The 2nd Younger Members Convention Use of Swaps in Matching Pension Fund Liabilities Huw Williams...
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Transcript of The 2nd Younger Members Convention Use of Swaps in Matching Pension Fund Liabilities Huw Williams...
The 2nd Younger Members Convention
Use of Swaps in Matching Pension Fund Liabilities
Huw Williams
1-2 December 2003
The Glasgow Moat House
Using Swaps to Match Pension Scheme Liabilities Agenda Pension scheme asset allocation – a trend towards greater bond investment Recent bond market performance – the impact on credit spreads Structure and capacity of the bond markets
Sterling Euro
How will pension scheme demand be met going forward? Introduction to swaps Applications for pension funds
Enhancing investment returns Using swaps to meet liabilities
Examples in practice Risks and other features of the swap market Summary
Pension Scheme Asset Allocation Strategic issues facing pension funds
Reduced scope for risk taking Funding levels have reduced Sponsoring companies downsizing Increased attention from Government, analysts, rating agencies Increasing focus on “insurance company buy-out solvency” Changes in the accounting environment – FRS17, IAS19
Government Action Plan – 11th June 2003 Reduction possible to LPI for future service benefits On voluntary wind up full accrued benefits (on insurance
company buy out) to be met Insurance scheme to apply where companies are insolvent.
Premiums to be based partly (or fully?) on risk – funding level to determine “riskiness”.
Trustees to be given the right to wind up a scheme where they judge this to be in members’ interests.
Pension Scheme Asset Allocation Pensions Protection Fund
Likely mechanics on formal insolvency of sponsoring employer: Buy-out from an insurer for PPF level of benefits or better OR if not possible Receive scheme assets and accept liability for PPF level of
benefits Buy-out basis - How much you would have to pay an insurer to take
on liabilities? Implied yield: gilts – 0.5% (reinforced by emerging actuarial
guidance) Risk-based premium expected - main risk factors are:
Current deficit Asset allocation relative to liabilities Probability of default of company
But expect a proxy – simplicity and political compromise US PBGC premium = 0.9% of deficit + $19 per member
Pension Scheme Asset Allocation Trend towards a higher bond allocation
Asset Allocation 1993 1996 1999 2002
UK Equities 56.1 53.3 51.0 39.4Overseas Equities 24.0 21.8 24.4 25.0
Total Equities 80.1 75.1 75.4 64.4
UK Bonds 4.0 6.0 8.1 12.5Overseas Bonds 3.8 2.9 3.6 4.0Index-Linked 3.0 5.0 4.9 9.3
Total Bonds 10.8 13.9 16.6 25.8
Property/Other 9.1 10.9 7.9 9.8
Total 100 100 100 100
Pension Scheme Asset Allocation Trend towards a higher bond allocation
Equity Allocation as Percentage of Total
5055
6065
70
7580
85
Dec-8
5
Dec-8
7
Dec-8
9
Dec-9
1
Dec-9
3
Dec-9
5
Dec-9
7
Dec-9
9
Dec-0
1
Series1
Series2
Factors Influencing Asset AllocationAn improvement in funding levels may have an impact?
FTSE 100 31/Dec/2002 to 17/Oct/2003
3000
3500
4000
4500
Oct-0
3
Sep
-03
Au
g-0
3
Ju
l-03
Ju
n-0
3
May-0
3
Ap
r-03
Mar-0
3
Feb
-03
Jan
-03
FTSE 100
The Impact on Gilt Yields
10yr vs 30yr Gilt spreads
-10
0
10
20
30
40
2-Ja
n
2-Feb
2-M
ar
2-Apr
2-M
ay
2-Ju
n
2-Ju
l
2-Aug
2-Sep
2-Oct
2-Nov
2-Dec
2-Ja
n
Spr
ead
Corporate Spread Performance
Over 15 year corporate bond spreads
0
50
100
150
200
250
300
01/0
7/20
00
07/2
1/20
00
01/2
6/20
01
08/1
0/20
01
02/1
5/20
02
08/3
0/20
02
03/0
7/20
03
Sp
rea
d A
AA
AAA
Euro versus Sterling MarketSterling offers longer maturities
The Sterling market is a long dated market, offering better long matching opportunities for UK pension funds The maturity of new issues in the sterling market are consistently longer dated the the euro market
Sterling Market
0%
10%
20%
30%
40%
50%
60%
1-3
ye
ars
3-5
ye
ars
5-7
ye
ars
7-1
0 y
ea
rs
10
-15
ye
ars
Gilts
GBP Corporates
Euro Market
0%
5%
10%
15%
20%
25%
30%
1-3
ye
ars
3-5
ye
ars
5-7
ye
ars
7-1
0 y
ea
rs
10
-15
ye
ars
Sovereigns
EUR Corporates
Euro versus Sterling MarketSterling offers greater access to credit risk
The euro market (£945bn. equiv.) is significantly larger than the sterling market (£258bn.); hence euro market is more liquid
The average credit rating of the sterling market is lower than the euro market; hence sterling offers higher spreads
Sterling Market
AAA
AA
A
BBB
Euro Market
Sterling Index Linked versus Fixed marketIndex linked: a small, utility sector dominated market
Fixed Market (£258bn)
AAA
AA
A
BBB
Index Linked Market (£9bn)
Supranational
Financial
Industrial
Utility
How Will Demand Be Met Going Forward?
From increased corporate bond issuance
Government issuance also rising
Greater use of the Euro and Dollar markets
But inflation-linked assets likely to remain a problem
Greater use of the swaps markets is likely to help alleviate capacity constraints both in fixed income and inflation linked
The Sterling Debt Market (£bn)
0
5
10
15
20
25
30
35
40
45
50
2001 2002 2003(E) 2004(F)
Gilts
Corps
ABS/MBS
Fins/supras/other
Overall sterling debt supply has increased from £81bn in 2001 to £128bn in 2003, but will stabilise in 2004.
Interest Rate SwapsMarket Growth
Interest Rate Swap Market Growth - 1989 to 2002
-
10,000
20,000
30,000
40,000
50,000
60,000
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Year
No
tio
nal
Ou
tsta
nd
ing
in G
BP
£b
n.
Interest Rate Swaps - All currencies Sterling Interest Rate Swaps
Interest Rate SwapsComparison with UK domestic debt
Sterling Interest Rate Swaps vs UK Domestic Debt1989 to 2002
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Year
No
tio
nal
Ou
tsta
nd
ing
in
GB
P £
bn
.
Sterling Interest Rate Swaps UK Domestic Debt (All Issuers) UK Domestic Government Debt
Interest Rate SwapsTenors
Quotes available out to 50 years
Reasonable liquidity out to 40 years
Source: Reuters
Introduction to swaps
What is a swap?
Simply an agreement to exchange two sets of cash flows
Usually these are equal in value but different in nature
For example a “fixed for floating” swap
Consider a deposit of £10m paying a floating rate of interest
The floating cash flows can be exchanged for a specified fixed rate of cash flows applicable for a given period
This fixed rate is known as the “swap rate” for a given maturity
Interest Rate Swap Example
Bank Fund
Fixed swap rate of 3.9% per annum on £10m, paid semi-
annually for 5 years
6 month Libor from cash deposit for 5 years
6 month Libor earned on 5 year cash deposit of £10m
Applications for Pension Schemes
Receiving a fixed return is a substitute for a corporate bond return
Achieved by placing funds on deposit and receiving floating cash flows, which are then swapped for fixed cash flows
And the end of the period the Scheme receives a return of principal (by taking the cash off deposit)
Returns are in line with a AA rated bond yield – swaps are effectively a measure of generic bank credit
Flexible instruments as the cash flow proceeds can be tailored to meet the specific circumstances of the fund
Different Types of Swap Contract
Cash flows can be structured to meet an investor’s particular needs
For example the swap flows can be tailored to meet specific liability cash flows
An example is where a pension scheme has inflation-linked liabilities, but owns a portfolio of fixed rate bonds
Solution is to enter into an inflation swap:
Pension scheme pays fixed flows (as generated by the corporate bond portfolio) Scheme receives inflation linked cash flows tailored to meet the projected liabilities of the scheme
Example of an Inflation Swap
Bank Fund
RPI-linked cashflows to match pension payments
Cashflows generated by bond portfolio.
Can be fixed/floating & in any currency
RPI-linked pension payments
Buy a diverse portfolio of bonds. This could be sterling fixed income or broader still, e.g. Euros or dollars
Swap the fixed cash flows generated from the bond portfolio for either RPI or LPI linked returns
Example Liability Cash flow Graphs
ALL LIABILITIES
-
50,000,000
100,000,000
150,000,000
200,000,000
250,000,000
300,000,000
350,000,000
2004
2007
2010
2013
2016
2019
2022
2025
2028
2031
2034
2037
2040
2043
2046
2049
2052
2055
2058
2061
2064
2067
2070
2073
CASH
FLO
W (£
)
LPI Post 88 GMP Pre 88 GMP
PENSIONERS
0
50,000,000
100,000,000
150,000,000
200,000,000
250,000,000
300,000,000
350,000,000
2004
2007
2010
2013
2016
2019
2022
2025
2028
2031
2034
2037
2040
2043
2046
2049
2052
2055
2058
2061
2064
2067
2070
2073
CASH
FLOW
(£)
LPI Post 88 GMP Pre 88 GMP
ACTIVES
-
50,000,000
100,000,000
150,000,000
200,000,000
250,000,000
300,000,000
350,000,000
2004
2007
2010
2013
2016
2019
2022
2025
2028
2031
2034
2037
2040
2043
2046
2049
2052
2055
2058
2061
2064
2067
2070
2073
CA
SH
FLO
W (£
)
LPI Post 88 GMP Pre 88 GMP
DEFERRED PENSIONERS
-
50,000,000
100,000,000
150,000,000
200,000,000
250,000,000
300,000,000
350,000,000
2004
2007
2010
2013
2016
2019
2022
2025
2028
2031
2034
2037
2040
2043
2046
2049
2052
2055
2058
2061
2064
2067
2070
2073
CA
SH
FLO
W (£
)
LPI Post 88 GMP Pre 88 GMP
Projected Pension PaymentsExample Liability Profile (Pensioners)
Projected Pension PaymentsMarket Implied RPI
£0
£2,000,000
£4,000,000
£6,000,000
£8,000,000
£10,000,000
£12,000,000
£14,000,000
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
2023
2025
2027
2029
2031
2033
2035
RPI-linked pension payments
Pension Payments Versus Index-Linked Cash Flows
Pension Payments versus Index-Linked Gilt FlowsMarket Implied RPI
£0
£10,000,000
£20,000,000
£30,000,000
£40,000,000
£50,000,000
£60,000,000
20
03
20
05
20
07
20
09
20
11
20
13
20
15
20
17
20
19
20
21
20
23
20
25
20
27
20
29
20
31
20
33
20
35
Index-linked gilt flows RPI-linked pension payments
Resulting Cash Flow MatchAfter substituting the index linked gilts for the swap
Pension Payments versus Swap InflowsMarket Implied RPI
£0
£2,000,000
£4,000,000
£6,000,000
£8,000,000
£10,000,000
£12,000,000
£14,000,000
20
03
20
05
20
07
20
09
20
11
20
13
20
15
20
17
20
19
20
21
20
23
20
25
20
27
20
29
20
31
20
33
20
35
RPI-linked pension payments RPI-linked Swap Inflows
Potential for Enhanced Returns Use of swaps effectively separates the asset and liability management from the investment of the assets
The swap payments to the Scheme can be tailored to meet the liability cash flows which need to be paid
Assets can then be invested independently – Trustees would be free to chose the most appropriate investment strategy without constraint
Hence potential for higher expected returns through:
Investment in asset classes with higher expected returns (e.g. corporate bonds versus index-linked gilts) Improved potential for investment manager out-performance
Corporate Bonds: Benefits & Risks Table
Bond Rating
Yield Over Gilts
(per annum)
(20yr spread)
Historic Default Rate
Over 10 Years
(per annum)
Historic Default Rate
Over 20 Years
(per annum)
Present Value of Performance
Improvement after costs & expected
losses. (Based on £100m of LPI/RPI
swaps)*
AAA 0.56% 0.08% 0.10% £3.7m
AA 0.70% 0.09% 0.14% £4.9m
A 0.84% 0.10% 0.27% £7m
* Costs include swap transaction costs and purchase of corporate bonds
ISSUER COUPON MATURITY VALUE RATING
Lloyds TSB Bank PLC 6.63 30-Mar-15 10,290,106 AA-
BOC Group Plc 6.50 29-Jan-16 11,235,999 A
Aviva Plc 9.50 20-Jun-16 14,144,150 AA-
Aviva Plc 9.50 20-Jun-16 14,144,150 AA-
Smiths Group PLC 7.25 30-Jun-16 11,676,480 A-
Coca-Cola Enterprises Inc 6.50 7-Dec-16 11,414,127 A
British Telecommunications PLC 7.75 7-Dec-16 12,455,145 A-
Safeway Plc 6.00 10-Jan-17 9,757,781 BBB+UPM-Kymmene Oyj 6.63 23-Jan-17 10,968,204 BBBNorthern Rock Plc 5.75 28-Feb-17 10,606,924 A-Northumbrian Water Finance Plc 6.00 11-Oct-17 10,688,722 BBBJapan Finance Corp for Municipal Enterprises 5.75 9-Aug-19 10,361,388 AA-Bank of Scotland 6.38 16-Aug-19 11,749,455 AA-GKN Plc 6.75 28-Oct-19 11,152,232 BBBMcDonald's Corp 6.38 3-Feb-20 10,849,527 ATussauds Finance Ltd 7.08 15-Mar-20 11,578,448 AGeneral Electric Capital Corp 6.25 29-Sep-20 11,464,344 AAAAXA 7.13 15-Dec-20 11,535,899 BBB+Enterprise Inns Plc 6.88 15-Feb-21 11,176,158 BBBNorsk Hydro ASA 6.50 7-Jun-21 10,793,528 ACoca-Cola Enterprises Inc 6.50 7-Jun-21 11,075,926 AEGG Banking PLC 6.88 29-Dec-21 10,489,361 A-Innogy Plc 8.13 9-Jun-22 12,007,357 A-Annington Repackaging No 1 Ltd 5.32 10-Jan-23 10,048,878 AA-Annington Finance No 4 8.07 10-Jan-23 11,753,029 BBB3i Group Plc 6.88 9-Mar-23 11,628,523 A+Highbury Finance NV 7.02 20-Mar-23 11,328,599 A-Land Securities Plc 6.38 27-Feb-24 10,781,392 A-THPA Finance Ltd 7.13 15-Mar-24 10,035,829 AUnique Pub Finance Co Plc 7.40 30-Mar-24 11,871,898 BBB+PowerGen U.K. PLC 6.25 29-Apr-24 10,920,646 A-United Utilities Electricity PLC 8.88 25-Mar-26 14,633,263 A-Citigroup Inc 5.15 21-May-26 9,894,166 AA-GHG Finance Ltd 7.78 15-Jul-26 12,210,456 BBBAviva Plc 6.13 16-Nov-26 10,475,923 AA-Canary Wharf Finance Plc 7.43 22-Oct-27 11,875,557 AAUnited Utilities Water Plc 5.63 20-Dec-27 10,381,756 A-HSBC Holdings Plc 5.75 20-Dec-27 10,859,364 ABAA Plc 6.38 4-Aug-28 10,792,676 A+Italy Government International Bond 6.00 4-Aug-28 11,217,067 AATesco Plc 6.00 14-Dec-29 11,001,081 A+Canary Wharf Finance II Plc 6.80 22-Apr-30 11,629,499 AARWE Finance BV 6.25 3-Jun-30 10,662,078 A+Deutsche Telekom International Finance BV 7.63 15-Jun-30 12,460,191 BBB+Electricite de France 5.88 18-Jul-31 10,331,396 AAGeneral Electric Capital Corp 5.63 16-Sep-31 10,712,488 AAAInnogy Plc 7.13 1-Oct-31 11,680,575 A-BAA Plc 5.75 10-Dec-31 10,132,652 A+Legal & General Finance Plc 5.88 11-Dec-31 10,776,728 AAJ Sainsbury Plc 6.00 5-Apr-32 10,138,924 A-McDonald's Corp 5.88 23-Apr-32 10,138,701 AEquity Release Funding Plc 5.88 26-May-32 10,873,951 AAASchlumberger PLC 6.50 4-Oct-32 11,917,490 A+Vodafone Group PLC 5.90 26-Nov-32 10,778,422 A3i Group Plc 5.75 3-Dec-32 9,522,388 A+Legal & General Finance Plc 5.88 5-Apr-33 10,729,260 AATrafford Centre Finance Ltd 6.50 28-Jul-33 11,913,727 AAA
Extreme Portfolio Default Losses
7.00%
9.20%
11.50%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
One in 10,000 event One in 100,000 event One in 1,000,000 event
Siz
e o
f lo
ss
as
a p
erc
en
tag
e o
f p
ort
folio
va
lue
SIZE OF DEFAULT LOSS VERSUS PROBABILITY OF OCCURRENCE(ANNUAL LONG-RUN AVERAGE)
6.7129%
1.3427%
0.3176%0.0800% 0.0207% 0.0054% 0.0014%
0.0000%
1.0000%
2.0000%
3.0000%
4.0000%
5.0000%
6.0000%
7.0000%
8.0000%
9.0000%
10.0000%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%
SIZE OF LOSS AS A PERCENTAGE OF PORTFOLIO VALUE
PROBABILITY OF LOSS GREATER THAN X%
[1] Based on long-run average historic default loss rates from Moody’s and S&P annual reports published in February 2003.
[2] The diversity score is an idea used by Moody’s for rating portfolios. A lower number means less diversity so it is a useful statistic for comparing portfolios. A portfolio may contain many different bonds but these might be issued by the same company, companies with common parents or companies in closely related industry sectors. The diversity score reduces the number of bonds to a number of bonds that are independent (except for common reliance on the global macro-economic environment).
Example Broad Investment Grade PortfolioNumber of bonds 57Portfolio Value £900mCredit Spread (duration w'td) 101Average Mod. Dur 10.4Average Default Probability 0.199%Diversity Score 43
Summary of Benefits of Swaps
Risk reduction through the ability to tailor asset proceeds to meet liabilities
Only realistic way of obtaining LPI assets
Only realistic way to achieve a cash flow match to expected benefit payments
Separates asset and liability management allowing potential for more efficient management of asset portfolio
Potential for higher expected returns
Counter-Party Risk Swap contracts introduce counterparty risk to the pension scheme
This is the risk that the bank counterparty defaults while owing money to the pension scheme under the contract
Counterparty risk can be mitigated by collateralisation – I.e calculating the mark to market exposure and passing collateral between parties to hold in the event of default.
Reduces the counterparty risk effectively to nil
This process is similar to margin calls on exchanged traded futures and options – collateralisation can be done daily if required
Summary
Pension Scheme switches have put the corporate bond market under pressure recently
Continued issuance and return to government issuance will help alleviate capacity somewhat
Capacity constraints are most acute in inflation-linked assets
The Swaps market is far bigger than the corporate bond market and offers significant benefits for pension schemes
A particular area of benefit is in matching inflation-linked liabilities, particularly LPI