Red views what lies beneath - the hidden cost of pension equity risk - march 2014


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Red views what lies beneath - the hidden cost of pension equity risk - march 2014

  1. 1. What Lies Beneath: The Hidden Cost of Pension Equity Risk March 2014 For Institutional Investors
  2. 2. 2 For Institutional Investors March 2014 Contents Situation A recent change to banking regulation brings pension risk to the fore 3 Problem Allowing for equity risk at a 99.5% 1-year risk level means reserving against quite extreme shocks 4 Implication Additional capital requirement can be lessened by capital protected equity strategies 5 Need Using a volatility controlled benchmark greatly reduces the cost of protecting an equity portfolio against large losses, while maintaining return expectations similar to a conventional equity portfolio 6 Source Data 12 About the Author 13 What Lies Beneath: The Hidden Cost of Pension Equity Risk
  3. 3. March 2014 For Institutional Investors 3 Situation A recent change to the banking regulatory landscape brought pension risk to the fore… On 29th November 2013, following a consultation, the Prudential Regulation Authority, responsible for the prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms, announced1 changes to the capital framework applying to UK banks and building societies, specifically with respect to defined benefit pensions risk. “The PRA has decided that firms should meet all Pillar 2A risks (5), including pension risk, with at least 56% CET1 capital from 1 January 2015 onwards. This matches the proportion of CET1 capital required for Pillar 1. In its consultation the PRA asked for views on whether Pillar 2A should be met in full with CET1 capital from 1 January 2016. In light of consultation responses, the PRA has decided that it will not require firms to meet Pillar 2A in full with CET1.” Source: The Bank of England1 Here, “pension risk” means the 1-year 99.5% Value-At-Risk (“VaR”) of the scheme assets relative to the liabilities. This is quite an onerous shock, for example for equities the 99.5% VaR would be around 2.5x the annual volatility of equities. The historic annual volatility of equities varies depending on the time period but is generally 16-20% per annum. The 99.5% VaR would also be nearly twice the 95% VaR which many pension schemes use for risk modelling. Pensions were already in the spotlight when it comes to banks’ accounting (see table 1) but the previous regulations required only a figure relating to the accounting deficit and agreed contributions be covered by tier 1 capital. Thus the risk of the scheme was not so important, this has now changed as a large proportion (56%) of the risk in the pension fund must be covered by high quality (“CET1”) capital. Table 1 : Number of times the word "pension" appeared in each bank's 2012 Annual report & Accounts Barclays HSBC Lloyds RBS Santander UK Word count for “pension” in 2012 report & accounts 59 107 183 163 199 This change signifies the latest in a series of efforts by regulators to tighten up banking capital regulations in the wake of the financial crisis of 2008 onwards. This seemingly small change can have deep and lasting effects on the way risk is measured and managed, and the capital banks must hold as a result. In this paper we analyse the most recent2 publicly available data on five UK banks (Barclays, HSBC, Lloyds, RBS and Santander UK). 1 2 For all the banks analysed, the most recent report & accounts available were for 2012. The pension position may have changed since this date Source: Individual Company 2012 Report & Accounts (see “Source data” section). Calculations: Redington
  4. 4. 4 For Institutional Investors March 2014 Problem Equity portfolios across the UK banks are considerable, and the 99.5% VaR used to determine the capital requirement is a large shock… Figure 1: Summary of Asset & Liability positions The Capital Requirement for Equities The capital charge is based on a 1-year 99.5% VaR estimate. There is no prescribed method for calculating this by the regulator, with each banking using their own modelling approach and calibration which are not publicised. The exact modelling approach and calibration used will affect the result of this calculation but one independent and public guide is the Solvency II standard formula, which gives an equity shock (base level) to determine the capital requirement of 39% for developed, quoted equities. For comparison, this is roughly equivalent to an annualized volatility of 16%. Redington’s own modelling produces a very similar result of a 38% equity shock. While each of the banks’ pension schemes will have other diversifying risks which makes the overall ALM VaR analysis more complicated, we can look at the new capital requirement arising solely from the equity portfolio simply by multiplying the capital charge of 39% by the £ size of the equity portfolio and then multiplying by 56%, that being the proportion of pension risk that is met with CET1 capital under the new regulation. Barclays HSBC Lloyds RBS Santander UK % Equity 26% 13% 41% 41% 27% Equity (£m) 6,265 2,129 12,450 10,812 2,026 Total Assets (£m) 24,096 16,380 30,367 26,370 7,503 Liabilities (£m) 25,407 17,999 31,324 30,110 7,554 - 5,000 10,000 15,000 20,000 25,000 30,000 35,000 £m Source: Individual Company 2012 Report & Accounts (see “Source data” section”)
  5. 5. March 2014 For Institutional Investors 5 Implication The high additional CET1 capital required to cover pension risk once equity risk is allowed for can be lessened by capital protected equity strategies … but these can often seem prohibitively expensive when applied to conventional equity portfolios Figure 2: Bank pension scheme equity holdings, VaR, current capital and pension adjustment • The increased CET1 requirements for equity risk (item 3 above) are large compared to the previous pensions adjustments to CET1 capital (for example those in the 2012 report & accounts). 3 Calculated as 39% of the amount held in equity 4 Calculated as 56% of the 1-year 99.5% VaR 5 Sourced from individual 2012 annual report and accounts – see source data section Barclays HSBC Lloyds RBS Santander UK 1. Equity holdings (£m) 6,300 2,100 12,500 10,800 2,000 2. Estimated 1-year 99.5% VaR (£m)3 2,400 830 4,900 4,200 790 3. Estimated CET1 Capital requirement equity-only (£)4 1,400 500 2,700 2,400 440 4. 2012 total CET 1 capital5 42,121 22,088 37,913 47,320 8,861 5. 2012 Pensions Adjustment to CET1 Capital (£m)4 2,445 1,218 1,438 913 52 Source: Individual Company 2012 Report & Accounts (see “Source data” section). Calculations: Redington
  6. 6. 6 For Institutional Investors March 2014 Need Using a volatility controlled benchmark greatly reduces the cost of protecting an equity portfolio against large losses using put options, while maintaining return expectations similar to a conventional equity portfolio Enter Volatility Control In previous papers we have introduced the idea of using a volatility controlled index to manage the equity portfolio6. This is an index that systematically adjusts its exposure to equity markets dynamically, in response to changes in the realised volatility of equities. This means that the index has a lower, and more constant level of volatility. Both our own work, and external studies7 find that a volatility controlled equity benchmark has delivered greater risk-adjusted returns than a static benchmark, over a wide variety of long-term time periods and equity indices. This means we can reasonably expect a similar level of return as a static allocation for a lower level of risk. Another consequence of reducing and controlling the level of volatility in an equity investment is the fact that put options on the value of the portfolio become much cheaper than on a static portfolio, which means that credible investment strategies can be adopted which embed this “hard floor” protection of the portfolio value on a rolling basis (see figure 3). Figure 3: Comparison of protection costs 1-Year protection level Current cost of protection on Global Equity Index (%) February 2014 Stressed market conditions cost of protection on Global Equity Index (%) Cost to Protect 10% Volatility Control portfolio (%) 90% 3.5% 6.5% 1.0% 85% 1.6% 4.8% 0.4% 80% 1.3% 3.5% 0.2% 6 Volatility Control : An Introduction CONTROL.aspx Volatility Control Taming the Beast: A Tale of Two Crashes 8243-9bcfdcc62d5b/Taming%20The%20Beast%20-%20A%20Tale%20of%20Two%20Crashes.aspx Volatility Control: The Hedgehog and the Fox fd8d1973f295/Taming%20The%20Beast.aspx 7 Guide Giese: The Optimal Design of Risk Control Strategy Indices (Journal of Indexes) Source: Redington, Investment Banks
  7. 7. March 2014 For Institutional Investors 7 While the capital reduction of implementing a volatility controlled benchmark (without capital protection) is model dependent (it does substantially reduce the 1-year VaR in our model as shown in figure 4, but this depends on how it is modelled), the capital reduction associated with a benchmark involving explicit downside protection should be much easier to demonstrate. Given the portfolio has protection in place at a certain level (90% say), and as long as this protection is maintained throughout the year and on a rolling basis, this level of protection should be reflected in a reduced capital requirement (see figure 4). Figure 4: Reducing Equity VaR using volatility control and put options 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 0% 10% 20% 30% 40% 50% ExpectedReturnoverswaps(bps) 1-year VaR 99.5% (% of notional exposure) Stage 1: Developed Market Equity Source & Calculations: Redington Stage 2: Developed Market Equity with Volatility Control Stage 3: Volatility Control with rolling 90% put option
  8. 8. 8 For Institutional Investors March 2014 Figure 5: Illustration of CET1 capital requirement reduction with volatility control + put option Barclays Lloyds HSBC RBS Santander UK Equity holdings (£m) 6,300 12,500 2,100 10,800 2,000 Estimated New CET1 capital requirement, equity risk only (£) 1,400 2,700 500 2,400 440 Estimated New CET1 capital requirement, replacing equity with volatility control + put option (£m)8 350 700 120 600 200 Change in Equity Only capital requirement from implementing volatility control (£m) -1,050 -2,000 -380 -1,800 -240 8 Volatility controlled equity includes annual put option with a strike of 90%. Capital charge calculated as 10% of the value of volatility controlled equity holding • This example focuses on equity risk in isolation, and so approximates a situation where other risks are either minimal or closely matched. In practice this will not be the case and the interplay between the other risks in the scheme will be a significant factor in determining the overall change in VaR, and hence capital requirement – this is discussed further below • The reductions in equity-only CET1 capital requirement from adopting a protected volatility controlled benchmark are substantial (the reduction is around 75%). • Figures above may not sum due to rounding Source: Individual Company 2012 Report & Accounts (see “Source data” section”). Calculations: Redington
  9. 9. March 2014 For Institutional Investors 9 Accounting for diversifying risks • So far, we have looked at the equity component of the capital requirement in isolation. In reality, the diversifying effects of other risks in the pension scheme, particularly unhedged interest rate risk will change the picture when viewed at the aggregate level • The extent of this will be depend on the individual assumptions and models that the banks use, which are not public. Further, it is not possible to tell exactly from the publicly available information the level of interest rate hedging that each bank has implemented within the pension fund • We can, however, make some approximate conclusions based on various assumptions. The most important modelling assumptions are the level of the interest rate shock, and the level of interest rate/equity correlation • The chart below shows the approximate percentage reduction in the overall capital requirement, for varying levels of liability hedge ratio. Each line depicts a different allocation to equities. The change in capital requirement reflects moving the entire equity portfolio from conventional equity to volatility controlled equity with put option
  10. 10. 10 For Institutional Investors March 2014 Figure 6: Reduction in capital requirement taking into account diversifying risks -80.0% -70.0% -60.0% -50.0% -40.0% -30.0% -20.0% -10.0% 0.0% ChangeinoverallCapitalrequirement Liability Hedge ratio Approx. Overall Capital reduction from applying protected volatility controlled equity 15% Equity 25% Equity 40% Equity How to read this chart: Each line represents a different level of equity allocation. The vertical axis tells us the approximate reduction in the overall capital requirement from implementing a capital protected volatility controlled allocation to equity (allowing for the diversifying effect of interest rate risk) at different levels of liability hedge ratio (along the horizontal axis). For example, for the 40% equity allocation, if the liability hedge ratio was 0% the overall capital requirement would be reduced by roughly 20% if the equity portfolio was changed to a volatility controlled benchmark with put option (grey line, left hand end). If the liability hedge ratio was then increased to 50%, for example by employing an increased interest rate matching overlay (moving to the right on the grey line) the reduction in overall capital requirement – from moving to volatility controlled equity plus put option - increases to around 35-40% (although the overall size of the capital requirement would also reduce). Notes: analysis takes into account equity and interest rate risk only. Correlation between bonds and equity assumed -0.2. Interest rate shock assumed to be a 1.2% fall in real yields. Assumed liability duration 20 years.
  11. 11. March 2014 For Institutional Investors 11 Conclusions • The latest change in regulatory landscape for banks and building societies brings pensions risk to the fore, requiring a more significant CET1 capital requirement for risks being run in the pension fund, including equity risk • The five schemes analysed represent more than £100bn of liabilities. The level of risk in each scheme is dependent on a number of factors, the most important being: – The proportion of assets invested in equities or other growth assets; – The level of liability hedging/matching undertaken • Looking at the capital requirement from the equity portfolios only, the new regulation points to a substantial increase in capital required, as the equity shock used to determine capital requirement is likely to be relatively high (although each bank’s methodology is not public) • In practice the interplay of the other risks in the scheme, particularly the unhedged liability interest rate risk will play a role in determining the reduction in capital requirement from employing volatility controlled equity • This effect is hard to quantify exactly as the specific assumptions and calibrations used by each banks modelling team will affect the result. We have however made an attempt to look at this affect approximately for a range of equity allocations and liability hedge ratios • We can draw two broad conclusions from this part of the analysis: – The capital reduction from employing volatility controlled equity with put option is more significant the greater the level of liability hedging already in place – However for equity allocation greater than 40%, a significant reduction in overall capital requirement can be obtained even at low liability hedge ratios – For low equity allocations of 15% or less, the benefits of adopting a capital protected equity strategy are likely to be small below liability hedge levels of 70%. Above this level the benefits begin to increase quite rapidly
  12. 12. 12 For Institutional Investors March 2014 Source Data Bank Source Barclays Barclay Bank PLC Annual Report 2012 pages 66, 212 blobheadername1=Content-Disposition&blobheadername2=MDT- Type&blobheadervalue1=inline;+filename%3D2012-Barclays-Bank-PLC-Annual- Report-PDF.pdf&blobheadervalue2=abinary;+charset%3DUTF- 8&blobkey=id&blobtable=MungoBlobs&blobwhere=1330696635849&ssbinary=tr ue Lloyds Annual Report and Accounts 2012 pages 49, 189, 272-4 dA_Interactive.pdf HSBC HSBC Group 2012 Annual Report & Accounts pages 82, 120, 133 content/content/pws/content/personal/pdfs/hbeu-2012-ara-final-online.pdf RBS RBS Group Annual Report and Accounts 2012 pages 381 - 383 2012.pdf Santander UK Annual Report and Accounts 2012 pages 84, 270 nnual%20report.pdf
  13. 13. March 2014 For Institutional Investors 13 About Redington Redington is committed to improving financial futures. We design, develop and deliver investment strategies for pension funds and insurance companies to help them to define and reach their goals, we work to help create a new pensions system for those currently saving and planning for retirement, and we run a financial education programme for young people. Our investment advice is more action-focused than many other consultancies, and we are not afraid to be innovative in the types of strategies we deliver. We take our clients through a rigorous 7 Steps to Full Funding™, and our three flagship clients are measurably better funded with less downside risk as a result of working through this. We were named Investment Consultancy of the Year by four separate award-giving bodies in 2013. We advise 50+ clients, eleven of the top 30 pension funds in the UK, and have over £300bn in assets under consulting. About the Author We would welcome the opportunity to discuss further. Please do get in touch to find out more. Dan Mikulskis Director, ALM & Investment Strategy • Dan joined Redington in June 2012 and is Co-Head of ALM. • Prior to this, Dan worked at Deutsche Bank in their Cross Asset Trading Group, where he focused on volatility trading and in- house systems development. • Earlier, he developed and tested quantitative tools to support portfolio management at Macquarie Funds Group. • Dan started his career as an Investment Consultant at Mercer. • He is a fellow of the Institute of Actuaries. Contact: +44 (0) 20 3326 7129
  14. 14. 14 For Institutional Investors March 2014