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Slides [ppt]

  1. 1. Liability Driven Benchmarks for UK Defined Benefit Pension Schemes Liability Driven Benchmark Working Party Alvar Chambers 21 June 2005
  2. 2. Liability Driven Benchmarks for UK Defined Benefit Pension Schemes <ul><li>Background </li></ul><ul><li>Types of Liability Driven Benchmarks </li></ul><ul><li>Implementation </li></ul><ul><li>Examples </li></ul><ul><li>Wider Issues </li></ul>
  3. 3. Background <ul><li>Trends in investment strategy </li></ul><ul><ul><li>Peer groups </li></ul></ul><ul><ul><li>Scheme specific benchmarks with market indices </li></ul></ul><ul><ul><li>Liability driven benchmarks </li></ul></ul><ul><li>Why move to Liability Driven Benchmarks? </li></ul><ul><ul><li>Maturing schemes, DC for new entrants </li></ul></ul><ul><ul><li>Equity bear market and falling bond yields </li></ul></ul><ul><ul><li>Market-based solvency & accounting standards </li></ul></ul><ul><ul><li>Myners </li></ul></ul><ul><ul><li>More sophisticated tools and liquid markets </li></ul></ul>
  4. 4. Background <ul><li>Alternative – buying out liabilities with an insurer </li></ul><ul><ul><li>Hedge mortality risk as well </li></ul></ul><ul><ul><li>May not be possible or cost may be prohibitive for many schemes, particularly if liabilities include deferred pensions </li></ul></ul><ul><li>Limitations of Liability Driven Benchmarks </li></ul><ul><ul><li>Significant uncertainty remains over mortality experience, other demographic factors </li></ul></ul>
  5. 5. Benchmarking Investment Risks 0% 2% 4% 6% 8% 10% 12% 14% 16% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Bond allocation Tracking error (%pa) Bonds Swap with no liability risk Source: Watson Wyatt LLP
  6. 6. Residual Demographic Risks Remain Bond allocation Source: Watson Wyatt LLP 0% 2% 4% 6% 8% 10% 12% 14% 16% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Tracking error (%pa) Bonds (total risks) Swap (total risks) Bonds (investment risk only) Swap (investment risk only)
  7. 7. Roles of Different Parties <ul><li>Trustees </li></ul><ul><ul><li>Responsible for investment strategy </li></ul></ul><ul><ul><li>Often not investment experts </li></ul></ul><ul><li>Actuaries/Investment Consultants </li></ul><ul><ul><li>Advice on asset allocation and implementation </li></ul></ul><ul><li>Investment Managers </li></ul><ul><ul><li>Management of assets within defined objectives </li></ul></ul><ul><li>Investment Banks </li></ul><ul><ul><li>Implementation of large transactions including derivative hedges </li></ul></ul>
  8. 8. Types of Liability Driven Benchmark <ul><li>Market Index </li></ul><ul><li>Immunised Bond Portfolio </li></ul><ul><li>Pooled Maturity Bucket Funds </li></ul><ul><li>Cash-flow Matching with Physical Bonds </li></ul><ul><li>Cash-flow Matching with Bonds and Swaps </li></ul>
  9. 9. Market Index <ul><li>Poor matching </li></ul><ul><li>Can split between fixed and RPI liabilities </li></ul><ul><li>No credit risk if gilts, but can use credit index </li></ul><ul><li>Easily investible, liquid benchmark </li></ul><ul><li>Can use mainstream pooled funds </li></ul><ul><li>Low cost </li></ul>
  10. 10. Immunised Bond Portfolio <ul><li>Match duration but not yield curve risk </li></ul><ul><li>Can split between fixed and RPI liabilities </li></ul><ul><li>No credit risk if gilts, but can use credit </li></ul><ul><li>Easily investible, liquid benchmark </li></ul><ul><li>Requires segregated portfolio (may be uneconomic for small schemes) </li></ul><ul><li>Low cost for larger schemes </li></ul>
  11. 11. Pooled Maturity Bucket Funds <ul><li>Fairly good matching within maturity buckets, can split fixed/RPI/LPI </li></ul><ul><li>May include credit exposure </li></ul><ul><li>Liquidity may be restricted </li></ul><ul><li>Increasing range of funds available </li></ul><ul><li>Low cost </li></ul>
  12. 12. Cash-flow Matched Bond Portfolio <ul><li>Good match out to limit of maturity of available bonds </li></ul><ul><li>Can split fixed/RPI liabilities, dynamic hedge for LPI </li></ul><ul><li>Can include credit exposure </li></ul><ul><li>Reasonable liquidity dependent on bonds used </li></ul><ul><li>Requires segregated portfolio </li></ul><ul><li>Cost/diversification restricts to larger schemes </li></ul>
  13. 13. Cash-flow Matched Bond & Swap Portfolio <ul><li>Very good match out to maturity of longest liquid swap </li></ul><ul><li>Can accurately hedge fixed, RPI and LPI liabilities </li></ul><ul><li>Counterparty risk, documentation issues </li></ul><ul><li>Can include credit exposure </li></ul><ul><li>Liquidity depends on bonds and swaps used </li></ul><ul><li>Requires segregated portfolio </li></ul><ul><li>Cost/diversification restricts to larger schemes </li></ul>
  14. 14. Types of Liability Driven Benchmark <ul><li>Choice of discount curve </li></ul><ul><li>Gilts vs swaps </li></ul><ul><li>Allowing for credit risk </li></ul><ul><li>What are the client’s investment objectives? </li></ul><ul><ul><li>No one right answer! </li></ul></ul>
  15. 15. Comparison of discount curves
  16. 16. Implementation <ul><li>Performance measurement and attribution </li></ul><ul><ul><li>A) Management against investible benchmark </li></ul></ul><ul><ul><li>B) Management against expected liability cash flows on defined discount rate </li></ul></ul><ul><li>Who takes responsibility for tracking error between investible portfolio and liability cash flows on agreed discount rate? </li></ul><ul><li>Frequency of benchmark review </li></ul>
  17. 17. Implementation including swaps <ul><li>Is scheme permitted to use OTC derivatives? </li></ul><ul><li>Legal documentation – ISDA/CSA </li></ul><ul><li>“ Umbrella ISDAs” </li></ul><ul><li>Counterparty risk and collateralisation </li></ul><ul><li>Pooled fund approach can make practical for smaller schemes </li></ul>
  18. 18. Examples <ul><li>Model Scheme – very simplified </li></ul><ul><ul><li>1,000 pensioners aged 60 </li></ul></ul><ul><ul><li>Level pension £4,000 pa payable in advance </li></ul></ul><ul><ul><li>PMA92C20 mortality </li></ul></ul><ul><ul><li>Investment data as at 8 April 2005 </li></ul></ul><ul><ul><li>Liabilities discounted off swap curve </li></ul></ul><ul><ul><li>Sufficient cash held to meet first year’s liabilities </li></ul></ul>
  19. 19. Examples - Gilt Index
  20. 20. Examples - Gilts Portfolio
  21. 21. Examples - Gilts and Swaps Portfolio
  22. 22. Examples
  23. 23. Examples <ul><li>Extension of model scheme example would add layers of complexity </li></ul><ul><ul><li>Choice of discount curve </li></ul></ul><ul><ul><li>Optimisation goals </li></ul></ul><ul><ul><li>Inclusion of credit, hedged overseas bonds, strips </li></ul></ul><ul><ul><li>Pension increases (fixed/RPI/LPI annual/LPI cumulative in deferment/other caps & floors) </li></ul></ul>
  24. 24. Wider Issues <ul><li>Incorporating active and deferred liabilities </li></ul><ul><ul><li>Greater uncertainty in liabilities </li></ul></ul><ul><ul><li>Cumulative LPI in deferment very complex </li></ul></ul><ul><ul><li>Salary inflation cannot be hedged </li></ul></ul>
  25. 25. Wider Issues <ul><li>Different types of inflation increases </li></ul><ul><ul><li>LPI (0,5) </li></ul></ul><ul><ul><li>LPI (0,2.5) for future accrual </li></ul></ul><ul><ul><li>GMPs (0,3) </li></ul></ul><ul><ul><li>LPI with higher cap (3,5) </li></ul></ul><ul><ul><li>Public sector RPI (0, infinity) </li></ul></ul><ul><ul><li>Bespoke hedge vs dynamic hedging for caps and floors </li></ul></ul>
  26. 26. Wider Issues <ul><li>Schemes with less than 100% solvency </li></ul><ul><ul><li>Hedge winding up/PPF benefits or total benefits? </li></ul></ul><ul><ul><li>Scale down liabilities to available assets (proportionate hedge or hedge fully for x years or combination) </li></ul></ul><ul><ul><li>Hedge whole liabilities e.g. using unfunded swap overlay for excess of liabilities over assets </li></ul></ul>
  27. 27. Wider Issues <ul><li>Incorporating active management into a Liability Driven Investment strategy </li></ul><ul><ul><li>Passive matching of benchmark, regular rebalancing </li></ul></ul><ul><ul><li>Active management of bonds/swaps portfolio vs benchmark </li></ul></ul><ul><ul><li>“ Portable alpha” </li></ul></ul><ul><ul><li>Retention of diversified beta risk </li></ul></ul><ul><ul><li>“ unconstrained long-term mandates” – are they true liability driven investment? </li></ul></ul>
  28. 28. Any Questions?

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