10th November 2008The Art of Risk ManagementRisk Budgeting
Longevity RiskPractical Applications2• Trustees and sponsoring employers are much more risk-aware as a result of changes in both pensions regulation andaccounting requirements imposed on the sponsor.• Initially, focus was primarily on funding levels and, to a lesser extent, the volatility of employer contributions. This hasbeen extended to cover assets and liabilities as well as governance issues.• This focus on risk reinforces the need to understand and quantify the components and sources of the risks in detail,leading to the development of a risk management policy that:• Transfers un(der)rewarded risks;• Diversifies rewarded risks, and;• Accesses returns as efficiently as possible.Risk BudgetingExecutive Summary
"When we first introduced the levy, we tried to make it simple as itsimplementation represented a major challenge for us, particularly as we hadlimited information about the risks we were exposed to. We now have a farbetter understanding of those risks - and this has led to a recognition that weneed to achieve greater fairness when we calculate the levy.”The risk-based element of the levy will recognise “a schemes contribution to thelong-term risks that PPF faces, even from well-funded schemes”.-Martin Clarke, Director of Financial risk at the PPFRisk BudgetingFurther Regulatory Comment...and the PPF4
Risk BudgetingFinancial Services RegulationEven Financial Regulators Have Trouble Getting Risk Treated Seriously“If a year and a half ago, the FSA had wanted higher capital adequacy, moreinformation on liquidity, had said it was worried about the business models atBradford & Bingley and Northern Rock, and had wanted to ask questions aboutremuneration, the fact is that we would have been strongly criticised for harmingthe competitiveness of the City of London, red tape, and over regulation.”-Lord Turner, Head of FSA - FT 16/10 ‘085
Risk BudgetingIgnorance and DenialCosts of Ignoring Risk6"Surrender to the reality that volatility exists, or volatility will introduce you to thereality that surrender exists.”-Famed commodities trader Ed Seykota“The first step in the risk management process is to acknowledge the reality ofrisk. Denial is a common tactic that substitutes deliberate ignorance for thoughtfulplanning.”-Charles Tremper
“Know when to hold ‘em, know when to fold ‘em”Limit poker is a science, but no-limit is an art. In limit you are shooting at a target. In no-limit, the target comes alive and shoots back at you.- Crandall Addington, Texas Oil Millionaire7Risk BudgetingUnderstanding Risk
The Rules• Each player bets a minimum amount to get things going.• Then each player receives two cards. A player’s cards are for the player’s eyes only. An initialbet is placed by each player depending on the quality of these two cards. At this point youcan decide that you want out and fold.• The Flop: The dealer then places three cards face up in the middle of the table. Based onthese three communal cards and the two in your hand, you have a five card hand. Bettingthen takes place.• The Turn: The dealer turns over another single card. Another round of betting takes place.• The River: The dealer places a final card face up on the table.• Using the seven cards (5 communal and 2 cards known only to each player), bettingcontinues until everyone drops out, or the remaining player is called by one or more otherplayers.• The player with the best five card holding wins the pot.Risk BudgetingTexas Hold’em Poker8
?Confident?WHAT ARE THE PROBABILITIES?Risk BudgetingA Case Study – Limited Information?9?????
?Very Confident?WHAT ARE THE PROBABILITIES?Risk BudgetingA Case Study – Enhanced Data?10????
?95.2%4.76% 0%WHAT ARE THE PROBABILITIES? 11Risk BudgetingA Case Study – What You Would Like to Know
100% 0%0%POKER IS NOT A GAME OF CHANCE, IT IS A GAME OF PROBABILITIES12Risk BudgetingA Case Study – Probabilities Not CertaintyA Tail Event
Pension fund strategyALTERNATIVE ASSETSCASHRisk BudgetingA Case StudyEQUITIESBONDSPROPERTY13In the real world, the unexpected does happen and pension fundshave to be prepared...?%?%?%?%?%
1. List the main risks you have to consider when running your pension fund.2. Break down your risks into three categories:• Liability Risk;• Asset Risk;• Scheme Risk.Risk BudgetingUnderstanding Risk14What are your main risks?
In our last training session on Pension Funding Risks, trustees identified 13 risks:Liability risksAsset risksScheme risksRisk BudgetingUnderstanding Risk15What are your main risks?RiskInflationInterest RatesMortalityEquity Market RiskPropertyDuration Mis-MatchCreditCounterpartyReinvestmentLiquidityEmployer CovenantLegislation ChangesAdditional Cost from PPF
Risk BudgetingUnderstanding the Importance of Risk16
17The Flight PlanRisk BudgetingThe Flight Plan
Fully funded PensionScheme18Sponsor TrusteesThe End Game• Solve for Return toreach target fundinglevel;• Then solve forminimum risk.• Solve for Risk;• Solve for maximumreturn given risk;• Solve for probabilityof reaching targetfunding level.• Solve for Risk (employer covenant review);• Set risk budget using 3 lenses;• Seek to optimise risk adjusted return (Fuel Efficiency);• Be proactive in changing market conditions;• Apply regular risk monitoring and riskmanagement.Redington ApproachVirtuous CircleRisk ReturnFuel EfficiencyRisk BudgetingStakeholders Aims
Risk Budget• The total amount of risk that a scheme should run has to take account of the:• size of the scheme relative to the corporate – impact on balance sheet;• size of the deficit relative to the liabilities and the corporate sponsor;• strength of the employer (but bear in mind that corporate strength can change over adecade, year or even a month!);• number of years in which to pay off deficit;• nature of the scheme: e.g. open/closed, mature, young;• risk appetite of the employer;• balance between future contribution level stability and excess asset return to reducedeficit;• investment experience of the trustees.Risk BudgetingConsiderations of a Robust Risk Budget19
ContactsDawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 email@example.comRobert Gardner | Partner Direct: +44 (0) 207 250 firstname.lastname@example.orgRedington Partners LLP13 -15 Mallow Street London EC1Y 8RDTelephone: +44 (0) 207 250 3331www.redingtonpartners.comTHE DESTINATION FOR ASSET & LIABILITY MANAGEMENTContactsDisclaimerDisclaimer 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 discussionpurposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that theparameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appearabove are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressedherein 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 isindicative 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 executedtransactions should be treated as preliminary and subject to further due diligence .Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees actuarialadvisors. Redington Partners will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in thatestimation. Additionally, the client recognizes that Redington Partners does not owe any party a duty of care in this respect.Redington Partners are investment consultants regulated by the Financial Services Authority. We do not advise on all implications of the transactions described herein. Thisinformation is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers howsuch particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon asaccurate.21