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

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 How to De-Risk When to De-Risk Commercial in Confidence 2

Increasing Maturity of Schemes Commercial in Confidence 3

Cash Flow Needs Commercial in Confidence 4

Need to Eliminate Funding Issues Commercial in Confidence 5

How to De-risk Joined-up thinking… Sponsor Trustees Valuations / Funding • Member security • Impact on P&L • Employer’s views • Impact on b/sheet • Employer covenant • Costs: level & volatility • The end game? Understanding Objectives • Compliance/ running Risk and the Risk • TPR guidelines Employer Covenant Appetite costs • Risk management, • Risk budget including liability • Trustees ultimately in management Investment Strategy control / De-Risking Strategy … consider objectives and constraints of key stakeholders Commercial in Confidence 6

De-risking is Costly? Effect of Changing Financial Assumptions 11 £m 10.0 10 4% p.a. 9 8 6.8 7 6 5 4 Now 10 years Effect of Changing Financial Assumptions 11 £m 10.0 10 3% p.a. 9 8 7.4 7 6 5 4 Now 10 years Commercial in Confidence 7

Nominal Gilt Yield 2.50 2.00 1.50 Redemption Yield % Gilt Yield Curve 31-Dec-16 1.00 Gilt Yield Curve 31-Dec-17 0.50 0.00 0.5 5.5 10.5 15.5 20.5 25.5 30.5 35.5 -0.50 Maturity (Yrs) Commercial in Confidence 8

Real Gilt Yield -1.00 -1.50 Real Redemption Yield % -2.00 Gilt Real Yield Curve 31-Dec-16 -2.50 Gilt Real Yield Curve 31-Dec-17 -3.00 -3.50 2.50 7.50 12.50 17.50 22.50 27.50 32.50 37.50 Maturity (Yrs) Commercial in Confidence 9

Equity-Linked Bond Funds Efficient Use of Capital Physical passive equity can be replicated by holding “cash” & equity futures 100% cash 75% Gilts & 25% cash + + 100% equity futures 100% equity futures The end result is full equity exposure with the benefit of reduced duration mismatching against liabilities Commercial in Confidence 10

Equity-Linked Bond Funds 1. Example Plan Assets 2. Replace Equities with Bonds 3. Replace Equities with ELBFs Traditional Traditional Equities, Traditional Physical Bonds, 0% Bonds, 40% 40% bonds with Equity Traditional Futures Linked Bond Traditional Equities, Overlay Fund, 60% Bonds, 60% 100% Required Return* 2.0% Required Return* 2.0% Required Return* 2.0% Expected Return* 2.0% Expected Return* 0.0% Expected Return* 2.0% Liability Duration 25 yrs Liability Duration 25 yrs Liability Duration 25 yrs Asset Duration 8.8 yrs Asset Duration 16 yrs Asset Duration 13.6 yrs * In excess of Gilts * In excess of Gilts * In excess of Gilts • Assets are expected to achieve • Reduced interest rate risk • Reduced interest rate risk the required return through better duration match through better duration match • Considerable interest rate risk • Reduced expected return on • Maintained expected return on investments investments Commercial in Confidence 11

LDI: Illustrative impact of changes in market conditions £330,000 £330,000 pension bond £300,000 £300,000 liabilities portfolio pension bond £270,000 £270,000 liabilities portfolio pension bond liabilities portfolio £130,000 £100,000 investment investment £70,000 investment Commercial in Confidence 12

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 Commercial in Confidence 13

Matching liabilities with leveraged LDI funds Advantages Disadvantages Relatively simple and available in passive More costly than bond funds form Capital efficient: can hedge materially Leverage can mean you loose more more liability exposure than bond funds money than you would otherwise do if interest rates rise significantly Frees up capital for growth assets and Volatility in absolute terms can be rewarded financial risks difficult to understand Derivative markets increasingly costly to trade in due to bank and financial market regulations Commercial in Confidence 14

Alternative Strategies 35% Equity 50% DGF1 40% Bonds 20% LDI1 VAR VAR £21.4m1 £12.0m 1 Commercial in Confidence 15

Flight Plan Example Fully funded scheme, i.e. 80 GBP Millions assets equal to liabilities 70 60 50 40 Self-sufficiency liabilities 30 Total assets 20 10 0 Commercial in Confidence 16

When to de-risk Did tools exist in the noughties 1200 Assets 1000 Liabilities 800 GBP Millions 600 Brexit 400 Eurozone Eurozone crisis crisis 200 Banking Banking Property Property Crisis Crisis Global Global bubble bubble Recession Recession burst burst Dotcom bubble 0 burst Commercial in Confidence 17

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. Commercial in Confidence 18

Approach 1: de-risking based on funding level triggers Opportunities to de-risk when actual funding level is above the expected funding level Benchmark Actual outcome Funding Level 110% 105% 100% Opportunities to de-risk 95% 90% 85% 80% 75% 70% 65% Years 60% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Commercial in Confidence 19

Approach 2 and 3: step change and gradual de-risk Risk (or expected return) 3.5% Current investment strategy risk (or expected return) 3.0% 2.5% Reduce risk / expected return via step change 2.0% 1.5% Relative to current investment policy, reduce risk now. However, relative to step change, take more 1.0% risk now, and reduce risk later. 0.5% 0.0% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Years Commercial in Confidence 20

Re-risking – to recover deficit? Commercial in Confidence 21

Re-risking – markets are cheap? Change Strategic allocation? 1200 Assets 1000 Liabilities 800 GBP Millions 600 Brexit 400 Eurozone Eurozone crisis crisis 200 Banking Banking Property Property Crisis Crisis Global Global bubble bubble Recession Recession burst burst Dotcom bubble 0 burst Commercial in Confidence 22

Innovation in buy-in/buy-out market Source: bulk annuity insurers and Capita analysis Commercial in Confidence 23

Annuity cost versus gilt value of liabilities Commercial in Confidence 24

Summary Why De-risk How to De-Risk When to De-Risk Commercial in Confidence 25

Questions? Commercial in Confidence 26