Aspects of Risk Risk Management Within The Investment Portfolio September 28, 2011 © 2011 Towers...

Aspects of RiskRisk Management Within The Investment Portfolio

September 28, 2011

© 2011 Towers Watson. All rights reserved.

2towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.

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Today’s Presenters

Jon Pliner, Investment Strategy Consultant

Mark Ruloff, Director of Asset Allocation


Today’s Discussion

Opening Thoughts

Payout/Liability Hedging

Better Diversification

Risk Steering

Risk Pricing

Long-Termism Risk Return Concepts

Beyond Investment Policy

Closing Thoughts

4


Opening Thoughts

Holistic

Many tools beyond diversification and liability hedging

Risk return management

5


6

Standard Efficient Frontier

Illustrative EfficientFrontier

100%90%

80%70% 60%

50%40% 30% 20% 10% 0%

3%

4%

5%

6%

7%

8%

9%

12% 13% 14% 15% 16% 17% 18% 19%

Most Desirable

Efficient FrontierPoint Labels represent % fixed income


7

Most Desirable

Asset/Liability Efficient Frontier


Liability Hedging

8

Desirable


Recent signs of slowing economic growth in the developed world have led to falling bond yields and a sharp sell off in equities

The USD has strengthened against many currencies, reinforcing it’s “safe haven” status

This in turn has led to rising uncertainty and increased market volatility, consistent with our “Bumpy Path with Slow Recovery” central scenario

An Eventful Couple of Months

9

Sources: Thomson, Towers Watson

Consumer confidence indicators

Fast(EM FX appreciation)

Slow(EM inf lation, DM def lation)

High(Fiscal stimulus,

high market liquidity)

Low(Fiscal austerity,

tight market liquidity)

Speed of global rebalancing(EM policy choices)

Public policy and financial conditions

(DM policy choices)

EM Overheating

Global growth slowdown

DM Deflation

High DM inflation

DM sovereign

debt crisis

Bumpy path with slow recovery

High DM

growth

EM: Emerging Markets DM: Developed Markets


Despite low absolute yield levels, the long end of the curve implies a normalization of cash rates in line with our outlook for anaemic economic growth in the US and Europe

Though moderately unattractive versus cash, yield curves still support hedging long-term liabilities

Government Bonds

10

Bond Yield Curves (As of August 31, 2011)

Source: Bank of England, Deutsche Bundesbank, Federal Reserve, Bank of Japan

Asset allocation in volatile times. What now?

Global Markets OverviewGlobal Investment Committee, September 2011

In this issue

2The outlook for EM equities

4Summary of market views

5World markets statistics

6Notes

• Valuations of risky assets fell sharply in early August. In a “normal” business cycle current market levels (especially global equity markets) would look attractive, supported by a new global easing cycle in reaction to the current broad-based economic slowdown.

• However, the high debt levels and deleveraging needs in developed countries that are constraining governments and households and weakening conditions have important structural elements. This is not a “normal” cyclical/ liquidity environment and a sustainable solution for growth and jobs requires bothmoney printing on the monetary side and specific structural reforms (egpublic finance reform in Europe and housing reform in the US) on the fiscal side.

• Recent mediocre growth rates in the developed world and a necessary slowdown in over-capacity emerging economies have been an important driver of falls in risky assets. However, economic and financial outcomes remain highly dependent on policymakers and politicians, especially in the euro area. This will continue in the short-term, keeping investor sentiment fragile and market volatility high.

• When thinking about asset allocation it is important to balance perceptions of value against a forward-looking view of the macro risks. Our central outlook is still for policymakers to adopt a gradualist approach to addressing the headwinds undermining economic growth and jobs and avoiding the very bad economic and market outcomes. Nevertheless, there are still significantly more positive and more negative risk scenarios that are plausible based on policymakers boldly addressing the structural problems or failing to address sovereign, bank or household solvency concerns. Moreover, these policy actions are very difficult to predict accurately.

• While risky asset valuations are moderately attractive, we do think them sufficiently compelling to take an overweight position. Equally, the current relative pricing of bonds and equities does not support an underweight position in risky assets. We continue to recommend an aggregate neutral stance on risk.

• Within global equity markets, we have a regional overweight to Asian and broader emerging markets. Given the price declines this year, EM equities in general offer good value. Our favoured dividend discount approach suggests that equities are now discounting a long-term real earnings growth rate that is markedly lower than our view of trend growth. We expect EM equities to outperform DM with a three to five year view, although this is not without risk.

Three-Year Horizon

Asset Class View

Global Government BondsModerately Unattractive

Global Inflation-linked Bonds Neutral

Global Credit (Investment Grade) Neutral

Global EquitiesModerately Attractive

CommoditiesModerately Attractive

Figure 01. Our current viewsModest opportunities due to recent moves, relative to cash


Diversified Portfolio: Risk/Return Buckets

11

Typical portfolio Well diversified portfolio

Source of returns as a percentage of total return

The typical portfolio includes some diversification….

…but equities still dominate returns (and risk)

In building a diversified portfolio, it is therefore important to think about sources of return and risk, rather than asset allocation

Term risk premium

Credit risk premium

Equity risk premium

Equity risk premium

Insurance risk premium

Skill risk premium

Inflation risk premium

Term risk premium

Credit risk premium

Inflation risk premium

Skill risk premium


Alternative beta

Treasuries and cash

Corporate bonds

Developed equities

Private markets

Emerging wealth

Traditional Unconstrained

Treasuries and cash

Corporate bonds

Developed equities

Private markets

Emerging wealth

Source: Towers Watson

Hedge funds

Alternative beta

Alternative credit

12

Sample DB Pension Fund


A sharp sell off leaves equities moderately attractive, albeit with significant downside risks given the large macro risks the economy faces

Emerging equities look attractive to developed equities given recent performance and long term outlook for growth

Equities

13

Most markets look attractive based on simple valuation metrics

Sources: Bloomberg LP, Towers Watson

Markets have failed to rally significantly from the August lows

Sources: Bloomberg LP, Towers Watson


14

20%FI (LGC)30%FI (LGC)

40%FI (LGC)

50%FI (LGC)

2%

4%

6%

8%

10%

12%

14%16%

18%

20%22%24% 26%

30%

2%

4%6%

8%

10%

12%

14%

16%

18%

20%22%24%

26%28%30%

$200

$210

$220

$230

$320 $330 $340 $350 $360 $370 $380

Combined: PV of Cumulative Contribution + TL Deficit ($M)95th Percentile

Asset/Liability Frontier Year 2019

28%

Sample Analysis of Dynamic Asset Allocation: Cumulative Contributions plus Deficits

Com

bin

ed:

PV

of

Cum

ulat

ive

Con

trib

utio

n +

TL

Def

icit

($M

)50

th P

erce

ntile


Risk Steering

Dynamic Asset Allocation Separating funded status trigger into interest rates, returns, and contributions

In declining markets

Enterprise Risk Management Compare investment portfolio options with core operations

Consideration of investments compared to core business risks Sponsor Beta

Commodities

Inflation

Cash contributions

15


0

100

200

300

400

500

600

700

800

-27

%

-23

%

-19

%

-15

%

-11

%

-7%

-3%

1%

5%

9%

13

%

17

%

21

%

25

%

29

%

33

%

37

%

41

%

45

%

49

%

53

%

57

%

61

%

65

%

69

%

73

%

Amount

Fre

qu

en

cy

65% Fixed Income - no Collar 65% Fixed Income with Collar

16

5th %

ile – no Collar

5th %

ile – Collar

25th %

ile – both

50th %

ile – both

75th %ile – Collar

75th %ile – no Collar

95th %ile – Collar

95th %ile – no Collar

16

Collared vs. Uncollared Domestic Equities: Annual Return


Approach is often to obtain the appropriate hedge for a certain risk exposure at the cheapest possible price

However, markets are complex and we expect negative swap spreads to continue to persist in the near-term

We outlined rationale for our view in a note to clients earlier this year

Development of Liability Hedging Elements

17

Sources: BarCap, Towers Watson


Risk Pricing

Puts, calls, and collars

Swaps, Swaptions, and Swaption collars

Generally would be a loss of value if done always and passively

Requires good governance to know when to use and how to implement

Could depend on connection with enterprise risks Put on swaption to avoid “unbearable” situation, like breaking of bond

covenants

18


Long-Termism Risk/Return Concepts in Model Portfolio

Risk framework Risk return framework

Risk return management, not just measurement

Long-term risk return management framework

Risk scenarios

Theme investing

Extreme risks


Sustainability

20

Sustainable Investing

Social and Environmental

Goals

Return Goals

Risk Management

Goals

Universal Owner


21

Beyond Investment Policy

PensionRisk

Effective at managing active liability risk profile and long-term

plan cost

Effective at managing short-term plan cost and volatility

Effective at managing long-term plan cost and volatility

Effective only for short-term issues

BENEFIT STRATEGY

FUNDING STRATEGY

ASSUMPTIONS & METHODS

INVESTMENTSTRATEGY


Holistic

Many tools beyond diversification and liability hedging

Risk return management

22

Closing Thoughts


Disclaimer

The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm or accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments.


25

Contact Details

Jon Pliner

335 Madison Avenue, New York, NY 10017-4605 212-309-3811 [email protected]

Mark Ruloff

901 N. Glebe Road, Arlington, VA 22203 703.258.8058 [email protected]

Aspects of Risk Risk Management Within The Investment Portfolio September 28, 2011 © 2011 Towers...

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