ACA Conference 2018 To De-Risk or not De-Risk 26 January 2018 - - PowerPoint PPT Presentation

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ACA Conference 2018 To De-Risk or not De-Risk 26 January 2018 - - PowerPoint PPT Presentation

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ACA Conference 2018 To De-Risk or not De-Risk 26 January 2018 Bobby Riddaway FIA Head of Investment Consulting 65 Gresham Street, London, EC2V 7NQ Tel 020 7709 4500 Fax 020 7709 4501 For Professional Clients Only Introduction Why De-risk

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ACA Conference 2018 To De-Risk or not De-Risk

26 January 2018 Bobby Riddaway FIA Head of Investment Consulting For Professional Clients Only

65 Gresham Street, London, EC2V 7NQ Tel 020 7709 4500 Fax 020 7709 4501

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Commercial in Confidence 2

Introduction

Why De-risk How to De-Risk When to De-Risk

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Commercial in Confidence 3

Increasing Maturity of Schemes

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Commercial in Confidence 4

Cash Flow Needs

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Commercial in Confidence 5

Need to Eliminate Funding Issues

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Commercial in Confidence 6

How to De-risk

Joined-up thinking… Trustees Sponsor

  • Member security
  • Employer’s views
  • Employer covenant
  • The end game?
  • TPR guidelines
  • Risk management,

including liability management

  • Impact on P&L
  • Impact on b/sheet
  • Costs: level &

volatility

  • Compliance/ running

costs

  • Risk budget
  • Trustees ultimately in

control

Valuations / Funding Objectives Understanding Risk and the Risk Appetite Investment Strategy / De-Risking Strategy Employer Covenant

… consider objectives and constraints of key stakeholders

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Commercial in Confidence 7

De-risking is Costly?

7.4 10.0 4 5 6 7 8 9 10 11 Now 10 years £m

Effect of Changing Financial Assumptions

3% p.a. 6.8 10.0 4 5 6 7 8 9 10 11 Now 10 years £m Effect of Changing Financial Assumptions 4% p.a.

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Commercial in Confidence 8

Nominal Gilt Yield

  • 0.50

0.00 0.50 1.00 1.50 2.00 2.50 0.5 5.5 10.5 15.5 20.5 25.5 30.5 35.5 Redemption Yield % Maturity (Yrs) Gilt Yield Curve 31-Dec-16 Gilt Yield Curve 31-Dec-17

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Commercial in Confidence 9

Real Gilt Yield

  • 3.50
  • 3.00
  • 2.50
  • 2.00
  • 1.50
  • 1.00

2.50 7.50 12.50 17.50 22.50 27.50 32.50 37.50 Real Redemption Yield % Maturity (Yrs) Gilt Real Yield Curve 31-Dec-16 Gilt Real Yield Curve 31-Dec-17

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Commercial in Confidence 10

Physical passive equity can be replicated by holding “cash” & equity futures

The end result is full equity exposure with the benefit of reduced duration mismatching against liabilities 100% cash 100% equity futures

+

100% equity futures

+

75% Gilts & 25% cash

Efficient Use of Capital

Equity-Linked Bond Funds

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Commercial in Confidence 11

Equity Linked Bond Fund, 60% Traditional Bonds, 40% Traditional Equities, 0% Traditional Bonds, 100% Traditional Equities, 60% Traditional Bonds, 40%

  • 1. Example Plan Assets
  • 2. Replace Equities with Bonds

Required Return* 2.0% Expected Return* 2.0% Liability Duration 25 yrs Asset Duration 8.8 yrs

* In excess of Gilts

Required Return* 2.0% Expected Return* 0.0% Liability Duration 25 yrs Asset Duration 16 yrs

* In excess of Gilts

  • 3. Replace Equities with ELBFs

Physical bonds with Futures Overlay Required Return* 2.0% Expected Return* 2.0% Liability Duration 25 yrs Asset Duration 13.6 yrs

* In excess of Gilts

  • Assets are expected to achieve

the required return

  • Considerable interest rate risk
  • Reduced interest rate risk

through better duration match

  • Reduced expected return on

investments

  • Reduced interest rate risk

through better duration match

  • Maintained expected return on

investments

Equity-Linked Bond Funds

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Commercial in Confidence 12

LDI: Illustrative impact of changes in market conditions

£300,000 pension liabilities £300,000 bond portfolio

£100,000 investment

£330,000 pension liabilities £330,000 bond portfolio

£130,000 investment

£270,000 pension liabilities £270,000 bond portfolio

£70,000 investment

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Commercial in Confidence 13

How leverage works

Source: BMO

  • Suppose investment = £100 and fund is leveraged 3 times to match £300 of liabilities
  • Assume interest rates fall so that the liabilities fall by 16.7% = (50/300)
  • LDI assets would fall by £50 ~ (16.7% X 3)
  • This would lead to a cash call of £33 to restore an appropriate level of leverage
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Commercial in Confidence 14

Matching liabilities with leveraged LDI funds

Advantages Disadvantages Relatively simple and available in passive form More costly than bond funds Capital efficient: can hedge materially more liability exposure than bond funds Leverage can mean you loose more money than you would otherwise do if interest rates rise significantly Frees up capital for growth assets and rewarded financial risks Volatility in absolute terms can be difficult to understand Derivative markets increasingly costly to trade in due to bank and financial market regulations

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Commercial in Confidence 15

Alternative Strategies

VAR £21.4m1 VAR £12.0m 1 50% DGF1 35% Equity 20% LDI1 40% Bonds

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Commercial in Confidence 16

Flight Plan Example

10 20 30 40 50 60 70 80 GBP Millions

Self-sufficiency liabilities Total assets

Fully funded scheme, i.e. assets equal to liabilities

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Commercial in Confidence 17

When to de-risk

Did tools exist in the noughties

200 400 600 800 1000 1200 GBP Millions Property bubble burst Global Recession Banking Crisis Eurozone crisis Property bubble burst Global Recession Banking Crisis Eurozone crisis Brexit Dotcom bubble burst

Liabilities Assets

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Commercial in Confidence 18

Approaches to de-risking

Broadly three approaches which are not necessarily independent. 1. Funding level triggers: when the funding level hits a predetermined level, return- seeking assets are sold for matching assets. 2. Step de-risk: reduce market risk via a step change in investment strategy. For example, sell return-seeking assets for matching assets. 3. Calendar-year de-risking: de-risk the asset allocation from say 80% in return-seeking assets to 20% in return-seeking over a pre-determined time period. Involves selling growth assets for matching on an annual basis.

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Commercial in Confidence 19

60% 65% 70% 75% 80% 85% 90% 95% 100% 105% 110% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Benchmark Actual outcome

Approach 1: de-risking based on funding level triggers

Opportunities to de-risk when actual funding level is above the expected funding level

Opportunities to de-risk Funding Level

Years

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Commercial in Confidence 20

Approach 2 and 3: step change and gradual de-risk

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Risk (or expected return) Years

Current investment strategy risk (or expected return) Reduce risk / expected return via step change Relative to current investment policy, reduce risk

  • now. However, relative to step change, take more

risk now, and reduce risk later.

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Commercial in Confidence 21

Re-risking – to recover deficit?

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Commercial in Confidence 22

Re-risking – markets are cheap?

Change Strategic allocation?

200 400 600 800 1000 1200 GBP Millions Property bubble burst Global Recession Banking Crisis Eurozone crisis Property bubble burst Global Recession Banking Crisis Eurozone crisis Brexit Dotcom bubble burst

Liabilities Assets

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Commercial in Confidence 23

Innovation in buy-in/buy-out market

Source: bulk annuity insurers and Capita analysis

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Annuity cost versus gilt value of liabilities

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Summary

Why De-risk How to De-Risk When to De-Risk

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Commercial in Confidence 26

Questions?