flow”..
Just.as.trustees.should.be.alert.to.the.financial.position.of.their.sponsor.and.the.potential.impact.of.pension.scheme.risk.on.the.corporate,.they.should.also.ensure.that.the.scheme’s.investment.strategy.takes.into.account.the.sponsor’s.ability..to.bear.risk.and.to.support.the.scheme.
Awareness.of.these.considerations.will.help.to.align.the.objectives.of.sponsors.and.trustees,.ensuring.that.both.stakeholders.are.better.positioned.to.face.an.uncertain.market.environment,.both.today.and.into.the.future.
Karen HeavenVice.President,.Investment.Consulting
8O U T L I N EDecember.2012
Scale: How.large.are.the.pension.schemes.compared.to.the.corporate?
.Impact:.
.How.does.pension.exposure..impact.key.corporate.financial.metrics.(e.g..the.impact.of.pension.deficits.on.the.net.debt/EBITDA.ratio)?
Risk:..By.how.much.could.the.funding.level..or.contributions.move.in.any.given.time.period?
From.the.sponsor’s.perspective,.pension.scheme.exposure..might.be.assessed.in.three.dimensions:
Illiquid.Credit.–.PFI.loans
Ever.since.George.Osborne’s.Autumn.Statement.and.the.announcement.of.a.National.Infrastructure.Plan.in.2011.there.has.been.increased.focus.on.infrastructure.amongst.investment.advisors.and.trustees..
What.is.PFI?
The.UK.government.has.been.supporting.private.lending.to.UK.infrastructure.since.the.1990’s.via.the.Private.Finance.Initiative.(PFI).framework..The.initiative.aims.to.ensure.that.local.authorities.have.access.to.a.steady.stream.of.private.funding.to.help.build,.refurbish.or.operate.assets.such.as.schools,.hospitals,.roads,.police.stations.and.social.housing.
Why.are.PFI.loans.attractive..to.pension.schemes?
Secondary.PFI.loans.provide.investors.with.immediate.access.to.already-complete.assets.(i.e..no.construction.risk).generating.steady,.long.dated.cashflows.with.liability.matching.characteristics..
PFI.loans.also.offer.a.significant.illiquidity.premium.(c.1%).relative.to.publicly.traded.bonds.(by.the.same.or.similar.issuers);.and.investors.also.benefit.from.increased.security.and.seniority.in.the.capital.structure.(senior.secured.loans.vs..senior.unsecured.bonds).
In.2011,.to.our.eternal.regret,.a.Danish.pension.scheme.purchased.£270mm.of.UK.PFI.loans.from.Bank.of.Ireland...we.strongly.believe.these.should.have.been.bought.by.a.UK.pension.scheme!.
9O U T L I N EDecember.2012
Conrad HolmboeAssociate,.Investment.Consulting
Typical.Financing.Structure
The.equity.and.mezzanine.financing.is.typically.provided.by.institutional.investors,.leaving.the.much.safer.(and.therefore.lower.yielding).senior.secured.debt.to.banks.
Fast.forward.to.2012
The.majority.of.banks.have.now.withdrawn.from.the.market.due.to.regulatory.and.financial.pressure,.and.many.are.now.actively.deleveraging..
This.has.created.a.significant.funding.gap,.driven.up.yield.on.senior.secured.debt,.and.created.an.opportunity.for.investors.to.purchase.these.assets.from.banks.at.very.attractive.levels...Prior.to.2008,.these.loans.would.typically.yield.Libor.+.[0.5%-1%]..Since.then.there.has.been.a.steady.rise.in.spreads.and.investors.can.now.expect.to.earn.Libor.+.[2%-3%].on.the.same.loans.
The.opportunity
So.whilst.details.of.the.government’s.National.Infrastructure.Plan.have.yet.to.be.finalised.(let.alone.implemented),.opportunities.do.exist.for.investors.to.purchase.PFI.loans.at.highly.attractive.levels.through.the.secondary.market.
To.access.these.opportunities.UK.schemes.are.increasingly.collaborating.with.each.other.and.their.advisors,.realising.that.their.combined.size.and.scale.could.allow.them.to.secure.opportunities.of.this.nature.at.very.cost.effective.levels..
About.time.I.say!
Index-linked.Utility.and.PFI.Swaps
Finding.Flight.Plan.Consistent.Asset.opportunities.in.the.UK.utility.and.PFI.sectors
As.pension.schemes.continue.to.establish.deficit.repair.strategies,.demand.for.inflation-linked.assets.remains.strong...While.most.schemes.access.their.exposure.to.inflation-linked.assets.through.either.their.LDI.or.gilt.manager,.more.agile.schemes.are.also.starting.to.consider.opportunities.beyond.the.index-linked.gilt.and.collateralised.swap.markets.
One.opportunity.that.has.arisen.recently.is.that.tighter.capital.standards,.in.particular.Basel.III,..are.incentivising.banks.to.reduce.the.index-linked.swap.exposures.they.have.on.their.books.to.regulated.UK.utility.companies.and.PFI.projects;.this.has.created.an.opportunity.for.pension.schemes.to.benefit.from.the.comparative.strength.of.their.own.balance.sheets.to.source.new.inflation-linked.assets..These.swaps.deliver.long.dated.inflation-linked.cash.flows.with.additional.compensation..for.the.credit.risk.of.facing.a.utility.company..or.PFI.project.on.an.uncollateralised.basis.
When.assessing.the.swaps.and.their.suitability.within.a.pension.portfolio,.their.background.is.important..The.main.source.of.inflation.supply.in.the.UK.is.the.index-linked.gilt.market;.it.is.approximately.£265.billion,.compared.to.a.defined.benefit.pensions.market.of.more.than.£1.3.trillion...Regulated.utility.companies.and.PFI.projects.are.also.important.sources.of.inflation..
These.entities.tend.to.have.revenue.streams.contractually.linked.to.RPI.and,.as.such,.are.keen.to.issue.inflation-linked.bonds.in.order.to.optimise.their.overall.capital.structure...However,.the.corporate.index-linked.bond.market.is.relatively.small.at.about.£30.billion,.and.much.less.liquid.than.the.gilt.market..
For.this.reason,.utility.companies.and.PFI.projects.have.historically.been.able.to.achieve.lower.financing.costs.by.using.alternatives.to.issuing.index-linked.bonds,.either.by.taking.out.bank.loans.or.by.issuing.conventional.bonds.in.conjunction.with.entering.into.inflation-linked.swaps.with.banks...
While.banks.have.used.the.inflation.supply.that.the.swaps.create.to.support.their.LDI.businesses,.the.cost.of.holding.these.utility.company.and.PFI.swaps.is.increasing.with.the.new.Basel.III.capital.requirements...Therefore,.they.are.increasingly.looking.for.opportunities.to.sell.these.exposures..to.suitable.investors,.particularly.pension.schemes.
Because.the.swaps.effectively.combine.LDI.with.credit.research,.it.often.takes.some.bespoke.work.to.ensure.that.they.can.be.supported.by.your.LDI.or.credit.manager...From.the.perspective..of.a.pension.scheme,.a.number.of.practical.issues.must.be.considered:.the.swaps’.cash.flow.profile,.credit.risk.and.seniority,.collateral.terms,.counterparty.rating.requirements,.and.break.clause..But.the.overriding.consideration.is.the.price.at.which.banks.are.prepared.to.sell.these.exposures..
With.the.upcoming.regulatory.change,.it.is.not.surprising.that.banks.are.willing.to.offer.these.assets.at.more.attractive.prices.than.previously,.and.indeed.a.few.transactions.have.already.completed.this.year...With.interest.rates.expected.to.remain.low.and.banks.continuing.to.count.the.cost.of.tighter.capital.requirements,.pension.schemes.can.benefit.from.new.opportunities.such.as.this.and.step.into.a.space.historically.occupied.by.banks.alone...
These.opportunities.will.exist.not.only.for.past.transactions.already.on.banks’.books.but.also.increasingly.for.new.transactions.going.forward.
John TownerDirector,.Investment.Consulting
10O U T L I N EDecember.2012
11O U T L I N EDecember.2012
Models.on.Models
The.calculation.of.inflation.risk.for.pension.funds.is.highly.dependent.on.the.underlying.model,.with.the.results.varying.dramatically.
The. terms. PV01. and. IE01. have. become.part.of.the.language.of.pension.scheme.trustees. and. actuaries,. when. previously.they. were. restricted. to. Fixed. Income.traders. and. structurers. in. investment.banks..PV01.is.the.change.in.present.value.of.an.asset.or. liability. for.a.1.basis.point.change.in.the.nominal.yield.curve.used.to.value.the.asset.or.liability.(usually.the.swap.curve);.IE01.is.the.change.in.present.value.of.an.asset.or.liability.for.a.1. basis. point. change. in. the. implied. inflation. curve.used. to. value. the. asset. or. liability. (usually. the. RPI.zero-coupon.curve)..
While.calculating.PV01.for.a.fixed/floating.swap.is.a.relatively.straightforward.calculation,.IE01,.in.the.context.of.a.pension.scheme,.is.complicated.by.the.presence.of.caps.and.floors.on.inflation.increases.in.the.benefit.structure..
A.little.thought.and.capital.markets.knowledge.made.people.realise.that.various.option-pricing.models.could.be.brought.to.bear.on.this.problem.and.that.the.true.value.of.the.sensitivity.of.the.LPI.benefit.to.changes.in.RPI.(in.the.language.of.option.pricing,.the.delta).is.not.0%.or.100%..but.somewhere.in.between..
These.option.pricing.models.could.be.readily.calibrated.to.the.market-observed.levels.for.LPI.swaps,.which.have.been.quoted.by.a.number.of.banks.since.2007.(shown.in.graph).
Given.the.opaque.nature.of.some.of.these.calculations,.the.model-dependency.is.not.in.our.view.always.appreciated.by.advisors.and.trustees..
If.I.gave.the.same.fixed.cashflow.to.four.different.fund.managers.I.would.expect.them.to.agree.on.the.PV01.of.that.swap.to.within.less.than.1%..The.calculation.is.standard.and,.on.the.whole,.unchangeable..However,.if.I.were.to.give.the.same.LPI.cashflow.to.four.fund.managers,.it.is.quite.possible.they.would.not.agree.on.the.IE01.to.within.20%.of.each.other.
The.calculation.of.IE01.lacks.a.prescribed.standard;.values.of.the.IE01.of.your.pension.scheme.could.be.materially.different.to.those.identified.by.another.advisor.or.fund.manager,.and.this.could.have.an.impact.on.the.portfolio.that.would.most.closely.hedge.the.liabilities..While.the.perfect.formula.for.an.IE01.calculation.is.still.an.elusive.concept,.pension.funds.should.be.asking.their.advisors.who.calculate.this.value.for.them,.and.asking.for.more.clarity.in.order.to.initiate.a.debate.on.the.correct.approach..
Dan MikulskisDirector,.ALM.&.Investment.Strategy
Escaping.“Friction”.–.Pension.Fund.Governance.and.the.Eurozone.Crisis
The.Eurozone’s.sovereign.debt.crisis.continues.to.occupy.the.headlines..How.can.pension.funds.adapt.their.governance.structures.so.they.come.through.the.crisis.safe.and.sound?
When.asked.about.how.best.to.succeed,.the.American.general.(and.later.president).Ike.Eisenhower.replied.that.he.had.found.“plans..to.be.useless,.but.planning.to.be.indispensable”...In.the.fast.shifting.environment.of.a.battlefield,.the.ability.to.make.the.right.decisions.quickly.is.the.key.to.survival.and.victory..The.famous.Prussian.strategist.Carl.von.Clausewitz.put.this.insight.into.slightly.different.terms:.the.ability.to.deal.with.“friction”.–.all.the.little.unforeseen.opportunities.and.threats.which.arise.during..a.complex.operation.–.whilst.focussing.on.the..main.objective.is.the.basis.of.success.
Luckily,.the.world.of.pension.fund.governance..is.far.less.prone.to.grievous.bodily.harm.than.the.average.battlefield..Nevertheless,.Eisenhower’s.and.Clausewitz’.insights.point.towards.one.central.lesson.for.pension.funds:.without.the.ability.to.make.goal-consistent.decisions.at.short.notice..to.react.to.a.rapidly.changing.environment,.success.will.prove.elusive.in.today’s.volatile.markets...
The.Eurozone’s.sovereign.crisis.is.probably.the.best.example.of.this..Seemingly.lurching.from.one.near.miss.to.the.next.(interspersed.with.occasional.outbreaks.of.optimism),.the.crisis..is.one.of.the.major.market.drivers..Share.prices,.corporate.bond.and.government.bond.yields,.both.in.the.Eurozone.and.elsewhere,.go.on.rollercoaster.rides,.edged.on.by.the.latest.news.of.possible.European.Central.Bank.bond.buying.or.politicians.arguing.about.who.will.foot.the.bill..
Periods.of.impending.doom,.like.late.2011.or.the.early.summer.of.2012,.alternate.with.periods.of.relative.calm...
This.environment.presents.pension.funds.with.both.attractive.opportunities.and.new,.suddenly.appearing.threats..In.order.to.manage.this.“friction”.successfully,.pension.funds.must.have:
•. A.clear.set.of.objectives;
•. Clearly.articulated.constraints;
•. .A.nimble.organisational.structure.that.allows.decision.makers.to.discuss.and.take.necessary.actions.quickly.to.keep.the.pension.fund.on.its.path.to.full.funding..
This.Pension.Risk.Management.Framework.(PRMF)ensures.that.trustees.remain.in.control.as.the.Eurozone.crisis.oscillates.between.catastrophe.and.deliverance..It.enables.them.to.identify.and.exploit.investment.opportunities.that.will.enhance.their.ability.to.achieve.their.objectives,.and.to.manage.any.new.risks.threatening.their.progress..
One.of.my.largest.clients.uses.weekly.meetings.to.benchmark.the.fund’s.performance.against.the.PRMF.and.to.review.any.new.opportunities.and.threats..This.fund.has.been.able.to.take.advantage.of.some.of.the.opportunities.created.by.the.Eurozone.crisis,.increasing.its.expected.returns..and.building.a.more.efficient.portfolio..
To.be.victorious.in.a.volatile.market.environment.driven.by.policymakers’.whim,.trustees.must.put.their.Pension.Risk.Management.Framework.in.place..Only.within.this.grand.strategy.framework.will.they.be.able.to.overcome.“friction”.and.guide.their.pension.funds.to.full.funding.
Sebastian SchulzeAssociate,.Investment.Consulting
12O U T L I N EDecember.2012
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