Outline 2013


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Outline 2013

  1. 1. March 2013
  2. 2. 1Clear Goalsand Objectives1 3 52 4 6 7LDI and OverlayStrategiesLiquid MarketStrategiesLiquid and SemiLiquid CreditStrategiesIlliquid CreditStrategiesIlliquid MarketStrategiesOngoingMonitoringSEVENSTEPSRedington designs, develops and delivers investment strategies to help pension funds and their sponsorsclose the funding gap with the minimum level of risk. We take our clients through a rigorous 7 Steps to FullFunding™, which begins with laying out clear goals and objectives and assigning tasks and responsibilities.The second step is building an LDI Hub, or putting in place a risk management toolkit. Steps 3-6 involvecrafting the right investment strategy to fit the need using a full range of tools and bearing in mind thegoals and constraints of the scheme. Finally, ongoing high quality monitoring is essential to continually trackprogress against the original objectives and guide smart and nimble changes of course. Introduction 2Smoothing Over The Truth 3The Genius Of The AND Versus The Tyranny Of The OR 4Importance Of Carry To LDI Strategies 2 5Estimating The Equity Risk Premium 3 6Equity Replacement Strategies 3 7Risk Parity Rationale 3 8Commercial Real Estate Debt 5 9Monitoring Progress On The Run 7 10Dynamic Risk Management In Practice 1-7 11A Step Change in “Money Safe” Defined Contributions Saving 12Further Information and Disclaimer 13ContentsO U T L I N E March 2013ContentsSTEP PAGE
  3. 3. IntroductionGurjit DehlVice President, Education & Researchgurjit.dehl@redington.co.ukWelcome to the second edition of Outline, Redington’s quarterly collection ofthought-pieces designed to help institutional investors make smarter and moreinformed decisions.The next ten pages feature articles on the key topics and opportunities we thinkinstitutional investors should be considering as they aim to meet their goals,including our thoughts on the DWP’s smoothing consultation, alternatives to theEquity Risk Premium, risk-controlled strategies for DB and DC and an exampleof dynamic risk management in practice.We hope you find the articles interesting and helpful as you consider how bestto manage the risk-adjusted return of your portfolios.For more information on any the topics, please do get in touch.Kind regards,Gurjit DehlOUTLINE2O U T L I N E March 2013Introduction
  4. 4. We believe that the DWP’srecent call for evidence on“whether to smooth asset andliabilities in scheme fundingvaluations” versus marking-to-market goes to the heart ofthe pension risk managementdebate.To value a pension liability using smoothedassumptions is akin to diagnosing a patient basedon the average of the last few years of symptoms; itis highly unlikely to produce the correct diagnosis oran effective cure.A practical perspectiveThe most important argument against smoothingis that it may lead to further under-funding ofpension schemes, as sponsors seek to reducecontributions based on a smoothed valuation, andcontribution rates become de-coupled from market-based funding positions. This may be particularlydetrimental in an employer insolvency situation, ashaving a contribution schedule that is unrelated tomarket movements increases the likelihood of thescheme being underfunded on the PPF’s valuationbasis.Smoothing could encourage “gaming” of the system,either in choosing to adopt (or not) smoothingin the first instance, or when moving betweensmoothed/unsmoothed valuation bases (if this werepermissible) to select the most favourable basis.Smoothing may also create confusion as schemescould report funding positions that move contrarily tothe accounting valuation or to what may be expectedbased on market observations.One driver of the consultation is the AutumnStatement in which the Chancellor said that “theGovernment is determined to ensure that defined-benefit pensions regulation does not act as abrake on investment and growth”. However, DBpension liabilities represent an enormous liabilityto UK businesses, very substantially protected inlaw. It is unavoidable that these liabilities affectinvestment and growth, with or without changesto pension regulation. There are two main issuesarising from DB pension schemes that may act todeter investment into companies. First, a pensiondeficit represents company debt; smoothing wouldsimply mean that investors look to other sources,such as the accounting valuation, for an estimateof the debt. Second, where a deficit exists, itusually requires cash deficit repair contributions.“Smoothing” of cash contributions can be achievedby amending the deficit repair schedule, which isalready feasible under the current system.Importantly, it should be possible for trustees andtheir sponsoring employers to produce an investmentstrategy that runs an appropriate degree of risk (andhence an appropriate contribution volatility) versusthe strength of the employer. If schemes are insteadable to reduce contribution volatility by smoothing,there is less incentive to reduce risk economicallye.g. to “hedge” the liabilities. Worse, smoothingcould potentially introduce additional volatility intothe funding positions of well-hedged schemes,driving schemes to adopt riskier investmentstrategies than they otherwise would. It wouldbe wrong to penalise schemes that have actedprudently to manage their investment risk,in favour of schemes that have not.Smoothing Over The TruthKaren HeavenVice President, Investment Consultingkaren.heaven@redington.co.uk3O U T L I N E March 2013Overview
  5. 5. The Genius Of The ANDVersus The Tyranny Of The ORCurrent debate over DefinedBenefit (DB) pensions continuesto capture the attention of thepublic and press.Recent years have dealt lethal blows to the industry,and now, in 2013, despite the introduction of auto-enrolment and the consultation of the Departmentfor Work and Pensions about reassessing thevaluation methodology, we face two seriouschallenges:1 Repairing DB pension deficits and improvingmember security without harming thecommercial future of our corporates.2 Growing and securing an adequate andsustainable income in retirement for thosenot in a DB pension.As an industry, I believe we are on the wholetrapped in what Jim Collins describes in his book“Built to Last – Successful habits of visionarycompanies” as the Tyranny of the OR. Collinsdefines the tyranny of the OR as the rational viewthat cannot easily accept paradox, that cannot livewith two seemingly contradictory forces or ideasat the same time. The tyranny of the OR makespeople believe that things must be either A or B,but not both:- High cost pensions or less secure pensions- Investment returns or low risk- Risk or low return (See the PensionRegulator’s Trustee Tool Kit, which assumesrisk and return are linear)In order to fix the pensions problem, we mustinstead adopt what Jim Collins and Jerry Porrascall the Genius of the AND: the ability to embraceboth extremes. We can reduce risk of investmentunderperformance against liabilities AND maintainexpected return in order to reach full funding.We must flout the calls of naysayers and shootfor this ideal.Redington’s 7 Step Framework to Full Funding™allows pension funds to embrace the Genius ofthe AND, helping stakeholders to accomplishwith trustees and sponsors that which shouldnot, according to traditional standards, bepossible. The 7 step framework encouragesvision and creativity and yet is grounded inrobust, accountable and disciplined businessprinciples. It’s not about sitting around dreaming,it’s about planning and strategising for the bestcase scenario, in a world in which the best casescenario is allowed to exist, even within the harsheconomic environment that surrounds us.No doubt there is a great challenge inaltering our collective mindset; embracingnew ideas is not an easy task for any collectiveof professionals. But we must switch, and switchquickly.“ The test of a first-rate intelligence isthe ability to hold two opposed ideasin the mind at the same time, and stillretain the ability to function.One should, for example, be ableto see that things are hopeless andyet be determined to make themotherwise.”F. Scott Fitzgerald, The Crack-UpIn the pursuit of pensions and business goals, adualistic third approach of generating investmentoutperformance and managing risk is everpresent. The habit of making either/or decisionsleads to thinking in the realm of Black OR Whiteand Risk OR Return. If important decisions aremade through the tyrannical lens of OR, vision isinhibited, and progress is therefore hampered.Without dreaming up a goal that could be, it willnever be.Robert GardnerFounder Co-CEOrobert.gardner@redington.co.uk4O U T L I N E March 2013Overview
  6. 6. Importance Of CarryTo LDI StrategiesIt may seem counterintuitive,but it is possible to invest in lowyielding assets and generateattractive excess returns.Consider, for example, Japanese GovernmentBonds (JGBs). Since 2002, 10 year JGBs haveyielded a measly 1.22% p.a., but their total returnsexceeded yields by almost 1.00% p.a. with avolatility of just 3.88%. This equated to a return ofLIBOR +1.86% per year and in risk adjusted terms,this made JGBs very attractive assets indeed. If,for example, they were leveraged such that theirvolatility was 10%, then JGBs would have delivereda mouth-watering LIBOR +5.06% p.a. While someof their excess return resulted from further, smalldeclines in interest rates, much of it was generatedby what is known as carry, as JPY rates werealready low and stayed low over this period.In a fixed income portfolio, carry is defined as themark-to-market that results, assuming that nothingchanges in the market except for the passageof time. Carry is a function of the shape of theinterest rate curve. When the curve is upwardlysloping, as it is currently, the market is implyingthat interest rates are expected to rise in thefuture. If the expected rises occur and forward ratesare realised, then carry will be zero. If the expectedrises, on the other hand, do not materialise andforward rates are not realised, then carry will resultand depending on the steepness of the curve,it can be significant.Within the context of UK LDI, an interestingquestion to ask is whether carry can have thesame impact here as it has in Japan over thepast ten years. Our current situation certainlyshares similarities; banks are deleveraging,economic growth is weak, and gilt yields are “low”.And, not surprisingly, carry in the GBP interestrate markets is similarly high.In today’s market environment, most pensionscheme liabilities will grow due to carry, evenif interest rates do not fall further. Using the currentinterest rate curve, a typical pension schemeliability profile would grow on theorder of 2.5% per year as a result of carry.If the current interest rate environment persistsfor the next three years, this means that liabilitieswould have grown by almost 8% simply throughthe passage of time (service accrual and benefitdisbursements notwithstanding). Unless a schemeis hedged, this would represent a significantcost to its funding level.Up to now, LDI strategies have mostly beenassessed against a backdrop of declining,not static, interest rates. Given this, it is notsurprising that one of the most commonpush-backs on LDI as a strategy is a viewthat pension schemes should wait forrates to return to higher levels before hedging.Interest rates will eventually rise, but the 2.5%in annual carry cost, aka potential funding levelerosion, is a very expensive price to pay for theprivilege of waiting.John TownerDirector, Investment Consultingjohn.towner@redington.co.ukSTEP 52O U T L I N E March 2013
  7. 7. Estimating TheEquity Risk PremiumThe last ten years have not gonequite the way most textbookssaid they should have. Indeed,anyone estimating the equity risk“premium” based on the last tenyears would have to concludethat it was sizeably negative,around -3 percentage points.But in reality, the whole idea of the risk premiumis that it is uncertain. It’s the concept of chasingthe two in the bush instead of the one bird in thehand. But, clearly, sometimes that risk doesn’tpay off; the historical, realised risk premiumshould fluctuate wildly and sometimes be negativeeven over long periods.What is indisputable is that over the verylong term – 100 years, say – equities havespectacularly outperformed bonds. Between1900 and 2011, the UK was hit by the GreatDepression, nearly bankrupted by two worldwars, lost the Empire, and was then again struckby the recent recession; yet according to theBarclays Equity-Gilt Study 2012 focusing on thatperiod, the equity markets still showed a realisedinflation-adjusted risk reward of 300bps. For theUS, from 1926, the figure was 4.54%.However, using simplehistorical data toestimate the equityrisk premium has twoserious drawbacks.The first is that itdepends enormouslyon which time periodone chooses. Evenover long periods(10+ years), there issubstantial variation:The reason for this substantial variation is thedomination of a few extreme results within theequity return data. So five good years and onebad day can create a bad five years of returns. Toput this in context, Professor Javier Estrada fromIESE Business School finds that “Outliers havea massive impact on long-term performance.On average across all 15 markets [considered],missing the best 10 days resulted in portfolios50.8% less valuable than a passive investment;and avoiding the worst 10 days resulted inportfolios 150.4% more valuable”.The second problem is that using historicaldata means that any estimate of the equity riskpremium would be highest just before a marketcrash, and lowest before a rally. If one were touse the estimate to make investment decisions,the investor would be underweight for all the gooddays and overweight for all the bad days, losing alot of money as a result.In the long term, equities seem likely tooutperform bonds. As an investor, one may wellfeel they are worth the risk. But to any individualor pension fund dependent on earning thatpremium, the question becomes: “how reliant canyou afford to be on an estimate that you expectto be highly uncertain?” And, “is there a way I canearn these returns in a more reliable way?”Alexander WhiteAnalyst, ALM Investment Strategyalexander.white@redington.co.ukSource: Data, http://www.econ.yale.edu/~shiller/; Calculations, RedingtonFrequency of 10 Year Rolling Annualized Returns of US equities from 1871STEP 6O U T L I N E March 20133
  8. 8. Equity Replacement StrategiesEstimates of the Equity RiskPremium (“ERP”) vary fromgilts +3% to 5%. Can this beachieved using other assetclasses?ERP estimates depend on whom – and when – youask. Many studies produced over the last few yearshighlight the equity market’s failure to deliver itsexpected ERP. Evidence also shows how excludingthe best or worst months can have a dramaticimpact on returns.Most pension funds rely on equities as thebiggest contributor to expected return – the riskcontribution is even greater.Hence, increasingly trustees are asking: “What isthe equity risk premium?”, “Can I rely on it?”, and“Can I earn it more reliably?”We believe alternative assets can be found thatcan deliver equity-like expected returns morereliably, with no more risk. A classic opportunityarose in Q408/Q109 when investment grade creditspreads ballooned such that credit offered ERP-like expected returns. However, credit spreadshave tightened such that, today, it is doubtful ifeven high yield bonds could offer gilts +3% (net ofconservative expected default losses).What opportunities areavailable today?It turns out that there are many: starting with HighYield and Leveraged Loans, spread tighteningmeans that – net of (conservative) expected losses– HY cannot match a 3% ERP. Due to markedlysuperior recovery rates in default, leveraged loansremain a candidate.At first sight, a conservative trustee might baulk atthe idea of a sub-investment grade loan; however,analysis shows that the risk-adjusted expectedreturn is attractive relative to equities.Moving down in liquidity, we find senior, securedlending opportunities where banks have beenforced out of the market due to increased capitalrequirements (Basel III) and balance sheet costs.Specifically, commercial real estate lending andSME lending can conservatively match the 3% to5% ERP.Credit markets remain severely impacted by thefinancial crisis and ongoing bank balance sheetdeleveraging and, in skilled hands, the resultingdislocations can be “harvested”. The best long/short credit managers have demonstrated theirability to earn ERP-like returns with a fractionof the equity market volatility.Nearly all of the opportunities highlighted abovehave investment horizons of 3 to 7 years, whereasthe ERP is typically assumed to be earned overhorizons of at least 10 years. Pension schemestypically have an even longer investment horizon;does this raise any issues?Considering the importance of entry levels to ex-post ERPs, if you believe that you can “call” theequity market and get the right entry levels, thenthis could be an issue.However, given the massive impact of “outlying”days (i.e. the best and worst) and the difficultyof calling entry levels, we believe that diversifyinginto assets that offer a more reliable ERP-likereturn over a shorter horizon – irrespective oftiming of entry level – can benefit many pensionscheme portfolios.David BennettManaging Director, Investment Consultingdavid.bennett@redington.co.ukSTEP 7O U T L I N E March 20133
  9. 9. Risk Parity RationaleAttractive alternatives to capital-based allocations are gainingtraction. Risk Parity offers onerisk-controlled route for investors.Traditionally, investors have allocated assetsbased on capital values: 50% of a portfoliomay be in equities, 30% of it in bonds and 20%in other asset classes including alternatives. Whilethis seems to be a diversified portfolio,it is startlingly undiversified when viewed throughthe lens of risk. An average UKpension fund holding 44% of its assets in equitieshas portfolio risk overwhelmingly stemming fromequities: c.87% of total risk.This imbalance is not healthy; the portfoliobecomes beholden to the performance ofequities. Using 40 years of data, for a portfolioconsisting of 60% equities and 40% bonds, thecorrelation of yearly returns between the equitycomponent and the overall portfolio is 95%.For this reason, traditional balanced portfoliossuffered large drawdowns during the financialcrisis mirroring the performance of equities.Risk Parity – A SolutionRisk Parity strategies have gained prominencedue to their superior long-term risk-adjustedperformance, weathering the financial crisis betterthan traditional portfolios. Their aim is to balancerisk evenly across asset classes (most commonlyacross equities, bonds and commodities). Thisallows Risk Parity-based portfolios to perform ina variety of environments, and not just those inwhich equities perform well.As the risk levels of different asset classeschange, Risk Parity strategies reweight to maintainthe overall balance.The benefits to allocating by risk rather than bycapital value are plain. Risk Parity strategiesare more consistent performers as economicconditions change – the aim of true diversification.During the high inflation period of the ‘70s, whenequities and bonds both performed poorly, it wasa Risk Parity strategy’s exposure to commoditiesthat bolstered return while a traditional balancedportfolio would have foundered.A feature of many Risk Parity strategies is the useof leverage to increase risk to a level comparableto that of a traditional balanced portfolio (avolatility of about 10%). If a Risk Parity strategydid not use leverage, the overall risk would usuallybe too low for most investors, resulting in returnsbelow those required. In fact, investor aversion toleverage may be one of the key reasons for RiskParity outperformance. As many investors hesitateto use leverage, they typically overweight higher-risk assets, such as equities, in order to achievetarget returns. This leaves lower risk assetsrelatively undervalued and may explain why lowvolatility assets have tended to outperform highvolatility assets over the long-term. Risk Paritystrategies overweight these undervalued assets,providing a possible pathway towards sustainable,higher risk-adjusted returns (higher Sharpe ratios).In an increasingly risk-focused world, Risk Paritystrategies represent a powerful way for pensionfunds to achieve their funding goals with minimumrisk.Aniket DasAssociate, Manager Research Teamaniket.das@redington.co.ukSTEP 8O U T L I N E March 20133
  10. 10. The deleveraging of bankshas created an attractiveopportunity in the CommercialReal Estate Debt space.The media hype surrounding bank deleveraging isunlikely to subdue in the near future as Basel III,a regulation which places a number of significantconstraints on banks’ activity, is just round thecorner; it is scheduled to be introduced graduallyover the next six years. The new law focuses onthree main areas: introducing a minimum liquiditystandard, limiting leverage, and increasing thelevel of existing required capital buffers. Giventhese more stringent rules, particularly aroundminimum capital requirements, capital-intensiveassets like Commercial Real Estate Debt (CREDebt) are likely to shift towards non-bank capital,particularly insurance companies and definedbenefit pension funds.What is CRE Debt?CRE Debt consists of fairly illiquid, usually floatingrate loans backed by commercial real estate, suchas offices, retail, hotels, etc. The average termis 5 years and there are commonly penalties onprepayment. In the past, investors accessed someCRE Debt via their investment in CommercialMortgage Backed Securities. Nowadays however,due to regulation and lack of buyer appetite, thismarket has dried up.The OpportunityAt the end of 2010, outstanding European debtsecured by commercial property and due tomature in the following ten years amounted to€960bn, according to CBRE. Around 75% of thisis held on banks’ balance sheets, and just over40% matures in the three year period between2013 and 2015 (inclusive). Given the reluctanceof banks to offer refinancing, particularly at moreelevated loan-to-value (LTV) ratios, the borrowersare likely to face a significant funding gap.As a result of this gap, two key positive shifts inthe CRE lending market have occurred: first, thetypical LTV levels of the senior debt portion havefallen dramatically, from 75 to 80% all the waydown to 50% to 60%. Second, at the same time,the lending spread being charged on this seniordebt has widened from approximately LIBOR+ 50-80 bps to a range of 300-450 bps overLIBOR.Before 2007, such levels were hardly attainableeven on mezzanine finance. See diagram below.These two changes have driven a significantimprovement in the overall risk-adjusted returnavailable to lenders at the senior debt level. Ontop of all this, significant falls in real estate capitalvalues have already occurred over the past fewyears, lending covenants have been strengthenedsignificantly, and additional equity contributionsfrom real estate owners have increased. Investorsenjoy another layer of security, too, stemmingfrom the location of underlying property. Abouthalf of the outstanding European CRE debt issecured against real estate in core countries suchas UK and Germany.We believe that pension funds and otherinstitutional investors such as insurancecompanies are in a good position to exploit thisopportunity, reaping attractive risk-adjustedreturns by providing the necessary finance.Kate MijakowskaAnalyst, Manager Research Teamkate.mijakowska@redington.co.ukSource: MGCommercial Real Estate DebtTypical Capital Structure2007 OriginationEquity5 -15 %Mezzanine / B-noteSenior loan / A-noteLIBOR + 200-300 bpsLIBOR + 50 - 80bps75-80%2007Typical Capital Structure2010 OriginationEquityFall in property values-13.4% (vs 2007)15 - 20 %5 - 15 %5 - 15 %20-25 %Mezzanine / B-noteLIBOR + 700-1200 bpsSenior loan / A-noteLIBOR + 200 - 250bps60-65%2010Typical Capital Structure2012 OriginationFall in property values-11.8% (vs 2007)Equity20-30 %Mezzanine / B-noteLIBOR + 900-1300 bpsSenior loan / A-noteLIBOR + 500 - 800 bpsStretch - SeniorLIBOR + 300 - 450 bps50-60%20125 - 15 %STEP 9O U T L I N E March 20135
  11. 11. “Human beings can’t runa mile in under 4 minutes.It simply isn’t possible.”Sound ridiculous? It does now!But for a long time it was theconsensus.A mental model: an assumption about how theworld worked.A sub-four minute mile seemed like a physicalfeat that humans could not break. But in 1954Roger Bannister ran a mile in three minutes, fiftynine seconds and four milliseconds. Suddenly, inthe following three years, sixteen other runnersran a mile in under four minutes.Was there some breakthrough in humanevolution? No. The mental model changed.Could a similar mental model have affectedthe defined benefit pension industry?For decades, schemes focussed on assetsand failed to pay adequate attention to liabilities.The consequences are still being felt today, withmany schemes experiencing falls in fundinglevels as a result of lower interest rates andtheir impact on the value of liabilities. Pensionscheme trustees now face increased complexityin an uncertain economic outlook, volatile marketconditions and upcoming regulatory changes thathave rendered returns uncertain too.“Everything should be made as simpleas possible, but not simpler”.Albert EinsteinPension schemes can simply start the process oftaking control by agreeing and writing clear goalsand objectives. The document in which theseare laid out then becomes the foundation forany funding, investment and risk managementdecisions and actions.Clear goals and objectives allow the stakeholdersto move away from a traditional asset-basedframework to a risk-based asset and liabilityframework; all key factors are consideredsimultaneously and, vitally, all decisions arecompletely informed.Once stakeholders have clear goals, monitoringhow the scheme performs against those objectivesis key to continually attaining success. Qualitymonitoring should not only feature visual andnumerical analysis, but also explain in plain Englishwhat the analysis actually means so stakeholderscan make informed decisionsas a result.Regular quality monitoring lets stakeholdersfully understand the sources and drivers of riskand return by using critical components such asrequired return, funding level, liquidity and collateralrequirements. By fully understanding these keydrivers, stakeholders can assess investmentopportunities within the goalsand constraints of their particular fund, and assessthe impact of expected returns versus requiredreturns.  Alongside good governance, monitoring enableseffective action by providing a clear frameworkwithin which to make decisions. It informs byhighlighting the most relevant scheme metrics, andgood monitoring reports provide obvious signpostsfor immediate action. Clear goalsplus easy-to-understand monitoring forms a powerful blueprint for any investment committee,CIO or fiduciary manager to follow.  Unsurprisingly, pension schemes that havetaken the time to agree their objectives andregularly use good monitoring and reporting toolshave clearer accountability within their teams,and post better results. Decisions are taken in thecontext of agreed objectives, and are reassessedregularly to determine progress and be adjustedaccordingly. With the right monitoring tool in place,schemes are smart, nimble and more successful.Teresa NgoneVice President, Investment Consultingteresa.ngone@redington.co.ukMonitoring ProgressOn The RunSTEP 10O U T L I N E March 20137
  12. 12. Pension schemes are realisingthe unpredictability of financialmarkets and looking for ways tomanage its volatility while meetingtheir return requirements. Is therea way out?Here’s the story of a small pension scheme whichhas managed this exceedingly well by followinga disciplined and robust approach, delivering animpressive performance as a result.Turning back to the summer of 2008, the Schemewas close to being fully funded on a buyout basis,but still with over 90% of its assets invested inequities and less than 5% in bonds. By the timethe trustees knew about the Scheme’s excellentposition, it was too late. In September 2008,financial markets collapsed and the Schemesuffered a sharp deterioration in its fundingposition, so a buy-out was outof reach.The trustees became determined to take control ofthe situation and set up a framework to ensure thisdidn’t happen to them again. The first step was toset clear and realistic funding and risk objectivesfor the Scheme, then using this, to design asimple yet efficient investment strategy to achievethose objectives. The trustees adopted the use ofderivative instruments to achieve efficiencyand simultaneously put in place a dynamicde-risking programme to monitor the funding levelon a daily basis. They would move from risky assetsto matching assets as their funding level improvedbased on pre-set trigger and action points. Theyalso had a plan to consider re-risking if things wereto go bad.The initial set-up required time and effort but thewhole Trustee Board was more than willing toengage and work with the Sponsor and InvestmentConsultant to set up the framework and becomecomfortable with the dynamic process. Later,the de-risking programme was automated andoutsourced to their LDI manager.After one and a half years, the Scheme is nowmore than 10% better funded than if it had notimplemented this approach, with a funding levelwhich is fully protected against interest rate andinflation movements. It has also reduced its equityexposure from more than 90% to less than 10%.The conditions this Scheme faced are the same asany other. Some may say the Scheme had simplybeen lucky when making certain timely de-riskingand re-risking decisions. Maybe that was the case;however, the decision to re-risk or de-risk was notbased on “market sentiments” but a well-definedmetric we call “required return to full funding”.In recognition of its work, the Scheme has receivedthree well-deserved pension awards during thisperiod.Neha BhargavaVice President, Investment Consultingneha.bhargava@redington.co.ukDynamic RiskManagement In PracticeDe-Risking TriggersDe-Risking TriggerRe-Risking and refresh of triggers Review investment StrategyDe-Risking TriggersRe-Risking TriggersSTEP 11O U T L I N E March 20137654321
  13. 13. A Step Change in“Money Safe” DefinedContributions SavingAs traditional sponsor-backedfinal salary pension provisionin the UK fades into thebackground, greater focusis being placed on DefinedContribution (“DC”) arrangementsand how institutional investmentstrategies could be adapted tomeet the needs of individualpension savers.Historically, many DC schemes have adoptedconventional approaches to asset allocation whichfeature substantial capital weighted allocationsto equities. However, the volatility of equitymarkets in the last 15 years, driven by a seriesof substantial falls, has led to disappointingoutcomes for members.In order to help improve confidence inpensions saving, the Pensions Minister,Steve Webb, challenged the industry lastyear to think hard about the feasibility of providing“money safe” products.We have been incorporating the latestthinking on rules-based risk control into ourdefined benefit clients’ investment strategies.Commonly known as Volatility Control, thisapproach systematically reduces exposure tomarkets as their daily volatility increases andraises exposure as the daily volatility falls.In driving terms, it means easing your foot offthe accelerator when the conditions you faceget worse – rain, visibility, grip - and pressingdown again as conditions improve.Highly liquid and transparent, we believe thismethodology has great application for DC andcould be used to offer DC saversboth the potential for improved outcomes and theability to provide such “money safe” protectionon member savings pots, all in a cost efficientmanner.We believe this approach would offer three layersof risk protection for the member:- Risk control at the individualasset class level.- Risk control and diversificationat the total portfolio level.- Outright downside protectionon the total portfolio.By way of example, the graph below show thenet of fees results of traditional DC approaches,standalone risk controlled approaches and a“money safe” risk controlled approach. Thesecalculations are based on a simple model ofDC investment savings over the 25 year periodending 31 December 2012, with regular monthlycontributions starting at £150 per month,increasing steadily over time.Patrick O’Sullivan FIA CFAVice President, Investment Consultingpatrick.osullivan@redington.co.ukSummary of outcomes for various DC approaches12O U T L I N E March 2013STEP
  14. 14. If you would like more details on thetopics discussed, please contact yourRedington representative, the authoror email enquiries@redington.co.ukStay up to date withour latest thinkingwww.redington.co.ukDownload theRed AppMore RedingtonPublicationsDisclaimerIn preparing this report we have relied upon data supplied by third parties. Whilst reasonable care has been taken to gauge the reliability of thisdata, this report carries no guarantee of accuracy or completeness and Redington Limited cannot be held accountable for the misrepresentationof data by third parties involved. This report is for investment professionals only and is for discussion purposes only. This report is based on data/information available to Redington Limited at the date of the report and takes no account of subsequent developments after that date. It may notbe copied modified or provided by you, the Recipient, to any other party without Redington Limited’s prior written permission. It may also not bedisclosed by the Recipients to any other party without Redington Limited’s prior written permission except as may be required by law. In the absenceof our express written agreement to the contrary, Redington Limited accept no responsibility for any consequences arising from you or any third partyrelying on this report or the opinions we have expressed. This report is not intended by Redington Limited to form a basis of any decision by a thirdparty to do or omit to do anything.“7 Steps to Full Funding” is a trade mark of Redington Limited.Registered Office: 13-15 Mallow Street, London EC1Y 8RD. Redington Limited (reg no 6660006) is a company authorised and regulated by theFinancial Services Authority and registered in England and Wales.© Redington Limited 2013. All rights reserved.RRRRR13O U T L I N E March 2013Further Information and Disclaimer