The Eurozone Crisis and UK Pension Funds


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The Eurozone Crisis and UK Pension Funds

  1. 1. Redington13-15 Mallow StreetLondon EC1Y 8RDT. 020 7250 Teach-InThe Eurozone Crisis and UK Pension Funds1st March 2012
  2. 2. Contents1. The Eurozone Sovereign Debt Crisis 32. Three Eurozone Scenarios 145. A Framework for Managing Risks 226. Contacts and Disclaimer 24
  3. 3. 3579111315Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12%1st Greek bailout agreed; €440bnEuropean Financial StabilityFacility (EFSF) establishedPortugal requests€77bn bailoutpackage from EFSFECB starts buying Italianand Spanish governmentbondsIreland receives€85bn bailoutpackage fromEFSFEurozone Periphery: 10-Year Government Bond Yields (1)(1) Calculated as un-weighted average of Italian, Spanish, Irish, Greek & Portuguese 10-Year yieldsSource: Redington, BloombergS&P downgradesGreek debt to“junk” statusEFSF given enhanced powersto buy government bonds &recapitalise banksGreece’s privatesector creditorsagree to 50%haircutS&P downgrades 9Eurozone countriesincluding FranceLTRO: ECB provides€490bn in 3-yearloans to banksThe Eurozone Sovereign Debt CrisisTimeline2nd Greekbailout and€107bnrestructuringagreed3
  4. 4. -1-0.8-0.6-0.4- 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 201212-month rolling Correlation between Equity Returns and Gilt ReturnsCorrelation[-1;1]As equities rise,yields on governmentbonds fall (pricesincrease)As equities fall, yieldson government bondsfall (prices increase)Periods of extreme marketstress: investors seek topreserve their capital.Source: Redington Calculations Based on the FTSE 100 total return and the FTSE Actuaries +15yr gilts total return indices 4The Eurozone Sovereign Debt CrisisEquity Returns vs. Gilt Returns
  5. 5. The Eurozone Sovereign Debt CrisisA Change of Focus• Peripheral government bonds perceived as lowrisk by investors• Underlying financial and economic problemswidely ignored• Manipulation of data (e.g. Greece’s “off balancesheet” actions)• Deficit and debt rules of the (first) Stability andGrowth Pact widely ignoredPre Crisis • Risk reassessed by investors - government bondyields rise• Focus on economic problems:• High levels of public debt / deficits,exacerbated by recession, falling tax revenuesand non-discretionary spending increasing(e.g. unemployment benefits)• Low economic growth and low externalcompetitiveness because of high wage costs• Lack of political will for reform• Systemic threats to the banking systemPost CrisisFinancialCrisisA Change of Focus5
  6. 6. 6Yields increaseAbility to (re)finance debt decreasesThe government has to paymore to service its debt.Risk of default increases,investors continue to sell.New EquilibriumCircuit BreakerAbility vs. willingness to payDefaultCredit risk vs. returnAusterity, central bank action,bailoutCycle of DebtThe Eurozone Sovereign Debt CrisisCycle of Debt
  7. 7. Maturity Profile – The European UnionThe Eurozone Sovereign Debt CrisisMaturity Profile – The European Union7Source: The Economist
  8. 8. PercentPercentofTotalDebtPercentofTotalDebtPercentofTotalDebtPercentofTotalDebtMaturity Profile – Southern PeripheryThe Eurozone Sovereign Debt CrisisMaturity Profile – Southern Periphery8Source: Thomson Reuters Credit ViewsItaly SpainGreece Portugal
  9. 9. Gov debt/GDP: 166% Gov debt/GDP: 121%Gov debt/GDP: 87% Gov debt/GDP: 83%Source: BBCPlease note thatfigures includegovernment andcorporate debt.Gov debt/GDPfigures as perSep 2011.The Eurozone Sovereign Debt CrisisWho Owes What to Whom?9Who Owes What to Whom?
  10. 10. 0100200300400Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12EUR GBP USD020406080100May 11 Aug 11 Nov 11 Feb 12EUR GBP USD 10Tensions in the Bank Funding MarketThe Eurozone Sovereign Debt CrisisTensions in the Bank Funding Market• The graphs on the right show thespread between 3-month Libor andthe 3-month Overnight Index Swap(OIS).• Essentially, Libor is uncollateralisedborrowing whereas the OIS is acollateralised transaction.• Consequently, the spread betweenthe two can be regarded as ameasure of the general stress inbank funding markets as it is ametric for how banks assess eachother’s creditworthiness.• If creditworthiness is perceived to below, higher rates will be demandedfor Libor transactions and the spreadwill therefore increase.Source: Bloomberg
  11. 11. Central Bank Intervention• ECB purchase of government bonds• LTRO: unlimited 3-year loans to banks at a fixed rate of 1%to address tensions in interbank funding and governmentbond markets (take-up of €489bn in December 2011,€530bn yesterday, 29 Feb 2012)Firewalls & Bailout Funds• European Stabilisation Mechanism (ESM), expected to beoperational from July 2012, with a lending capacity of€500bn to provide funding for Eurozone members unableto raise money in the bond markets• The ESM will replace the European Financial StabilityFacility (EFSF)Short-term SolutionsDebt Restructuring/Defaults• Greek bondholders accept “haircuts” of c.53.5% of thenominal value to bring the country’s debt to a“sustainable” level. Note that even after the restructuring,investors remain exposed to mark-to-market and creditlosses.Economic Reform• Fiscal austerity and structural reform, especially aiming atinternal devaluation (reducing labour costs to makeexports more competitive) and primary surpluses(government revenues higher than outlays before interestrate payments)• Revised Stability and Growth Pact with “quasi-automaticsanctions” for countries that break deficit rulesLong-term SolutionsSolutions (?)The Eurozone Sovereign Debt CrisisSolutions (?)11
  12. 12. The Eurozone Sovereign Debt CrisisGrowth in the ECB Balance SheetGrowth in the ECB Balance SheetSource: Federal Reserve, European Central Bank, Bank of Japan, Bank of England (via 12
  13. 13. • Are the firewalls/bailout funds big enough? Are countries like Italy or France credible financial backers of the bailout funds?• Will banks be able to raise enough capital to withstand the ongoing market turmoil? If they are not able to raise it in the markets,will governments be able to offer support?• Is the new Stability and Growth Pact credible?• How will the Long Term Refinancing Operation (LTRO) be unwound/rolled over in an environment of ongoing bank balance sheetdeleveraging?• Will core Eurozone members be prepared to offer support to the periphery on an ongoing basis? Will politicians be able to actquickly enough to prevent the crisis from spreading even further? Will the European Central Bank be prepared to intervene on anongoing basis?• How likely are other long-term solutions like Eurobonds? Are the proposed solutions sufficient?(Some) Open QuestionsThe Eurozone Sovereign Debt Crisis(Some) Open Questions13
  14. 14. Three Eurozone ScenariosAllocation A – A Typical UK Pension FundEquity,50.0%Index-linkedgilts,17.5%Corporatebonds,17.5%Property,10.0%Funds ofhedgefunds,2.5%Privateequity,2.5%Allocation A• Allocation A represents what we believe is a fairly typical assetallocation for a UK pension fund• Whilst there is some protection against movements in interest andinflation rates and a sizeable investment in fixed income, thelargest allocation is to equity and comparable asset classes (e.g.hedge funds)Key StatsExpected Return over Swaps 229bpsFunding Ratio 80.0%Net Interest Rate PV01 £1.78mInterest Rate Hedge Ratio 16.9%Net Inflation PV01 - £1.35mInflation Hedge Ratio 16.8%Value at Risk 95 (% of liabilities) 28.4%Expected returns are based on Redington’s in-house assumptionsTotal Assets: £800mTotal Liabilities: £1,000m14
  15. 15. Three Eurozone ScenariosFlight Plan AnalysisFlight Plan Analysis7508008509009501,0000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20£millionsYearsto full fundingLiabilitiesSwaps+ 275bps Swaps+ 196bpsSwaps+ 159bps15
  16. 16. 16Three Eurozone ScenariosAssumptionsScenario 1 Scenario 2 Scenario 3Background Hit by a continuing economiccollapse and spreading socialunrest, the Greekgovernment goes into adisorderly default. Concernsabout other peripheralEurozone members increaseto the point of panic.However, Greece remains inthe Eurozone.Deciding that the social andeconomic cost of continuingausterity are unbearable, thesouthern periphery (Italy,Spain, Portugal and Greece)leaves the common currency.The crisis continues to spreaddespite the combined efforts ofEurozone and internationalpolicymakers. Eventually, thecommon currency breaks apartwith member states re-introducing nationalcurrencies.Asset Assumptions Scenario 1 Scenario 2 Scenario 3Equities(MSCI World Index)-20% -30% -40%Credit Spreads(Bank of America/Merrill Lynch GBPNon-Gilt)+100bps +150bps +200bpsInterest Rates(GBP gilt/swap curve)-50bps -75bps -50bpsInflation(RPI swap curve)Unchanged Unchanged +50bpsThree Eurozone Scenarios16
  17. 17. Equity-linkedbond fund,30.0%Index-linkedgilts,25.0%Credit,15.0%Diversifiedgrowthfund,10.0%Socialhousing,5.0%Securedleases,5.0%Macrohedgefund,10.0%Three Eurozone ScenariosAllocation B – A More Efficient ApproachAllocation B• Allocation B represents what we consider to be a more efficientasset allocation. Expected Return is lower than for Allocation A, butexposure to risks should be reduced significantly.• The allocation to equities is significantly smaller than for AllocationA. New return-seeking assets and “Flight Plan Consistent Assets”*have been introduced and the allocation to index-linked gilts islarger.Key StatsExpected Return over Swaps 204bpsFunding Ratio 80.0%Net Interest Rate PV01 £0.43mInterest Rate Hedge Ratio 80.0%Net Inflation PV01 - £0.32mInflation Hedge Ratio 80.0%Value at Risk 95 (% of liabilities) 13.2%Hedging Swaps OverlayExpected returns are based on Redington’s in-house assumptions*Flight Plan Consistent Assets provide long-dated, relatively secure and inflation-linked cash flows at attractive returns and are a good match for pension liabilities.Total Assets: £800mTotal Liabilities: £1,000m17
  18. 18. 1%7% 0% 1%2%7%5% 10%13%0%5%10%15%20%25%30%35%40%45%50%PercentageofTotalLiabilities1%11% 1% 1% 1%21%8% 16%28%0%5%10%15%20%25%30%35%40%45%50%PercentageofTotalLiabilitiesThree Eurozone ScenariosInitial Risk AnalysisValue at Risk 95Minimal increase in thedeficit in a worst-case (1-in-20) scenario over the nextyearInitial Risk AnalysisMetric Allocation A Allocation BSingle Factor Stress TestChange in the deficit as aresult of stressing a singlerisk factor-160-211-142-10-250-200-150-100-500Equitiesdown40%Interestratesdown100 basispointsInflationratesup100 basispointsCreditspreadsup100 basispoints£millions-96-51-21 -24-250-200-150-100-500Equitiesdown40%Interestratesdown100 basispointsInflationratesup100 basispointsCreditspreadsup100 basispoints£millions18
  19. 19. 33433333322075-418-416-416-275-94-600 -400 -200 0 200 400 60041Y+31Y - 40Y21Y - 30Y11Y - 20Y0 - 10Y£ thousandsAssetsLiabilities4946896225-418-416-416-275-94-600 -400 -200 0 200 400 60041Y+31Y - 40Y21Y - 30Y11Y - 20Y0 - 10Y£ thousandsAssetsLiabilities-401-423-447-316-122502528559395153-800 -600 -400 -200 0 200 400 600 80041Y+31Y - 40Y21Y - 30Y11Y - 20Y0 - 10Y£ thousandsAssetsLiabilities-60-48-112-90-51502528559395153-800 -600 -400 -200 0 200 400 600 80041Y+31Y - 40Y21Y - 30Y11Y - 20Y0 - 10Y£ thousandsAssetsLiabilitiesInterest Rate PV01Change in the value ofassets, liabilities and deficitas a result of 1basis point(0.01%) move in interestratesInitial Risk AnalysisMetric Allocation A Allocation BInflation PV01Change in the value ofassets, liabilities and deficitas a result of 1basis point(0.01%) move in inflationratesNet: £1.78m16.9% hedgedNet: £0.43m80.0% hedgedNet: -£1.35m16.8% hedgedNet: -£0.32m80.0% hedgedThree Eurozone ScenariosInitial Risk Analysis
  20. 20. 75%80%78%73%80%77%70%80% 80%76%60%65%70%75%80%85%Equities Interest Inflation CreditspreadsScenario1 Scenario2 Scenario3Original FundingRatio (80%)Three Eurozone ScenariosScenario ImpactsSingle Factor Stress Test Single Factor Stress TestAllocation A Allocation BScenario Impacts – Single Factor Stress TestsImpact on DeficitImpact on FundingLevel-80-97-10-120-151-14-160-97-71-18-180-160-140-120-100-80-60-40-200Equities Interestrates Inflation Creditspreads£millionsScenario1 Scenario2 Scenario3-48-23 -24-72-36 -34-96-23-16-43-120-100-80-60-40-200Equities Interestrates Inflation Creditspreads£millionsScenario1 Scenario2 Scenario372% 73%79%68%70%79%64%73% 75%78%60%65%70%75%80%85%Equities Interest Inflation CreditspreadsScenario1 Scenario2 Scenario3Original FundingRatio (80%)20
  21. 21. Three Eurozone ScenariosScenario ImpactsAllocation A Allocation BScenario Impacts – Multifactor Stress TestsImpact on DeficitImpact on FundingLevel-190-291-366-400-350-300-250-200-150-100-500£millionsScenario1 Scenario2 Scenario3-90-135-195-400-350-300-250-200-150-100-500£millionsScenario1 Scenario2 Scenario365%58%53%50%55%60%65%70%75%80%85%Scenario1 Scenario2 Scenario3Original FundingRatio (80%)74%72%67%50%55%60%65%70%75%80%85%Scenario1 Scenario2 Scenario3Original FundingRatio (80%)21
  22. 22. A Framework for Managing Risks• Know your biggest risks• Set clear goals and objectives• Have your game plan ready• Importance of strong governance• Set realistic trigger levels for re-risking/de-risking• Integrate Flight Plan Consistent Assets (non-cyclical assetswith enhanced real returns)• Diversify sources of alpha and betaPension Risk Management FrameworkA Framework for Managing Risks• The results of the stress tests demonstrate the importance ofunderstanding exactly where a pension scheme’s risks lie and whatcan be done to monitor and manage them.• We believe that the most effective way is the Pension RiskManagement Framework – a clear, strategic and market-consistentapproach for identifying, monitoring and controlling your risks.22
  23. 23. Sample Pension Risk Management FrameworkA Framework for Managing RisksSample Pension Risk Management FrameworkObjective Triggers Performance Indicators Actual PerformanceWhat is the overall objective? Full funding on self-sufficiency basis By 2020 on a swaps + [50]bps basis withcontributionsof £[25]m p.a.How will we measure theobjective?Required return on the scheme’sassetsRequired return of assets is swaps +[160]bpsWhat are the primary risk targets? Required return at risk (RRaR)Contributions at Risk (CaR)RRaR < swaps +[200]bpsCaR should be kept below £[50]mWhat is the secondary risk target? Value at Risk (VaR) VaR should not exceed [20]% of theliabilitiesWhat are the primary aspirationaltargets?To be fully inflation and interest ratehedgedHedge ratios should be equal to [100%]What are the secondaryaspirational targets?Increase efficiency of hedges byearningmore return for same riskRegular monitoring of relative value ofswaps vs. giltsWhat is the primary schemeconstraint?Liquidity Sufficientliquidity to make pensionpaymentsWhat is the secondary schemeconstraint?Collateral requirements Enough available collateral to cover the1-year derivative [VaR95]Metric is at orabove targetMetric is within10%of targetMetric is morethan 10% awayfromtarget23
  24. 24. Disclaimer For professional investors only. Not suitable for private customers.The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety ofmarket factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can beduplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or otherreference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf.Unless otherwise stated, any pricing information in this message is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs.Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence .Redington Ltd are investment consultants regulated by the Financial Services Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposesand prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect oftax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate.©Redington Limited 2012. All rights reserved. No reproduction, copy, transmission or translation in whole or in part of this presentation may be made without permission. Application for permission shouldbe made to Redington Limited at the address below.Redington Limited (reg no 6660006) is registered in England and Wales. Registered office: 13-15 Mallow Street London EC1Y 8RDTHE DESTINATION FOR ASSET & LIABILITY MANAGEMENTContactsDirect Line: +44 (0) 20 3326 7147Telephone: +44 (0) 20 7250 3331Redington13-15 Mallow StreetLondon EC1Y 8RDDavid BennettManaging Director | Investment Management Firm of the YearDirect Line: +44 (0) 20 3326 7137Telephone: +44 (0) 20 7250 3331Redington13-15 Mallow StreetLondon EC1Y 8RDSebastian SchulzeAssociate | Investment Line: +44 (0) 20 3326 7102Telephone: +44 (0) 20 7250 3331Redington13-15 Mallow StreetLondon EC1Y 8RDGurjit DehlCreative Economist | Education &