On October 23rd, 2014, we updated our
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Measurable possibility of losing not gaining value
The volatility or variability of returns
For a pension fund – volatility in funding status
But what influences funding volatility?
Funding Level ASSETS LIABILITIES FUNDING LEVEL
Typical Pension Fund Assets
Typical Pension Fund Liabilities
A set of guaranteed future cash flows
Mostly linked to inflation
Sources of Volatility (£1bn)
Exposure Sensitivity Annual Volatility Ann. Impact (£m) (£m) Assets
Equity 700 1 15.5% 101
Interest rates (1000) 20 yrs 1.1% (220)
Inflation (1000) 20 yrs 1.0% (200)
Are You Being Paid to Take Risk?
Volatility Rewarded Hedgeable
Equity market volatility 10.0%
Changes in interest rates 22.0%
Changes in inflation expectations 20.0%
Volatility in Funding Level Impact on liabilities of significant changes in interest rates and inflation
Summary of the Problem Heavy reliance on Equity Risk Premium
Large and unmanaged Liability Risks
Volatile Funding Level
A Better Approach?
Manage pension fund risk as you manage other financial risks
Optimise risk allocation
Remove unintended and unrewarded risk
Diversify sources of return
Outperform other managers 10 years ago? Outperform these indices 5 years ago? Outperform our Liabilities The Future? GREATER FOCUS ON LIABILITIES
Same Target Return but Less Risk Unintended by-product Consciously sought Manager Skill Equity 10.8% Inflation 20% Interest Rates 22% Cash Credit Property Risk measured relative to the scheme’s liabilities Diversified active risk consistent with return objective. (risk ~4% p.a.) Manager Skill Property Credit and other risk premia Equity Inflation Interest Rates Consciously sought
Delivering a Smoother Path to the Funding Objective Funding level 110% 90% Traditional approach LDI TIME
Hedging the Financial Risks HEDGEABLE SOURCES OF RISK HEDGING INSTRUMENTS INTEREST RATES INFLATION GOVT. AND CORP. BONDS & INTEREST RATE SWAPS INFLATION-LINKED BONDS AND RPI/LPI SWAPS Liability Matched Portfolio Liability Matched Portfolio
Use of Swaps
Could construct physical bond portfolios to match liabilities
But constrained by available bonds
And restricts ability to seek returns
Interest rate and inflation swaps:
Offer the means to fine tune the match
Free up capital to seek returns
(Change the investment challenge to outperforming cash)
Translating Asset Relative Returns to Liability Relative Returns Swaps Assets Liabilities Extra Return Extra Return
Significantly Lower Funding Level Volatility Impact on liabilities of significant changes in interest rates and inflation Change in FUNDING LEVEL as interest rates and inflation change
What does it look like in practice? Interest Rate Swaps Inflation Swaps
WE WOULD ALSO POINT OUT:
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Unless otherwise stated, the source of information is Insight Investment. Any forecasts or opinions are Insight Investment’s own at the date of this document and may change. They should not be regarded as a guarantee of future performance.
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Depending on the investor’s currency of reference, currency fluctuations may adversely affect the value of investments and the income therefrom.
Past performance is not a guide to future performance.
Unit prices may go down as well as up, particularly in the short term. The value of an investment may fluctuate and cannot be guaranteed. Unless otherwise indicated, the performance of the pooled funds illustrated is calculated on an offer to offer basis with income reinvested and net of management charges.
Trading in derivative instruments may involve a higher degree of risk and there can be no assurance that the objectives of the portfolio will be attained.
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ISSUED BY INSIGHT INVESTMENT
Insight Investment Management (Global) Limited, Clerical Medical Investment Group Limited and Clerical Medical Managed Funds Limited are authorised and regulated by the Financial Services Authority and are part of the HBOS Group. All companies registered in England and Wales. Registered office 33 Old Broad Street, London EC2N 1HZ.
Notes for clients and prospects of Insight Investment Management (Global) Limited: Issued by Insight Investment Management (Global) Limited, Reg. No. 00827982.
Notes for clients and prospects of Clerical Medical Investment Group Limited: Issued by Insight Investment Management (Global) Limited on behalf of Clerical Medical Investment Group Limited. Clerical Medical Investment Group Limited, Reg. No. 03196171.
Notes for clients and prospects of Clerical Medical Managed Funds Limited: Issued by Insight Investment Management (Global) Limited on behalf of Clerical Medical Managed Funds Limited. Insight Investment Management (Global) Limited, Reg. No. 00827982. Clerical Medical Managed Funds Limited, Reg. No. 01580284.
Notes for clients and prospects of Insight Investment Management (CI) Limited: Issued by Insight Investment Management (CI) Limited. Registered Office St. Julian’s Court, St. Julian’s Avenue, St. Peter Port, Guernsey. Reg. No. 1518. Authorised and regulated by the Guernsey Financial Services Commission.