What are the Current Dynamics Driving UK Pensions Investment?
Redington13-15 Mallow StreetLondon EC1Y 8RDT. 020 7250 3331www.redington.co.uktwitter.com/redingtontweetsPensions Management Institute – Boosting Confidence in UK PensionsWhat are the current dynamics driving UK pensions investment?Robert Gardner, Redington22nd November 2011
2Liability Driven Investments (LDI)Maximise your toolset
A Chronology of LDI30-Year Gilt real yield & key events in LDI30.00.51.01.52.02.53.030-YearGiltRealYieldin%Boots Pension Fund shifts to 100% AAA long-dated sterling bond allocationDMO issues 50-year inflation-linked giltXYZ implementsdynamic de-riskingframeworkF&C launchesequity-linkedpooled bondfund30-Year Gilt Real Yield & Key Events in LDIInflation concerns elevated after oil price hits record $145per barrelFriends Provident implements firstderivative-based inflation and interestrate hedgeCollapse of Lehman Brothers, traditionalgilt/swap spread invertsBarclays Global Investors launchessegregated and pooled fundsfor LDISource: Bloomberg, Redington
A Chronology of LDIKey events in LDI4Boots pension scheme shifts out ofequities and into bonds2001Friends Provident hedges interestrate and inflation risk with swaps2003• Head of Corporate Finance, John Ralfe, recognises pensionfund liabilities are bond-like in nature• Allocation before rebalancing: 75% equities, 20% bonds, 5%cash• Allocation after rebalancing: 100% long-dated AAA sterlingbonds, half of which is inflation-linked• First non-bank to implement LDI hedging strategy• Locked in a 2.1% real yield on 30-year index linked gilts – thereal yield today is below 0.5%• Conventional wisdom at the time: “equities are the biggestsource of risk to a scheme’s funding level, and real yieldscannot drop below 2%”Lehman Brothers collapses and newopportunities arise2008• Lehman Brothers collapse shows robustness of collateralisedswaps that are easily transferred to other counterparties• Swaps are perceived as safer than gilts and the gilt/swapspread inverts• Pension funds can take advantage of spread dislocation andhedge via gilts instead of swapsXYZ Scheme engages in dynamic de-risking2010• Rising equities and improved financial market conditionsallows XYZ Scheme to de-risk• Triggers are pre-defined and linked to improvements infunding level, using a solid framework for decision-making• Due to de-risking, fund reaches a higher funding level withlower VaR compared to no de-riskingXYZ
• Having a clear game plan is essential for implementing effective strategies in a volatile environment: only when you know exactly what you want (andwhat you don’t want), can you make the decisions that enable you to reach your objectives.• We call this the Pension Risk Management Framework: a clear, concise and effective tool for making focussed investment decisions. It allows pensionfunds to evaluate each opportunity according to how it supports their progress towards full funding.• It can therefore be used to identify whether an LDI strategy fits a scheme’s individual requirements.Objective Triggers Performance Indicators Actual PerformanceWhat is the overall objective? Full funding on self-sufficiency basis By 2020 on a swaps + bps basis withcontributions of £m p.a.How will we measure the objective? Required return on the scheme’s assets Required return of assets is swaps +bpsWhat are the primary risk targets? Required return at risk (RRaR)Contributions at Risk (CaR)RRaR < swaps +bpsCaR should be kept below £mWhat is the secondary risk target? Value at Risk (VaR) VaR should not exceed % of theliabilitiesWhat are the primary aspirationaltargets?To be fully inflation and interest ratehedgedHedge ratios should be equal to [100%]What are the secondary aspirationaltargets?Increase efficiency of hedges by earningmore return for same riskRegular monitoring of relative value ofswaps vs. giltsWhat is the primary schemeconstraint?Liquidity Sufficient liquidity to make pensionpaymentsWhat is the secondary schemeconstraint?Collateral requirements Enough available collateral to cover the 1-year derivative [VaR95]Metric is at orabove targetMetric is within10%of targetMetric is morethan 10% awayfrom targetThe Pension Risk Management Framework (PRMF)The Pension Risk Management Framework
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020GBPMillionsLiabilities Path Actual Liabilities Assets Path Actual AssetsLiability BasisContributions & Asset ReturnsTime HorizonThe Flight Plan is an effective tool for making focussed LDI decisions and identifyingthe best opportunities.Together with the PRMF, it allows schemes to identify the strategies that will providethe most support for making progress towards full funding.Flight PlanFrom ‘set and forget’ to ‘anticipate and recalibrate’7The Flight Plan• Maps out the path of ascheme’s assets andliabilities from theircurrent position to fullfunding• Requires three keyvariables to build: theassumed rate of returnon assets, the cashcontribution schedule,and the target date forfull funding.
10Growth“FlightPlanConsistentAssets”MatchingFlight Plan Consistent AssetsKey features
11-6-4-2024680 5 10 15 20 25 30GBPMillionsYearsInitial investmentAttractive realreturnsInflation-linkedcashflowsProviding a matchfor liabilitiesInflowsOutflowsSource: RedingtonFlight Plan Consistent Asset – Example Cashflow ProfileFlight Plan Consistent AssetsKey featuresKey CharacteristicsFlight PlanConsistent Assets• Offer a particularlyefficient means ofachieving LDI.• Enable schemes toaccess attractive realreturns and long-datedinflation-linked cashflows .Key CharacteristicsAttractive real returns and inflation-linked cashflows High-quality, often secured cashflowsIlliquid Varying degrees of complexity/might be difficult to access
• Take advantage of attractive yields on long-term secured propertyleases• Yields may be in excess of yields on corporate bonds issued bysame borrower• Long-dated index-linked cashflowsSecured Leases• Ground rent created when freehold land or building is sold on longlease• Typically “pepper-corn” rent for land only (not buildings)• Offers attractive returns, limited credit risk and high level ofsecurityGround Rents• Low-cost rental housing provided for disadvantaged people inneed of housing• Generally provided by local councils and housing associations• Offers long-dated, inflation-linked cashflows from securedborrowers (i.e. housing associations) with quasi-governmentguaranteeSocial Housing• Investing in public sector projects through, for example, PrivateFinance Initiatives (PFIs), bespoke investments structures or bypurchasing a suitable infrastructure asset• Wide range of possible assets, from roads to power generation• Long-term, potentially inflation-linked revenue streamsInfrastructureFlight Plan Consistent AssetsExamples
Social Housing: Risk profileFlight Plan Consistent AssetsSocial housing• The diagram shows a typicalsocial housing portfolio for apension fund investor with ablended real return of ca. 3-4%p.a.• The portfolio consists of differenthousing types with specificrisk/return profiles.• By adapting the share of thedifferent housing types in theportfolio, an investor can tailorthe portfolio’s return and the riskcharacteristics so that they fitrequirements.Social Housing is typically a low-risk asset class but the returnsand the risk on a portfolio can be tailored (to some extent) tomeet pension funds’ requirements.13Source: Evolution Securities, Redington
• Bought by HSBC in August 2011 (for warehousing)for £74m• Provides water for 300,000 people in Cambridgeshire• 2010/2011: Revenue of £20m with profits of £7mbefore tax with no external debt except for a revolvingcredit facility to cover working capital• Attractive purchase opportunity for a large pension fund or aconsortium of funds• Redington advised two UK schemes who bid for this asset. However,although this bid was acceptable on price, it could not compete withthe winning cash bid which had an accelerated timetable and no duediligenceFlight Plan Consistent AssetsWater infrastructureExample: Tapping the illiquidity premium in waterThe UK water sector is an excellent example of a Flight PlanConsistent Asset, providing the security, returns and cashflowsthat pension funds need.• Economic environment has small impact on returns:water is a necessity and will therefore be demandedirrespective of economic growth.• Inflation-linked cashflows and returns: water companies’regulatory regime means they can increase prices in linewith the agreed price review which in turn is based on aformula related to RPI.• Low regulatory risk: The regulator’s desire to increasecompetition in the area could have a negative impact onreturns but the Government is likely to block any suchmove.Water sector: key characteristicsCase study: Cambridge Water14
Redington Publications15Spring Collection Highlights: LDI 2.0, Secured Leases,Ground Rents, Equity Release Mortgages, SocialHousing, Insurance-Linked Securities, Infrastructurehttp://www.redington.co.uk/Redington/media/PDFs/knowledge/Other%20Publications/Redington-Spring-Collection-2010.pdfSpring/Summer 2011 Collection: Enhanced Matching Assets,Socially Responsible Investing and Long-Term Growth Assetshttp://www.redington.co.uk/Redington/media/PDFs/knowledge/Other%20Publications/Redington-Spring-Summer-Collection-2011.pdfKeeping up with the latest in LDIRedington publications