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Road to the End Game


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Road to the End Game

  1. 1. Teach-in Road to the End Game 17 September 2013 Road to the End Game: Terminal Portfolios and Buy-In / Buy-out 1
  2. 2. Teach-in Road to the End Game 17 September 2013 The End Game The End Game describes the position that a scheme aims to be in as it reaches maturity: • This may mean targeting a “Terminal Portfolio” i.e. a low-risk asset allocation or; • a buy-out or buy-in with an annuity provider The path to the End Game for most schemes will be a dynamic process: whilst a less mature scheme with a large deficit (and strong sponsor) may run a high-risk / high-return strategy, as the scheme’s funding position improves, it makes sense to take de-risking opportunities where the scheme can afford to do so This presentation is in two parts: • Road to the End Game and Terminal Portfolios • Buy-ins and Buy-outs with an annuity provider 2
  3. 3. Teach-in Road to the End Game 17 September 2013 Setting the Scene Open 33% Closed to new members 49% Closed to future accruals 17% Winding up 1% 3 Source: Pension Protection Fund “Purple Book” 2012. Excludes hybrid schemes Open 17% Closed to new members 52% Closed to future accruals 29% Winding up 2% More schemes are closing to new members and to future accruals... Distribution of Scheme Status (% of Schemes) 2012 Distribution of Scheme Status (% of Schemes) 2006
  4. 4. Teach-in Road to the End Game 17 September 2013 Setting the Scene 4 Overall, schemes are moving to lower risk asset allocations (lower equities, higher fixed interest)... Equities 61% Gilts & fixed interest 29% Property 4% Cash & deposits 2% Other 4% Source: Pension Protection Fund “Purple Book” 2012. Excludes hybrid schemes Equities 39% Gilts & fixed interest 43% Property 5% Cash & Deposits 5% Other 8% Average Asset Allocation in Total Assets 2006 Average Asset Allocation in Total Assets 2012
  5. 5. Teach-in Road to the End Game 17 September 2013 Setting the Scene 5 -0.6 0.0 0.6 1.2 1.8 3,000 4,000 5,000 6,000 7,000 FTSE 100 30yr Real Yield (%) Source: Bloomberg (chart 1), PPF “Purple Book 2012 (chart 2) 60% 65% 62% 58% 68% 67% 60% 0% 20% 40% 60% 80% 2006 2007 2008 2009 2010 2011 2012 2013 Funding Ratio – Full Buy out basis ? But most schemes are nowhere near fully funded on a buy-out basis
  6. 6. Teach-in Road to the End Game 17 September 2013 What do we mean by a Terminal Portfolio? • A Terminal Portfolio is a portfolio that enables a scheme to continue paying out member benefits without any deterioration to the funding level, until the very last benefit payment is made, or a buy-out occurs. • A Terminal Portfolio assumes the Scheme is fully funded on a prudent valuation basis • In addition, a Terminal Portfolio: • No longer requires deficit-repair contributions from the Sponsor; • Is fully interest rate and inflation hedged; • Will likely have exposure to liquid and/or illiquid credit to: • Fund the spread to Gilts (or Swaps) on the liability discount basis; and/or • Provide a sufficient buffer to underpin the residual risks in the scheme, for example longevity risk • The Terminal Portfolio is not implemented once the Scheme reaches full-funding. Rather, the Scheme’s current investment strategy should converge towards this Terminal Portfolio as the Scheme approaches full funding 6
  7. 7. Teach-in Road to the End Game 17 September 2013 Why think about the End Game now? 7 150 175 200 225 250 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Liabilities Assets Liabilities have risen Assets (Required Return after liability rise) 1. Required Return to reach full funding in 15yrs: Gilts + 2.50% 3. After liabilities have risen, Required Return on Assets is Gilts + 3.25% 2. Liabilities have risen • If liabilities rise, all else being equal, Required Return on Assets to meet full funding will rise; the closer the target full funding date, the greater the impact on Required Returns • It therefore makes sense to adopt an investment strategy that de-risks dynamically through time to give greater certainty around the path to full funding as the scheme matures: • As funding ratio improves, reduce reliance on less predictable sources of return e.g. equities, and allocate to assets with more predictable and less risky cashflows that better match the liability cashflows £m Illustrative Flight Plan Time Horizon
  8. 8. Teach-in Road to the End Game 17 September 2013 Objective Measurement Performance Indicators Performance (30 Jun 13) Status Primary Funding Objective To reach full funding by [2025] based on discount rate of Gilts + 1.00% (Technical Provisions basis) Expected Returns (ER) > Required Returns (RR) RR: Gilts + 275bps ER: Gilts + 200bps Difference: -75bps Secondary Funding Objective To reach full funding on a buyout basis by [2035] based on a Gilts Flat discount rate Expected Returns (ER) > Required Returns (RR) RR: Gilts + 250bps ER: Gilts + 200bps Difference: -50bps Risk Budget The investment strategy should not risk the deficit worsening by [20%] of liabilities over a 1 year period VaR95 < [20%] of liabilities VaR95: 30.0% Hedging Strategy Nominal/Inflation hedge ratio should be maintained within +/- 5% of the funding ratio. Funding Ratio (Gilts + 1.00%) 60% Nominal Hedge Ratio (Gilts + 1.00%) 20% Inflation Hedge Ratio (Gilts + 1.00%) 25% Collateral Maintain sufficient eligible for meeting collateral requirements that may arise from the Scheme’s current derivative positions over a 1 year period. Total available eligible collateral £300m Remaining collateral after VaR95 event £200m Road to the End Game: Setting Clear Goals and Objectives 8 Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away The first step is for all stakeholders to agree what the objectives are...
  9. 9. Teach-in Road to the End Game 17 September 2013 Constructing a Terminal Portfolio: What Required Returns should a Terminal Portfolio target? 9 1.Discount Rate 2.Buffer Target Required Returns Once a Scheme has reached full funding, the Required Returns needed to maintain this position will be: • The liability discount rate on which the Scheme has reached full-funding plus; • A buffer/margin to cover risks, such as: • Longevity Risk: the risk that members live longer • Underperformance of credit portfolio: risk that the credit allocation underperforms i.e. defaults • Reinvestment Risk: credit spreads tighten over time so the scheme can not achieve the same credit spreads in the future • Deflation: where a scheme has a large proportion of LPI floored liabilities, it is exposed to sustained periods of deflation • Other: expenses (advisors, legal, admin etc.)
  10. 10. Teach-in Road to the End Game 17 September 2013 Constructing a Terminal Portfolio The asset allocation of a Terminal Portfolio will depend on what the scheme is trying to achieve e.g. how certain does the scheme need to be that it will have no further need for sponsor contributions? • The higher the discount rate, the higher the returns needed to maintain full-funding; this implies more risk • The lower credit spreads are when the Scheme reaches full-funding, the higher the allocation to credit will need to be to generate sufficient expected returns • Note that these are not suggested portfolios. A Terminal Portfolio may also hold other (non-fixed income) assets 10 Liquid credit 70% Gilts / Swaps / Cash 25% Illiquid credit 5% Liquid credit 15% Gilts / Swaps / Cash 75% Illiquid credit 10% Illustration 1 - Full funding by 2035 - Credit spreads = 100bps - Discount basis = Gilts+50bps Illustration 2 - Full funding by 2035 - Credit spreads = 200bps - Discount basis = Gilts+25bps Illustrative Terminal Portfolio 1 Illustrative Terminal Portfolio 2
  11. 11. Teach-in Road to the End Game 17 September 2013 The Role of Credit 11 The Role of Credit Within a Scheme’s Asset Allocation
  12. 12. Teach-in Road to the End Game 17 September 2013 Illiquid Asset Universe 12 ILS: Insurance linked securities CTA: Commodity Trading Advisors ABS: Asset backed securities CRE: Commercial Real Estate Debt Illiquid Asset Considerations • Do incremental returns contribute to expected returns > required returns? • Interest rate / inflation hedge? • Impact on overall Scheme risk? • Is there still sufficient collateral to cover scheme requirements? • Do the returns compensate for the investment’s level of risk, illiquidity, complexity and governance? • Are there less complex opportunities available? • How is liquidity affected at the Scheme level? Can the Scheme afford to hold illiquid assets? • Scheme tolerance for fluctuations in funding ratio due to valuation of illiquid assets? Note: Above chart based on responses to a Redington survey
  13. 13. Teach-in Road to the End Game 17 September 2013 Further Considerations for a Terminal Portfolio 13 Why ? Further Considerations Liquidity In the absence of sponsor contributions, a scheme may rely largely on coupon payments, maturing assets and the disposal of assets to pay benefits; it is therefore important to manage the level of illiquid assets held that may be difficult to sell in the short-term However, long-dated illiquid assets will typically provide an attractive illiquidity premium while reducing reinvestment risk Collateral Collateral requirements will increase if the scheme uses unfunded instruments, such as swaps to reduce risk; emphasis should be on effectively managing these collateral requirements Reinvestment Risk As traditional credit is typically shorter-dated than scheme liabilities, where a scheme relies on credit for returns, it will be exposed to reinvestment risk (the risk that a scheme can not reinvest at the same credit spreads as when the bond was initially purchased); this may result in the scheme’s Expected Returns being lower than its Required Returns Allocation to long-dated credit reduces this risk (subject to no defaults) as it locks into current returns for longer Buy-Out Compatibility If a Scheme wishes to consider a buy-out in future, it should consider which assets are preferable to an insurer in the event of a buy-out
  14. 14. Teach-in Road to the End Game 17 September 2013 Ideally, a Scheme’s investment strategy should converge towards the Terminal Portfolio as the Scheme approaches full funding; this can be achieved systematically within a dynamic de-risking framework, for example: 1. Reduce interest rate and inflation risk by increasing hedging • Could be time-based i.e. level of hedge increased incrementally over time and/or; • Trigger-based i.e. increase hedge ratio as funding ratio rises to “lock-in” funding ratio improvements 2. Reduce allocation to “return-seeking” assets (e.g. equities) as and when funding level improves: • Where funding level improves, “Required Return” will fall, so the scheme can afford to reduce the level of Expected Return (by reducing return-seeking assets) – see chart below Dynamic De-Risking 14 0 100 200 300 400 500 60% 64% 68% 72% 76% 80% 84% 88% 92% 96% 100% Required Return Expected Return Spread over Gilts Funding Ratio
  15. 15. Teach-in Road to the End Game 17 September 2013 15 Dynamic De-Risking Case Study: The Journey of a Small Scheme Scheme 2008 2013 Comments Clear Funding Objectives   Pension Risk Management Framework Risk Budget   Reduced VaR from 30% to 15% Monitoring   Missed Buy-Out opportunity in 2008 Allocation to Equities 90% 0% Dynamic asset allocation Hedge Ratio 5% 90% Funding Level immunised to rates & inflation
  16. 16. Teach-in Road to the End Game 17 September 2013 Considerations for Terminal Portfolio vs. Partial Buy-in vs. Buy-out • What are the residual risks in the scheme? e.g.: • Longevity risk, credit risk, basis risks (e.g. discounting using a Gilts basis but hedging using swaps) • Counterparty risk of the annuity provider • What are relative costs of the solutions? • Dependent on level of risk being run • Market prices for solutions change over time • Does the scheme have an appropriate governance framework for the solution? • A dynamic de-risking strategy requires additional governance bandwidth • Implementation of buy-in / buy-out / longevity swap will require trustee / investment committee time 16
  17. 17. Teach-in Road to the End Game 17 September 2013 13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 Contacts 17 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 of market 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 be duplicated 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 other reference 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 . 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' actuarial advisors. Redington Ltd 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 that estimation. Additionally, the client recognizes that Redington Ltd does not owe any party a duty of care in this respect. Redington Ltd are investment consultants regulated by the Financial Conduct Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposes and 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 of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate. ©Redington Limited 2013. 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 should be made to Redington Limited at the address below. Redington Limited (6660006) is registered in England and Wales. Registered office: 13-15 Mallow Street London EC1Y 8RD Karen Heaven Director | Investment Consulting Direct Line: 0203 326 7134
  18. 18. Teach-in Road to the End Game 17 September 2013 Building Pensions SuperTeams 18 About the event What’s the difference between a SuperTeam and an average one? Why does creating the right team set the conditions to produce the best outcomes? And how can understanding the success of the Rolling Stones help pension schemes to achieve their goals? Pinsent Masons and Redington cordially invite you to learn the secrets of stellar performance from leadership and teamwork advisor, Khoi Tu, author of ‘SuperTeams’. We all work in teams, both within and across organisations, to solve complex issues such as repairing DB pension deficits or designing robust investment strategies for DC members. With inspiration and insight from some of the greatest teams in the world, we hope to give you the guidelines and protocols for success with your trustee board, your sponsor and your advisors. Agenda: 4.00pm Registration and Refreshments 4.30pm Welcome Address (Pinsent Masons, Redington) 4.40pm Presentation, Q+A (Khoi Tu) 6.15pm Drinks and Canapes Building Pensions SuperTeams Date: 14 Oct 2013 Time: 16:00 Venue: 30 Crown Place, Earl Street, London EC2A 4ES
  19. 19. 19 ROAD TO THE END GAME: TERMINAL PORTFOLIOS AND BUY-IN / BUY-OUT – AN INSURER’S VIEW 17 SEPTEMBER 2013 Michael Abramson – Co-Head of Business Development for Bulk Annuities and Longevity Insurance
  20. 20. INSURER PRICING FOR BUY-IN AND BUY- OUT. 20 20 Investment strategy Mortality Inflation expectations Reserving requirements Shareholder demands
  21. 21. ANNUITY INVESTMENT STRATEGY. 21 • Strategy varies from one insurer to the next • Credit LDI • Funding trade • Legal & General approach • Predominantly credit • Average rating: A • Currencies: GBP, USD, EUR • Appropriate duration • Diversification • Actively managed • Some gilt holdings for collateral • Increasing allocation to direct investments, e.g. sale and leaseback, infrastructure • Rates, inflation and fx hedging to match liabilities
  22. 22. DETERMINING SCHEME PRIORITIES. 22 • Hedge vs. Outperform annuity pricing • Hedge: Investing like an insurer • Which insurer? • Credit LDI strategy • Default risk; exposure to illiquid assets • Outperform • Requires a good knowledge of true market price • Timing is critical • Possible approaches: price tracking, “toe in the water”, pre- approval of contracts
  23. 23. MINIMISING TRANSACTION COSTS. 23 • In specie transfer generally based on overall insurer investment strategy • Gilts are generally simplest • Can transfer corporate bonds, although pooled funds may be tricky • Illiquid assets will require insurer due diligence • Swaps – can they be novated? • A hedged strategy with low exit costs may be more effective than focussing on in specie transfer
  24. 24. 24 APPENDIX
  25. 25. FSCS Statutory reserves (containing prudent margins above best estimate liability) Regulatory Capital Requirements Additional shareholder capital Regulator intervention • UK insurers are required to hold significant amounts of capital – Life insurers hold statutory reserves, which contain prudent margins above best estimate liabilities – Insurers must hold additional Regulatory Capital Requirements – Additional shareholder capital is held above Regulatory Capital Requirements • Additional protections – Regulator intervention to protect policyholders’ benefits – Financial Services Compensation Scheme (the “FSCS”) protection – FSCS covers at least 90% of benefits • Layers of policyholder protections Technical insolvency (c. 110% of best estimate) Capital Resource Requirement (c. 115% of best estimate) UK INSURANCE REGULATORY REGIME. 25
  26. 26. Michael Abramson Co-Head of Business Development, Bulk Purchase Annuities and Longevity Insurance direct: 020 3124 2978 mob: 07889 748927 email: CONTACT DETAILS. 26
  27. 27. This presentation contains confidential and proprietary information of Legal & General Group Plc (“L&G”). The presentation, and any opinions on financial products it contains, may not be modified, sold, or otherwise provided, in whole or in part, to any other person or entity without L&G's written permission. L&G makes no representations as to the accuracy or completeness of any of the information in this presentation and any liability on the part of L&G in relation to the inaccuracy or incompleteness of the information is excluded to the extent permitted by law. Nothing in this presentation amounts to an offer or promise.