P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012What to Ask of yourLDI Manager?Pete Drewienkiewicz27 September 20121
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Asset/Liability Management: Recap (i)2£Liabilities AssetsLDIManagerAssetManager 1AssetManager 2AssetManager 3AssetManager 4
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012SchemeLDI ManagerAdvisorAssetManager 1AssetManager 2AssetManager 3AssetManager 4Asset/Liability Management: Recap (ii)3£Liabilities Assets
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Good Governance: Ability to ACT4AgilityAs markets can be volatile,pension funds must have theagility to implementdecisions quickly.Good GovernanceControl TransparencySwift decisions are onlypossible with a solidframework which sets clearand reasonable goals.Setting a strong frameworkrequires a clear andtransparent understandingof the fund’s current assetand liability position.
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Control:The Pensions Risk Management Framework (PRMF)5Source: Redington.Objective Performance Indicators Actual PerformanceFunding strategyTo reach full fundingby 2020Funding ratio on IAS19 basis 85%Funding ratio on Gilts Flat basis 70%Expected returns inexcess of requiredreturnsExpected returns from currentinvestment strategyGilts + 300bpsRisk target1-year 1-in-20minimum worst-caseloss should notexceed 15% ofliabilities1-year 95% Value-at-Risk >%Aspirational targetTo be fully inflationand interest ratehedgedNominal hedge ratio <%Inflation hedge ratio <%Scheme constraintLiquidity & collateralrequirementsLiquidity: cash held sufficient to paytwo months of benefits£50mCollateral: available eligible collateralsufficient to meet potential collateralcalls on derivative positions>£500m
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012The Flight Plan6
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Improving LDI SophisticationIncreasing Capacity to ACT7LDI 1.0Liability ImmunisationLDI 2.0The LDI “Manager”LDI 3.0Holistic ALM• Interest rate swaps• Nominal gilts• Inflation swaps• Index-linked gilts• Gilt repo and TRS• Swaptions• Unfunded assetexposures• Corporate linkers• Sophisticated optionoverlays• Flight-plan consistentassets• Forward starting CDS?• Shift to fixed income• Static liability matchingpools• Focus on de-risking• Some active management• Much wider LDI toolkit• Evolution of trigger rates• Delegated opportunistictrades• Centralised collateral pools& credit risk management• Reinvestment risk?
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Agility:The LDI 3.0 Manager as “Quarterback”8
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Control:Managing Assets Against Liabilities9
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012LDI Strategy Case Study:Agility and ControlReplicate physical equity exposures withsynthetic instrumentsThe client is a large UK DB scheme (£3bn in liabilities) with an overall objective to reduce its risk.Purchase funded and unfunded hedginginstruments, including:• Forward-starting index-linked gilts• Index-linked gilts on asset swap• Inflation-linked US treasuries (“TIPS”)on asset swap• Zero-coupon inflation swaps• Index-linked gilt on TRS with nominalexposure hedged out using a mixture ofswaps and long gilt futuresReview major LDI managers and selectmost appropriate managerMeet weekly with new LDI manager torefine hedging strategyManage transition of assetsClient receives regular monitoring of hedgeratio, level of collateral held, etc.PROCESSPurchase long-dated assets with liabilitymatching and return-generating attributes:• Long-lease property• Social housing• PFI debt10
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012...Transparency?Agility?11
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012IMA and Risk LimitsCounter-partiesLeverageAssetAllocationCounterparty diversification constraintsinsufficiently robustIMA provides inadequate risk framework(e.g. based on simple tracking error limit)Loose controls often originate from outdated IMAs, agreed when risk limits were less stringently negotiated.InvestmentRisk LimitsPoor sector/issuer diversification acrossbond holdings and loose credit rating limitsLeverage limits of repurchase transactionsexcessively highTime£LiabilitiesHedgingConcentrating solely on tracking error canresult in a lack of understanding of howliabilities are hedged over the entire curve (seegraph)12
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Gold Standard LDI Risk Limits13Much greater confidence can beplaced in LDI managerRisk factor restriction for portfolioMaximumRisk LimitMinimumRisk LimitPV01 / IE01Total PV01 relative to liability BM 100% 80%Total IE01 relative to liability BM 100% 80%Differential between total PV01 andtotal IE01 20% -20%LPIMaximum overweight position in LPI(0,inf) IE01 relative to liability BM 100% 90%Maximum overweight position in LPI(0,5) IE01 relative to liability BM 100% 90%Z-SpreadTotal z-spread PV01 relative to liabilityBM 25% -10%Iota positioningTotal Iota PV01 relative to liability BM 25% -10%Sonia and basis restrictionsSonia swap PV01 exposure relative toliability BM 10% 0%3 month vs 6 month basis PV01exposure relative to liability BM 25% 0%Repo and TRSMarket Exposure 25% 0%Curve position relative to liabilitybenchmarkMaximumRisk LimitMinimumRisk LimitMaximum cumulative nominal PV01differential between buckets0 - 10 years vs 10 - 25 years 25% -25%10 - 25 years vs 25 + years 25% -25%25+ years vs 0 - 10 years 15% -15%Maximum cumulative real rate PV01differential between buckets0 – 10 years vs 10 - 25 years 25% -25%10 - 25 years vs 25 + years 25% -25%25+ years vs 0 - 10 years 15% -15%123Managers to report regularly of theirpositions within these limitsReduces probability of largeunidentified or unintended risksSource: Redington
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Gold Standard Governance FrameworkGold standardgovernanceframeworkoutlined inconsultationwith all threeparties.The aim is not to imposeartificial restrictions on anLDI manager or restrictcapacity.The aim is to enhanceunderstanding of the risksan LDI manager isrunning.Is the reporting frameworkadequate to monitorrisks?NO RISK LIMIT = NO REPORTSchemeLDI ManagerAdvisor14
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Conclusion: ACT15Your LDI manager can enhance your agility to identify andrapidly take advantage of market opportunitiesUse of an LDI manager can allow for more efficient liabilitycontrol, using external asset managers and asset classesFull transparency in the reporting andmonitoring framework ensures that LDIrisk limits are properly set and managed
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 201213-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.ukContactsPete DrewienkiewiczDirector | Head of Manager ResearchDirect Line: 020 3326 email@example.comRisk Management Firmof the Year (2011, 2012)Pension Consultant of theYear 2012http://twitter.com/redingtontweetsDisclaimerFor professional investors only. Not suitable forprivate customers.The information herein was obtained from varioussources. We do not guarantee every aspect of itsaccuracy. The information is for your privateinformation and is for discussion purposes only. Avariety of market factors and assumptions mayaffect this analysis, and this analysis does not reflectall possible loss scenarios. There is no certainty thatthe parameters and assumptions used in thisanalysis can be duplicated with actual trades. Anyhistorical exchange rates, interest rates or otherreference rates or prices which appear above arenot necessarily indicative of future exchange rates,interest rates, or other reference rates or prices.Neither the information, recommendations oropinions expressed herein constitutes an offer to buyor sell any securities, futures, options, or investmentproducts on your behalf. Unless otherwise stated,any pricing information in this message is indicativeonly, is subject to change and is not an offer totransact. Where relevant, the price quoted isexclusive of tax and delivery costs. Any reference tothe terms of executed transactions should be treatedas preliminary and subject to further due diligence .Please note, the accurate calculation of the liabilityprofile used as the basis for implementing anycapital markets transactions is the sole responsibilityof the Trustees actuarial advisors. Redington Ltd willestimate the liabilities if required but will not be heldresponsible for any loss or damage howsoeversustained as a result of inaccuracies in thatestimation. Additionally, the client recognizes thatRedington Ltd does not owe any party a duty of carein this respect.Redington Ltd are investment consultants regulatedby the Financial Services Authority. We do notadvise on all implications of the transactionsdescribed herein. This information is for discussionpurposes and prior to undertaking any trade, youshould also discuss with your professional tax,accounting and / or other relevant advisers how suchparticular trade(s) affect you. All analysis (whether inrespect of tax, accounting, law or of any othernature), should be treated as illustrative only and notrelied upon as accurate.Redington Limited (reg no 6660006) is a companyauthorised and regulated by the FinancialServices Authority and registered in England andWales. Registered office: 13-15 Mallow StreetLondon EC1Y 8RD16
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Appendix17
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Appendix 1:Multi-Manager Structures18Early adopters of LDIhave often built up largeexposures to onemanagerDiversifyingoperational risk canlead to fresh problems:• Inefficient use ofcollateral• Need for aggregatedreporting• Managers usingdifferent liabilitymodels• Managers compete toexecute tradesSchemeLDI Mgr2LDI Mgr1Custodian2BankCounterpartiesCustodian1Different LDI managers not netting off trades leads to trapped collateral
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Appendix 2:Counterparties and Collateral19Downgrading of swap counterparties inJune 2012 places counterparty risk oncentre stageVariety of opinions among LDImanagers regarding counterparty riskUse of ATE clauses within ISDAsRequire sufficient collateral to meet marginrequirements, but inefficient use will drag onperformanceImpact of central clearing on collateralrequirementsRehypothecation of collateralScheme CounterpartyCollateralCashflows
P. Drewienkiewicz What to Ask of your LDI Manager? 27 September 2012Appendix 3:Credit Spread and Gilt Yield Evolution20-1000100200300400500600bpsSterling IG 15+ Corporate Spread 20-Year Gilt Real Yield IG Spread + Real Yield
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