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Pensions Management Institute – Boosting Confidence in UK Pensions What are the current dynamics driving UK pensions investment?

Robert Gardner, Redington 22nd November 2011

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Liability Driven Investments (LDI)

Maximise your toolset

A Chronology of LDI

30-Year Gilt real yield & key events in LDI

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0.0

0.5

1.0

1.5

2.0

2.5

3.0

30

-Yea

r G

ilt

Rea

l Yie

ld in

%

Boots Pension Fund shifts to 100% AAA long-dated sterling bond allocation

DMO issues 50-year inflation-linked gilt

XYZ implements dynamic de-risking

framework

F&C launches equity-linked pooled bond

fund

30-Year Gilt Real Yield & Key Events in LDI

Inflation concerns elevated after oil price hits record $145 per barrel

Friends Provident implements first derivative-based inflation and interest

rate hedge

Collapse of Lehman Brothers, traditional gilt/swap spread inverts

Barclays Global Investors launches segregated and pooled funds

for LDI

Source: Bloomberg, Redington

A Chronology of LDI

Key events in LDI

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Boots pension scheme shifts out of equities and into bonds

2001

Friends Provident hedges interest rate and inflation risk with swaps

2003

• Head of Corporate Finance, John Ralfe, recognises pension fund liabilities are bond-like in nature • Allocation before rebalancing: 75% equities, 20% bonds, 5% cash • Allocation after rebalancing: 100% long-dated AAA sterling bonds, half of which is inflation-linked

• First non-bank to implement LDI hedging strategy • Locked in a 2.1% real yield on 30-year index linked gilts – the real yield today is below 0.5% • Conventional wisdom at the time: “equities are the biggest source of risk to a scheme’s funding level, and real yields cannot drop below 2%”

Lehman Brothers collapses and new opportunities arise

2008

• Lehman Brothers collapse shows robustness of collateralised swaps that are easily transferred to other counterparties • Swaps are perceived as safer than gilts and the gilt/swap spread inverts • Pension funds can take advantage of spread dislocation and hedge via gilts instead of swaps

XYZ Scheme engages in dynamic de-risking

2010

• Rising equities and improved financial market conditions allows XYZ Scheme to de-risk • Triggers are pre-defined and linked to improvements in funding level, using a solid framework for decision-making • Due to de-risking, fund reaches a higher funding level with lower VaR compared to no de-risking

XYZ

The PRMF Dashboard

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• Having a clear game plan is essential for implementing effective strategies in a volatile environment: only when you know exactly what you want (and what you don’t want), can you make the decisions that enable you to reach your objectives.

• We call this the Pension Risk Management Framework: a clear, concise and effective tool for making focussed investment decisions. It allows pension funds to evaluate each opportunity according to how it supports their progress towards full funding.

• It can therefore be used to identify whether an LDI strategy fits a scheme’s individual requirements.

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]bps CaR 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 aspirational targets?

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

The Pension Risk Management Framework (PRMF)

The Pension Risk Management Framework

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

GB

P M

illi

on

s

Liabilities Path Actual Liabilities Assets Path Actual Assets

Liability Basis

Contributions & Asset Returns

Time Horizon

The Flight Plan is an effective tool for making focussed LDI decisions and identifying the best opportunities.

Together with the PRMF, it allows schemes to identify the strategies that will provide the most support for making progress towards full funding.

Flight Plan

From ‘set and forget’ to ‘anticipate and recalibrate’

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The Flight Plan

• Maps out the path of a scheme’s assets and liabilities from their current position to full funding

• Requires three key

variables to build: the assumed rate of return on assets, the cash contribution schedule, and the target date for full funding.

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Good Governance

ACT

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XYZ Scheme Case Study: Dynamic De-Risking

The Pension Risk Management Framework in action

Original strategy 78.4%

Dynamic de-risking 79.2%

Low risk allocation (no derisking) 79.2%

Original strategy 70.6%

Low risk allocation (no de-risking) 71.8%

Dynamic de-risking 76.2%

Original strategy 82.3%

Low risk allocation (no de-risking) 84.9%

Dynamic de-risking 85.1%

Funding level comparison 01/10/2010 – 07/09/2011

Fun

din

g le

vel

Funding Level Volatility

Original strategy 18%

Low Risk Allocation 16%

Dynamic de-risking 13%

Source: Redington

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Growth

“Flight Plan

Consistent Assets”

Matching

Flight Plan Consistent Assets

Key features

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2

4

6

8

0 5 10 15 20 25 30

GB

P M

illi

on

s

Years

Initial investment

Attractive real returns

Inflation-linked cashflows

Providing a match for liabilities

Inflows

Outflows

Source: Redington

Flight Plan Consistent Asset – Example Cashflow Profile

Flight Plan Consistent Assets

Key features

Key Characteristics

Flight Plan

Consistent Assets • Offer a particularly

efficient means of achieving LDI.

• Enable schemes to access attractive real returns and long-dated inflation-linked cash flows .

Key Characteristics

Attractive real returns and inflation-linked cashflows

High-quality, often secured cashflows

Illiquid

Varying degrees of complexity/might be difficult to access

• 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 index-linked cashflows

Secured Leases

• Ground rent created when freehold land or building is sold on long lease

• Typically “pepper-corn” rent for land only (not buildings)

• Offers attractive returns, limited credit risk and high level of security

Ground Rents

• 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

Social Housing

• Investing in public sector projects through, for example, Private Finance Initiatives (PFIs), bespoke investments structures or by purchasing a suitable infrastructure asset

• Wide range of possible assets, from roads to power generation

• Long-term, potentially inflation-linked revenue streams

Infrastructure

Flight Plan Consistent Assets

Examples

Social Housing: Risk profile

Flight Plan Consistent Assets

Social housing

• The diagram shows a typical social housing portfolio for a pension fund investor with a blended real return of ca. 3-4% p.a.

• The portfolio consists of different

housing types with specific risk/return profiles.

• By adapting the share of the

different housing types in the portfolio, an investor can tailor the portfolio’s return and the risk characteristics so that they fit requirements.

Social Housing is typically a low-risk asset class but the returns and the risk on a portfolio can be tailored (to some extent) to meet pension funds’ requirements.

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Source: Evolution Securities, Redington

• Bought by HSBC in August 2011 (for warehousing)

for £74m

• Provides water for 300,000 people in Cambridgeshire

• 2010/2011: Revenue of £20m with profits of £7m

before tax with no external debt except for a revolving

credit facility to cover working capital

• Attractive purchase opportunity for a large pension fund or a

consortium of funds

• Redington advised two UK schemes who bid for this asset. However,

although this bid was acceptable on price, it could not compete with

the winning cash bid which had an accelerated timetable and no due

diligence

Flight Plan Consistent Assets

Water infrastructure

Example: Tapping the illiquidity premium in water The UK water sector is an excellent example of a Flight Plan Consistent Asset, providing the security, returns and cashflows that pension funds need.

• Economic environment has small impact on returns: water is a necessity and will therefore be demanded irrespective of economic growth.

• Inflation-linked cashflows and returns: water companies’

regulatory regime means they can increase prices in line with the agreed price review which in turn is based on a formula related to RPI.

• Low regulatory risk: The regulator’s desire to increase competition in the area could have a negative impact on returns but the Government is likely to block any such move.

Water sector: key characteristics

Case study: Cambridge Water

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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 http://www.redington.co.uk/Redington/media/PDFs/knowledge/Other%20Publications/Redington-Spring-Collection-2010.pdf

Spring/Summer 2011 Collection: Enhanced Matching Assets, Socially Responsible Investing and Long-Term Growth Assets http://www.redington.co.uk/Redington/media/PDFs/knowledge/Other%20Publications/Re

dington-Spring-Summer-Collection-2011.pdf

Keeping up with the latest in LDI

Redington publications

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Questions?

Contacts Disclaimer

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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

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