Liability Driven Investing Andrew Welch
Liability Driven Investing <ul><ul><li>Is not just about buying lots of bonds </li></ul></ul><ul><ul><li>Is not just about...
Remember 2004? <ul><ul><li>Investment strategy: 70% Equities / 30% Bonds </li></ul></ul><ul><ul><li>Assumed return = 7% </...
Definitions of Risk <ul><ul><li>Measurable possibility of losing not gaining value </li></ul></ul><ul><ul><li>The volatili...
Funding Level ASSETS LIABILITIES FUNDING LEVEL
Typical Pension Fund Assets
Typical Pension Fund Liabilities <ul><ul><li>A set of guaranteed future cash flows </li></ul></ul><ul><ul><li>Mostly linke...
Sources of Volatility (£1bn) <ul><li>Exposure Sensitivity Annual Volatility Ann. Impact  (£m) (£m) Assets </li></ul><ul><l...
Are You Being Paid to Take Risk? <ul><ul><li>  Volatility Rewarded  Hedgeable </li></ul></ul><ul><ul><li>Equity market vol...
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 <ul><li>Large and unmanaged Liability Risks </li></ul><ul><ul...
A Better Approach? <ul><ul><li>Manage pension fund risk as you manage other financial risks </li></ul></ul><ul><ul><li>Opt...
Same Target Return but Less Risk Unintended by-product Consciously sought Manager Skill Equity 10.8% Inflation  20% Intere...
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...
Use of Swaps <ul><ul><li>Could construct physical bond portfolios to match liabilities </li></ul></ul><ul><ul><li>But cons...
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...
What does it look like in practice? Interest Rate Swaps Inflation Swaps
Notes <ul><li>WE WOULD ALSO POINT OUT: </li></ul><ul><ul><li>All features in this pack are current at the time of publicat...
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  • Hopefully, it’s clear from all of this that LDI is not all about: Eliminating all risk Locking-in current funding deficits Raising the long-term funding cost or, Investing in bonds LDI is about allowing the profile of the liabilities - their nature, term and magnitude - to directly influence the selection of appropriate investments and choice of suitable strategies. 1. The LDI priority is to eliminate unnecessary, unintended risks and, 2. To ensure that, where scheme’s do need to take risk, that it is taken in ways that introduce the minimum amount of additional risk relative to the liabilities. In short, LDI is not about whether to take risk but rather how best to take the RIGHT risks.
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    1. 1. Liability Driven Investing Andrew Welch
    2. 2. Liability Driven Investing <ul><ul><li>Is not just about buying lots of bonds </li></ul></ul><ul><ul><li>Is not just about locking in deficits </li></ul></ul><ul><ul><li>Does leave scope to seek additional returns </li></ul></ul><ul><ul><li>Is a new risk framework </li></ul></ul>But why do we need a new risk framework?
    3. 3. Remember 2004? <ul><ul><li>Investment strategy: 70% Equities / 30% Bonds </li></ul></ul><ul><ul><li>Assumed return = 7% </li></ul></ul><ul><ul><li>Portfolio return = 9.5% </li></ul></ul><ul><ul><li>Good news? </li></ul></ul><ul><ul><li>Start of 2004 funding level was 77% </li></ul></ul><ul><ul><li>End of 2004 funding level was 74% </li></ul></ul>Success at asset level ≠ success at fund level
    4. 4. Definitions of Risk <ul><ul><li>Measurable possibility of losing not gaining value </li></ul></ul><ul><ul><li>The volatility or variability of returns </li></ul></ul><ul><ul><li>For a pension fund – volatility in funding status </li></ul></ul>But what influences funding volatility?
    5. 5. Funding Level ASSETS LIABILITIES FUNDING LEVEL
    6. 6. Typical Pension Fund Assets
    7. 7. Typical Pension Fund Liabilities <ul><ul><li>A set of guaranteed future cash flows </li></ul></ul><ul><ul><li>Mostly linked to inflation </li></ul></ul>
    8. 8. Sources of Volatility (£1bn) <ul><li>Exposure Sensitivity Annual Volatility Ann. Impact (£m) (£m) Assets </li></ul><ul><li>Equity 700 1 15.5% 101 </li></ul><ul><li>Liabilities </li></ul><ul><li>Interest rates (1000) 20 yrs 1.1% (220) </li></ul><ul><li>Inflation (1000) 20 yrs 1.0% (200) </li></ul><ul><li>Longevity (1000) </li></ul>
    9. 9. Are You Being Paid to Take Risk? <ul><ul><li> Volatility Rewarded Hedgeable </li></ul></ul><ul><ul><li>Equity market volatility 10.0%   </li></ul></ul><ul><ul><li>Changes in interest rates 22.0%   </li></ul></ul><ul><ul><li>Changes in inflation expectations 20.0%   </li></ul></ul>
    10. 10. Volatility in Funding Level Impact on liabilities of significant changes in interest rates and inflation
    11. 11. Summary of the Problem Heavy reliance on Equity Risk Premium <ul><li>Large and unmanaged Liability Risks </li></ul><ul><ul><ul><ul><li>Interest rates </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Inflation </li></ul></ul></ul></ul>Volatile Funding Level
    12. 12. A Better Approach? <ul><ul><li>Manage pension fund risk as you manage other financial risks </li></ul></ul><ul><ul><li>Optimise risk allocation </li></ul></ul><ul><ul><ul><li>Remove unintended and unrewarded risk </li></ul></ul></ul><ul><ul><ul><li>Diversify sources of return </li></ul></ul></ul>Outperform other managers 10 years ago? Outperform these indices 5 years ago? Outperform our Liabilities The Future? GREATER FOCUS ON LIABILITIES
    13. 13. 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
    14. 14. Delivering a Smoother Path to the Funding Objective Funding level 110% 90% Traditional approach LDI TIME
    15. 15. 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
    16. 16. Use of Swaps <ul><ul><li>Could construct physical bond portfolios to match liabilities </li></ul></ul><ul><ul><li>But constrained by available bonds </li></ul></ul><ul><ul><li>And restricts ability to seek returns </li></ul></ul><ul><ul><li>Interest rate and inflation swaps: </li></ul></ul><ul><ul><ul><li>Offer the means to fine tune the match </li></ul></ul></ul><ul><ul><ul><li>Free up capital to seek returns </li></ul></ul></ul><ul><ul><ul><li>(Change the investment challenge to outperforming cash) </li></ul></ul></ul>
    17. 17. Translating Asset Relative Returns to Liability Relative Returns Swaps Assets Liabilities Extra Return Extra Return
    18. 18. 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
    19. 19. What does it look like in practice? Interest Rate Swaps Inflation Swaps
    20. 20. Notes <ul><li>WE WOULD ALSO POINT OUT: </li></ul><ul><ul><li>All features in this pack are current at the time of publication but may be subject to change in the future. </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>This document is intended for investment professionals only and should not be relied upon by private investors. No modifications or amendments to this presentation may be made without the prior permission of Insight Investment. The document is to be used by the intended recipient(s) only and the document may not be forwarded to a third party without prior consent from Insight Investment. </li></ul></ul><ul><ul><li>Depending on the investor’s currency of reference, currency fluctuations may adversely affect the value of investments and the income therefrom. </li></ul></ul><ul><ul><li>Past performance is not a guide to future performance. </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>Telephone calls may be recorded. </li></ul></ul><ul><li>ISSUED BY INSIGHT INVESTMENT </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>Notes for clients and prospects of Insight Investment Management (Global) Limited: Issued by Insight Investment Management (Global) Limited, Reg. No. 00827982. </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>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. </li></ul></ul>
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