the eurozone crisis and uk pension funds
TRANSCRIPT
Redington 13-15 Mallow Street London EC1Y 8RD T. 020 7250 3331 www.redington.co.uk
Breakfast Teach-In
The Eurozone Crisis and UK Pension Funds
1st March 2012
Contents 1. The Eurozone Sovereign Debt Crisis
3
2. Three Eurozone Scenarios
14
5. A Framework for Managing Risks
22
6. Contacts and Disclaimer
24
3
5
7
9
11
13
15
Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12
%
1st Greek bailout agreed; €440bn European Financial Stability Facility (EFSF) established
Portugal requests €77bn bailout package from EFSF
ECB starts buying Italian and Spanish government bonds
Ireland receives €85bn bailout package from EFSF
Eurozone Periphery: 10-Year Government Bond Yields (1)
(1) Calculated as un-weighted average of Italian, Spanish, Irish, Greek & Portuguese 10-Year yields Source: Redington, Bloomberg
S&P downgrades Greek debt to “junk” status
EFSF given enhanced powers to buy government bonds & recapitalise banks
Greece’s private sector creditors
agree to 50% haircut
S&P downgrades 9 Eurozone countries including France
LTRO: ECB provides €490bn in 3-year
loans to banks
The Eurozone Sovereign Debt Crisis
Timeline
2nd Greek bailout and
€107bn restructuring
agreed
3
-1
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
12-month rolling Correlation between Equity Returns and Gilt Returns
Co
rre
lati
on
[-1
;1]
As equities rise, yields on government bonds fall (prices increase)
As equities fall, yields on government bonds fall (prices increase)
Periods of extreme market stress: investors seek to preserve their capital.
Source: Redington Calculations Based on the FTSE 100 total return and the FTSE Actuaries +15yr gilts total return indices 4
The Eurozone Sovereign Debt Crisis
Equity Returns vs. Gilt Returns
The Eurozone Sovereign Debt Crisis
A Change of Focus
• Peripheral government bonds perceived as low risk by investors
• Underlying financial and economic problems widely ignored
• Manipulation of data (e.g. Greece’s “off balance sheet” actions)
• Deficit and debt rules of the (first) Stability and Growth Pact widely ignored
Pre Crisis
• Risk reassessed by investors - government bond yields rise
• Focus on economic problems:
• High levels of public debt / deficits, exacerbated by recession, falling tax revenues and non-discretionary spending increasing (e.g. unemployment benefits)
• Low economic growth and low external competitiveness because of high wage costs
• Lack of political will for reform
• Systemic threats to the banking system
Post Crisis
Financial Crisis
A Change of Focus
5
6
Yields increase
Ability to (re)finance debt decreases
The government has to pay more to service its debt.
Risk of default increases, investors continue to sell.
New Equilibrium
Circuit Breaker
Ability vs. willingness to pay
Default
Credit risk vs. return
Austerity, central bank action, bailout
Cycle of Debt
The Eurozone Sovereign Debt Crisis
Cycle of Debt
Maturity Profile – The European Union
The Eurozone Sovereign Debt Crisis
Maturity Profile – The European Union
7 Source: The Economist
Percent
Per
cen
t o
f To
tal D
ebt
Per
cen
t o
f To
tal D
ebt
Per
cen
t o
f To
tal D
ebt
Per
cen
t o
f To
tal D
ebt
Maturity Profile – Southern Periphery
The Eurozone Sovereign Debt Crisis
Maturity Profile – Southern Periphery
8 Source: Thomson Reuters Credit Views
Italy Spain
Greece Portugal
Gov debt/GDP: 166% Gov debt/GDP: 121%
Gov debt/GDP: 87% Gov debt/GDP: 83%
Source: BBC
Please note that figures include government and corporate debt. Gov debt/GDP figures as per Sep 2011.
The Eurozone Sovereign Debt Crisis
Who Owes What to Whom?
9
Who Owes What to Whom?
0
100
200
300
400
Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
EUR GBP USD
0
20
40
60
80
100
May 11 Aug 11 Nov 11 Feb 12
EUR GBP USD 10
Tensions in the Bank Funding Market
The Eurozone Sovereign Debt Crisis
Tensions in the Bank Funding Market
• The graphs on the right show the spread between 3-month Libor and the 3-month Overnight Index Swap (OIS).
• Essentially, Libor is uncollateralised borrowing whereas the OIS is a collateralised transaction.
• Consequently, the spread between the two can be regarded as a measure of the general stress in bank funding markets as it is a metric for how banks assess each other’s creditworthiness.
• If creditworthiness is perceived to be low, higher rates will be demanded for Libor transactions and the spread will therefore increase.
Source: Bloomberg
Central Bank Intervention
• ECB purchase of government bonds
• LTRO: unlimited 3-year loans to banks at a fixed rate of 1% to address tensions in interbank funding and government bond markets (take-up of €489bn in December 2011, €530bn yesterday, 29 Feb 2012)
Firewalls & Bailout Funds
• European Stabilisation Mechanism (ESM), expected to be operational from July 2012, with a lending capacity of €500bn to provide funding for Eurozone members unable to raise money in the bond markets
• The ESM will replace the European Financial Stability Facility (EFSF)
Short-term Solutions
Debt Restructuring/Defaults
• Greek bondholders accept “haircuts” of c.53.5% of the nominal value to bring the country’s debt to a “sustainable” level. Note that even after the restructuring, investors remain exposed to mark-to-market and credit losses.
Economic Reform
• Fiscal austerity and structural reform, especially aiming at internal devaluation (reducing labour costs to make exports more competitive) and primary surpluses (government revenues higher than outlays before interest rate payments)
• Revised Stability and Growth Pact with “quasi-automatic sanctions” for countries that break deficit rules
Long-term Solutions
Solutions (?)
The Eurozone Sovereign Debt Crisis
Solutions (?)
11
The Eurozone Sovereign Debt Crisis
Growth in the ECB Balance Sheet
Growth in the ECB Balance Sheet
Source: Federal Reserve, European Central Bank, Bank of Japan, Bank of England (via blogs.ft.com/gavyndavies/) 12
• Are the firewalls/bailout funds big enough? Are countries like Italy or France credible financial backers of the bailout funds?
• Will banks be able to raise enough capital to withstand the ongoing market turmoil? If they are not able to raise it in the markets, will governments be able to offer support?
• Is the new Stability and Growth Pact credible?
• How will the Long Term Refinancing Operation (LTRO) be unwound/rolled over in an environment of ongoing bank balance sheet deleveraging?
• Will core Eurozone members be prepared to offer support to the periphery on an ongoing basis? Will politicians be able to act quickly enough to prevent the crisis from spreading even further? Will the European Central Bank be prepared to intervene on an ongoing basis?
• How likely are other long-term solutions like Eurobonds? Are the proposed solutions sufficient?
(Some) Open Questions
The Eurozone Sovereign Debt Crisis
(Some) Open Questions
13
Three Eurozone Scenarios
Allocation A – A Typical UK Pension Fund
Equity, 50.0%
Index-linked gilts,
17.5%
Corporate
bonds, 17.5%
Property,
10.0%
Funds of hedge funds, 2.5%
Private equity, 2.5%
Allocation A
• Allocation A represents what we believe is a fairly typical asset allocation for a UK pension fund
• Whilst there is some protection against movements in interest and inflation rates and a sizeable investment in fixed income, the largest allocation is to equity and comparable asset classes (e.g. hedge funds)
Key Stats
Expected Return over Swaps 229bps
Funding Ratio 80.0%
Net Interest Rate PV01 £1.78m
Interest Rate Hedge Ratio 16.9%
Net Inflation PV01 - £1.35m
Inflation Hedge Ratio 16.8%
Value at Risk 95 (% of liabilities) 28.4%
Expected returns are based on Redington’s in-house assumptions Total Assets: £800m Total Liabilities: £1,000m
14
Three Eurozone Scenarios
Flight Plan Analysis
Flight Plan Analysis
750
800
850
900
950
1,000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
£ m
illio
ns
Years to full funding
Liabilities
Swaps + 275bps Swaps + 196bps
Swaps + 159bps
15
16
Three Eurozone Scenarios
Assumptions
Scenario 1 Scenario 2 Scenario 3
Background Hit by a continuing economic collapse and spreading social unrest, the Greek government goes into a disorderly default. Concerns about other peripheral Eurozone members increase to the point of panic. However, Greece remains in the Eurozone.
Deciding that the social and economic cost of continuing austerity are unbearable, the southern periphery (Italy, Spain, Portugal and Greece) leaves the common currency.
The crisis continues to spread despite the combined efforts of Eurozone and international policymakers. Eventually, the common currency breaks apart with member states re-introducing national currencies.
Asset Assumptions Scenario 1 Scenario 2 Scenario 3
Equities (MSCI World Index)
-20% -30% -40%
Credit Spreads (Bank of America/Merrill Lynch GBP Non-Gilt)
+100bps +150bps +200bps
Interest Rates (GBP gilt/swap curve)
-50bps -75bps -50bps
Inflation (RPI swap curve)
Unchanged Unchanged +50bps
Three Eurozone Scenarios
16
Equity-linked
bond fund, 30.0%
Index-linked gilts,
25.0%
Credit, 15.0%
Diversified growth fund, 10.0%
Social housing,
5.0%
Secured leases, 5.0%
Macro hedge
fund, 10.0%
Three Eurozone Scenarios
Allocation B – A More Efficient Approach
Allocation B
• Allocation B represents what we consider to be a more efficient asset allocation. Expected Return is lower than for Allocation A, but exposure to risks should be reduced significantly.
• The allocation to equities is significantly smaller than for Allocation A. New return-seeking assets and “Flight Plan Consistent Assets”* have been introduced and the allocation to index-linked gilts is larger.
Key Stats
Expected Return over Swaps 204bps
Funding Ratio 80.0%
Net Interest Rate PV01 £0.43m
Interest Rate Hedge Ratio 80.0%
Net Inflation PV01 - £0.32m
Inflation Hedge Ratio 80.0%
Value at Risk 95 (% of liabilities) 13.2%
Hedging Swaps Overlay
Expected returns are based on Redington’s in-house assumptions
*Flight Plan Consistent Assets provide long-dated, relatively secure and inflation-linked cash flows at attractive returns and are a good match for pension liabilities.
Total Assets: £800m Total Liabilities: £1,000m
17
1%
7% 0% 1%2%
7%
5% 10%
13%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Pe
rce
nta
ge o
f To
tal L
iab
iliti
es
1%
11% 1% 1% 1%
21%
8% 16%
28%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Pe
rce
nta
ge o
f To
tal L
iab
iliti
es
Three Eurozone Scenarios
Initial Risk Analysis
Value at Risk 95 Minimal increase in the deficit in a worst-case (1-in-20) scenario over the next year
Initial Risk Analysis Metric Allocation A Allocation B
Single Factor Stress Test Change in the deficit as a result of stressing a single risk factor
-160
-211
-142
-10
-250
-200
-150
-100
-50
0
Equities down 40%
Interest rates down 100 basis
points
Inflation rates up 100 basis
points
Credit spreads up 100 basis
points
£ m
illi
on
s
-96
-51
-21 -24
-250
-200
-150
-100
-50
0
Equities down 40%
Interest rates down 100 basis
points
Inflation rates up 100 basis
points
Credit spreads up 100 basis
points
£ m
illi
on
s
18
334
333
333
220
75
-418
-416
-416
-275
-94
-600 -400 -200 0 200 400 600
41Y+
31Y - 40Y
21Y - 30Y
11Y - 20Y
0 - 10Y
£ thousands
Assets
Liabilities49
46
89
62
25
-418
-416
-416
-275
-94
-600 -400 -200 0 200 400 600
41Y+
31Y - 40Y
21Y - 30Y
11Y - 20Y
0 - 10Y
£ thousands
Assets
Liabilities
-401
-423
-447
-316
-122
502
528
559
395
153
-800 -600 -400 -200 0 200 400 600 800
41Y+
31Y - 40Y
21Y - 30Y
11Y - 20Y
0 - 10Y
£ thousands
Assets
Liabilities-60
-48
-112
-90
-51
502
528
559
395
153
-800 -600 -400 -200 0 200 400 600 800
41Y+
31Y - 40Y
21Y - 30Y
11Y - 20Y
0 - 10Y
£ thousands
Assets
Liabilities
Interest Rate PV01 Change in the value of assets, liabilities and deficit as a result of 1basis point (0.01%) move in interest rates
Initial Risk Analysis Metric Allocation A Allocation B
Inflation PV01 Change in the value of assets, liabilities and deficit as a result of 1basis point (0.01%) move in inflation rates
Net: £1.78m
16.9% hedged
Net: £0.43m
80.0% hedged
Net: -£1.35m
16.8% hedged
Net: -£0.32m
80.0% hedged
Three Eurozone Scenarios
Initial Risk Analysis
75%
80%78%
73%
80%77%
70%
80% 80%
76%
60%
65%
70%
75%
80%
85%
Equities Interest Inflation Credit spreads
Scenario 1 Scenario 2 Scenario 3
Original Funding Ratio (80%)
Three Eurozone Scenarios
Scenario Impacts
Single Factor Stress Test Single Factor Stress Test Allocation A Allocation B
Scenario Impacts – Single Factor Stress Tests
Impact on Deficit
Impact on Funding Level
-80
-97
-10
-120
-151
-14
-160
-97
-71
-18
-180
-160
-140
-120
-100
-80
-60
-40
-20
0
Equities Interest rates Inflation Credit spreads
£ m
illio
ns
Scenario 1 Scenario 2 Scenario 3
-48
-23 -24
-72
-36 -34
-96
-23-16
-43
-120
-100
-80
-60
-40
-20
0
Equities Interest rates Inflation Credit spreads
£ m
illio
ns
Scenario 1 Scenario 2 Scenario 3
72% 73%
79%
68%70%
79%
64%
73% 75%78%
60%
65%
70%
75%
80%
85%
Equities Interest Inflation Credit spreads
Scenario 1 Scenario 2 Scenario 3
Original Funding Ratio (80%)
20
Three Eurozone Scenarios
Scenario Impacts
Allocation A Allocation B
Scenario Impacts – Multifactor Stress Tests
Impact on Deficit
Impact on Funding Level
-190
-291
-366-400
-350
-300
-250
-200
-150
-100
-50
0
£ m
illi
on
s
Scenario 1 Scenario 2 Scenario 3
-90
-135
-195
-400
-350
-300
-250
-200
-150
-100
-50
0
£ m
illi
on
s
Scenario 1 Scenario 2 Scenario 3
65%
58%
53%
50%
55%
60%
65%
70%
75%
80%
85%
Scenario 1 Scenario 2 Scenario 3
Original Funding Ratio (80%)
74%72%
67%
50%
55%
60%
65%
70%
75%
80%
85%
Scenario 1 Scenario 2 Scenario 3
Original Funding Ratio (80%)
21
A Framework for Managing Risks
• Know your biggest risks
• Set clear goals and objectives
• Have your game plan ready
• Importance of strong governance
• Set realistic trigger levels for re-risking/de-risking
• Integrate Flight Plan Consistent Assets (non-cyclical assets with enhanced real returns)
• Diversify sources of alpha and beta
Pension Risk Management Framework
A Framework for Managing Risks
• The results of the stress tests demonstrate the importance of understanding exactly where a pension scheme’s risks lie and what can be done to monitor and manage them.
• We believe that the most effective way is the Pension Risk Management Framework – a clear, strategic and market-consistent approach for identifying, monitoring and controlling your risks.
22
Sample Pension Risk Management Framework
A Framework for Managing Risks
Sample Pension Risk Management Framework
Objective Triggers Performance Indicators Actual Performance
What is the overall objective? Full funding on self-sufficiency basis By 2020 on a swaps + [50]bps basis with contributions of £[25]m p.a.
How will we measure the objective?
Required return on the scheme’s assets
Required return of assets is swaps + [160]bps
What are the primary risk targets? Required return at risk (RRaR)Contributions at Risk (CaR)
RRaR < swaps +[200]bpsCaR should be kept below £[50]m
What is the secondary risk target? Value at Risk (VaR) VaR should not exceed [20]% of the liabilities
What are the primary aspirationaltargets?
To be fully inflation and interest rate hedged
Hedge ratios should be equal to [100%]
What are the secondary aspirational targets?
Increase efficiency of hedges by earning more return for same risk
Regular monitoring of relative value of swaps vs. gilts
What is the primary scheme constraint?
Liquidity Sufficient liquidity to make pension payments
What is the secondary scheme constraint?
Collateral requirements Enough available collateral to cover the 1-year derivative [VaR95]
Metric is at or above target
Metric is within 10%of target
Metric is more than 10% away from target
23
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 .
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.
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London EC1Y 8RD
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Contacts
Disclaimer
24