Slides [ppt]

Liability Driven Benchmarks for UK Defined Benefit Pension SchemesLiability Driven Benchmark Working Party

Alvar Chambers

21 June 2005

Liability Driven Benchmarks for UK Defined Benefit Pension Schemes

Background Types of Liability Driven Benchmarks Implementation Examples Wider Issues

Background

Trends in investment strategy Peer groups Scheme specific benchmarks with market indices Liability driven benchmarks

Why move to Liability Driven Benchmarks? Maturing schemes, DC for new entrants Equity bear market and falling bond yields Market-based solvency & accounting standards Myners More sophisticated tools and liquid markets

Background

Alternative – buying out liabilities with an insurer Hedge mortality risk as well May not be possible or cost may be prohibitive for

many schemes, particularly if liabilities include deferred pensions

Limitations of Liability Driven Benchmarks Significant uncertainty remains over mortality

experience, other demographic factors

Benchmarking Investment RisksTracking error versus certain cashflows: a measure of investment risk in liability

0%

2%

4%

6%

8%

10%

12%

14%

16%

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Bond allocation

Tracking error (%pa)

Bonds

Swap with no liability risk

Source: Watson Wyatt LLP

Residual Demographic Risks RemainTracking error versus uncertain cash flows:a measure of total investment and non-investment risks in liability benchmark

Bond allocation Source: Watson Wyatt LLP

0%

2%

4%

6%

8%

10%

12%

14%

16%

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Tracking error (%pa)

Bonds (total risks)

Swap (total risks)

Bonds (investment risk only)

Swap (investment risk only)

Roles of Different Parties

Trustees Responsible for investment strategy Often not investment experts

Actuaries/Investment Consultants Advice on asset allocation and implementation

Investment Managers Management of assets within defined objectives

Investment Banks Implementation of large transactions including derivative

hedges

Types of Liability Driven Benchmark

Market Index Immunised Bond Portfolio Pooled Maturity Bucket Funds Cash-flow Matching with Physical Bonds Cash-flow Matching with Bonds and Swaps

Market Index

Poor matching Can split between fixed and RPI liabilities No credit risk if gilts, but can use credit index Easily investible, liquid benchmark Can use mainstream pooled funds Low cost

Immunised Bond Portfolio

Match duration but not yield curve risk Can split between fixed and RPI liabilities No credit risk if gilts, but can use credit Easily investible, liquid benchmark Requires segregated portfolio (may be

uneconomic for small schemes) Low cost for larger schemes

Pooled Maturity Bucket Funds

Fairly good matching within maturity buckets, can split fixed/RPI/LPI

May include credit exposure Liquidity may be restricted Increasing range of funds available Low cost

Cash-flow Matched Bond Portfolio

Good match out to limit of maturity of available bonds Can split fixed/RPI liabilities, dynamic hedge for LPI Can include credit exposure Reasonable liquidity dependent on bonds used Requires segregated portfolio Cost/diversification restricts to larger schemes

Cash-flow Matched Bond & Swap Portfolio

Very good match out to maturity of longest liquid swap Can accurately hedge fixed, RPI and LPI liabilities Counterparty risk, documentation issues Can include credit exposure Liquidity depends on bonds and swaps used Requires segregated portfolio Cost/diversification restricts to larger schemes

Types of Liability Driven Benchmark

Choice of discount curve Gilts vs swaps Allowing for credit risk What are the client’s investment objectives?

No one right answer!

Comparison of discount curves

Sterling Yield Curves as at 31 May 2005

4

4.5

5

0 5 10 15 20 25 30 35 40 45 50Term

Yie

ld

Gilts Swaps AA-rated bonds Source: BLOOMBERG

Implementation

Performance measurement and attribution A) Management against investible benchmark B) Management against expected liability cash flows

on defined discount rate

Who takes responsibility for tracking error between investible portfolio and liability cash flows on agreed discount rate?

Frequency of benchmark review

Implementation including swaps

Is scheme permitted to use OTC derivatives? Legal documentation – ISDA/CSA “Umbrella ISDAs” Counterparty risk and collateralisation Pooled fund approach can make practical for

smaller schemes

Examples

Model Scheme – very simplified 1,000 pensioners aged 60 Level pension £4,000 pa payable in advance PMA92C20 mortality Investment data as at 8 April 2005 Liabilities discounted off swap curve Sufficient cash held to meet first year’s liabilities

Examples - Gilt IndexModel Scheme Cash flows - Over 5 yr gilt index

Annual Cash flow Comparison

-£9,000,000

-£7,000,000

-£5,000,000

-£3,000,000

-£1,000,000

£1,000,000

£3,000,000

£5,000,000

£7,000,000

£9,000,000

Apr-0

5

Apr-0

7

Apr-0

9

Apr-1

1

Apr-1

3

Apr-1

5

Apr-1

7

Apr-1

9

Apr-2

1

Apr-2

3

Apr-2

5

Apr-2

7

Apr-2

9

Apr-3

1

Apr-3

3

Apr-3

5

Apr-3

7

Apr-3

9

Apr-4

1

Apr-4

3

Apr-4

5

Apr-4

7

Apr-4

9

Apr-5

1

Apr-5

3

Projected Liability Cash-flowsProjected Asset Cash-flowsProjected Net Cumulative Cash-flows

Model Scheme net cash flows - Over 5 yr gilt index

-£4,000,000

-£2,000,000

£0

£2,000,000

£4,000,000

£6,000,000

Apr-0

5

Apr-0

7

Apr-0

9

Apr-1

1

Apr-1

3

Apr-1

5

Apr-1

7

Apr-1

9

Apr-2

1

Apr-2

3

Apr-2

5

Apr-2

7

Apr-2

9

Apr-3

1

Apr-3

3

Apr-3

5

Apr-3

7

Apr-3

9

Apr-4

1

Apr-4

3

Apr-4

5

Apr-4

7

Apr-4

9

Apr-5

1

Apr-5

3

Apr-5

5

Net Cash-flows

Source: Insight Investment

Examples - Gilts PortfolioModel Scheme Cash flows - Gilts solution


-£5,000,000

-£3,000,000

-£1,000,000

£1,000,000

£3,000,000

£5,000,000

£7,000,000

£9,000,000

Apr-0

5

Apr-0

7

Apr-0

9

Apr-1

1

Apr-1

3

Apr-1

5

Apr-1

7

Apr-1

9

Apr-2

1

Apr-2

3

Apr-2

5

Apr-2

7

Apr-2

9

Apr-3

1

Apr-3

3

Apr-3

5

Apr-3

7

Apr-3

9

Apr-4

1

Apr-4

3

Apr-4

5

Apr-4

7

Apr-4

9

Apr-5

1

Apr-5

3


Model Scheme net cash flows - Gilts solution

-£4,000,000

-£2,000,000

£0

£2,000,000

£4,000,000

£6,000,000

Apr-0

5

Apr-0

7

Apr-0

9

Apr-1

1

Apr-1

3

Apr-1

5

Apr-1

7

Apr-1

9

Apr-2

1

Apr-2

3

Apr-2

5

Apr-2

7

Apr-2

9

Apr-3

1

Apr-3

3

Apr-3

5

Apr-3

7

Apr-3

9

Apr-4

1

Apr-4

3

Apr-4

5

Apr-4

7

Apr-4

9

Apr-5

1

Apr-5

3

Apr-5

5

Net Cash-flows


Examples - Gilts and Swaps PortfolioModel Scheme Cash flows - Gilts & Swaps Solution


-£1,000,000

£1,000,000

£3,000,000

£5,000,000

£7,000,000

£9,000,000

Apr-0

5

Apr-0

7

Apr-0

9

Apr-1

1

Apr-1

3

Apr-1

5

Apr-1

7

Apr-1

9

Apr-2

1

Apr-2

3

Apr-2

5

Apr-2

7

Apr-2

9

Apr-3

1

Apr-3

3

Apr-3

5

Apr-3

7

Apr-3

9

Apr-4

1

Apr-4

3

Apr-4

5

Apr-4

7

Apr-4

9

Apr-5

1

Apr-5

3


Model Scheme net cash flows - Gilts & Swaps Solution

-£4,000,000

-£2,000,000

£0

£2,000,000

£4,000,000

£6,000,000

Apr-0

5

Apr-0

7

Apr-0

9

Apr-1

1

Apr-1

3

Apr-1

5

Apr-1

7

Apr-1

9

Apr-2

1

Apr-2

3

Apr-2

5

Apr-2

7

Apr-2

9

Apr-3

1

Apr-3

3

Apr-3

5

Apr-3

7

Apr-3

9

Apr-4

1

Apr-4

3

Apr-4

5

Apr-4

7

Apr-4

9

Apr-5

1

Apr-5

3

Apr-5

5

Net Cash-flows


Examples

0ver 5 year gilt index Gilts & Cash solution Gilts, Cash & swapssolution

Asset Breakdown ofsolution

% % %

Gilts 93.01% 90.60% 37.49%

Cash backed swaps 0.00% 0.00% 55.49%

Cash 6.99% 9.40% 7.02%

Total 100.00% 100.00% 100.00%

Risk measures bp of fund value bp of fund value bp of fund value

PV01 of assets relative toliabilities

-0.6 -0.1 0.1

Annualised tracking error 261.5 252.3 25.4

One month VAR 95%confidence interval

124.2 119.7 12.1


Examples

Extension of model scheme example would add layers of complexity Choice of discount curve Optimisation goals Inclusion of credit, hedged overseas bonds, strips Pension increases (fixed/RPI/LPI annual/LPI

cumulative in deferment/other caps & floors)

Wider Issues

Incorporating active and deferred liabilities Greater uncertainty in liabilities Cumulative LPI in deferment very complex Salary inflation cannot be hedged

Wider Issues

Different types of inflation increases LPI (0,5) LPI (0,2.5) for future accrual GMPs (0,3) LPI with higher cap (3,5) Public sector RPI (0, infinity) Bespoke hedge vs dynamic hedging for caps and

floors

Wider Issues

Schemes with less than 100% solvency Hedge winding up/PPF benefits or total benefits? Scale down liabilities to available assets

(proportionate hedge or hedge fully for x years or combination)

Hedge whole liabilities e.g. using unfunded swap overlay for excess of liabilities over assets

Wider Issues

Incorporating active management into a Liability Driven Investment strategy Passive matching of benchmark, regular rebalancing Active management of bonds/swaps portfolio vs

benchmark “Portable alpha” Retention of diversified beta risk “unconstrained long-term mandates” – are they true

liability driven investment?

Any Questions?

Slides [ppt]

Documents

Transcript of Slides [ppt]