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Understanding Modelling And Defined Benefit Pension Risk
1. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
Understanding, Modelling and
Managing Defined Benefit
Pension Risk
Oxford-Man Institute of Quantitative Finance
Wednesday 21st May 2014
1
2. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
Agenda
What is a Defined Benefit Pension Fund? 4
How do we Measure the Health of a Pension Fund? 5
What are the Different Stages of a Defined Benefit Pension Fund? 6
What are the Key Risks to a Pension Fund? 7
What are the Main Challenges to the Pension Industry? 8
How do we Measure the Risks to a Pension Fund? 10
How can a Pension Fund Measure and Hedge Risk? 11
What if? Stress Testing 13
How do you Combine Contributions, Investment Return and Funding
Date to fund a Pension Fund?
15
How can a Pension Fund Manage and Monitor its Risks in a single
Framework?
16
How does this Framework work in practice to determine Dynamic
Risk Management Actions?
17
Any Questions 18
2
6. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
What are the Different Stages of a Defined Benefit Pension Fund?
6
1,000
1,200
1,400
1,600
1,800
2,000
2,200
2,400
GBP Millions
Liabilities (Gilts Flat) Liabilities (TP Basis) Assets
Expected Return: Gilts +2.25%
Risk: 11.2%
Hedge Ratio: 35%
Expected Return: Gilts +1.62%
Risk: 6.5%
Hedge Ratio = Funding Ratio
Expected Return: Gilts +0.25%
Risk: 2.2%
Hedge Ratio = 100%
1. Managing the
Deficit
2. Preparing for
the End Game
3. Running Off the
Pension Fund
7. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
What are the Key Risks to a Pension Fund?
7
Liabilities
CovenantAssets
Equity
Credit
Manager Skill
Contributions (ยฃ):
Willingness to Pay
Ability to Pay
Longevity
Interest Rate
Inflation
Modelling
8. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014 8
What are the Main Challenges to the Pension Industry?
10. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How do we Measure the Risks to a Pension Fund?
Using Value at Risk
10
Funding Ratio at Risk
11. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How can a Pension Fund Measure and Hedge Risk?
Using Sensitivity Analysis
11
Interest Rate Sensitivity (PV01)
12. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How can a Pension Fund Measure and Hedge Risk?
Using Sensitivity Analysis
12
Inflation Sensitivity (IE01)
13. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
What if? Stress Testing
13
Impact on Deficit of Stress Test by Assets and Liabilities
15. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How do you combine Contributions, Investment Return and Funding Date to
fund a Pension Fund?
15
16. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How can a Pension Fund Manage and Monitor its Risks in a single Framework?
16
Objective Measurement Performance Indicators Performance RAG
Primary Funding
Objective
To reach 100% funded on a swaps flat
basis by 2026
Expected Returns (ER) > Required Returns
(RR)
RR: Libor + 300bps
ER: Libor + 200bps
Difference: -100bps
Investment Strategy
Actual Returns should exceed Expected
Returns
Actual Returns (AR) > Expected Returns (ER)
AR: Libor + 210bps
ER: Libor + 200bps
Difference: +10bps
Risk Budget
The investment strategy should not risk
the deficit worsening by ยฃ600mm over
a 1 year period
VaR95 < ยฃ600mm VaR95: ยฃ700mm
Hedging Strategy
Nominal and inflation hedge ratio
should be maintained within +/- 5% of
the funding ratio
Funding Ratio (swaps flat) 70% n/a
Nominal Hedge Ratio (swaps flat) 50%
Inflation Hedge Ratio (swaps flat) 85%
Collateral
Sufficient liquidity to make pension
payments and to cover margin calls
that may arise from derivative
positions.
Total available eligible collateral ยฃ900mm
Remaining collateral after VaR95 event ยฃ600mm
RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away
17. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014 17
How does this Framework work in practice to determine Dynamic Risk
Management Actions?
19. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
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19
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