The document provides an outline for Redington's quarterly publication called "Outline" which features thought pieces on key investment topics for institutional investors. The March 2013 issue includes articles on: 1) Arguments against smoothing asset and liability valuations for pension schemes. 2) The importance of considering both risk and return, rather than an "either-or" approach, when developing investment strategies. 3) How carry, or the mark-to-market impact of the passage of time, is an important factor for liability driven investment strategies given current low interest rates. 4) Challenges with relying on historical estimates of the equity risk premium to inform investment decisions. 5) Potential alternatives

1. March 2013

2. 1
Clear Goals
and Objectives
1 3 52 4 6 7
LDI and Overlay
Strategies
Liquid Market
Strategies
Liquid and Semi
Liquid Credit
Strategies
Illiquid Credit
Strategies
Illiquid Market
Strategies
Ongoing
Monitoring
SEVEN
STEPS
Redington designs, develops and delivers investment strategies to help pension funds and their sponsors
close the funding gap with the minimum level of risk. We take our clients through a rigorous 7 Steps to Full
Funding™, 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 involve
crafting the right investment strategy to fit the need using a full range of tools and bearing in mind the
goals and constraints of the scheme. Finally, ongoing high quality monitoring is essential to continually track
progress against the original objectives and guide smart and nimble changes of course.
Introduction 2
Smoothing Over The Truth 3
The Genius Of The AND Versus The Tyranny Of The OR 4
Importance Of Carry To LDI Strategies 2 5
Estimating The Equity Risk Premium 3 6
Equity Replacement Strategies 3 7
Risk Parity Rationale 3 8
Commercial Real Estate Debt 5 9
Monitoring Progress On The Run 7 10
Dynamic Risk Management In Practice 1-7 11
A Step Change in “Money Safe” Defined Contributions Saving 12
Further Information and Disclaimer 13
Contents
O U T L I N E March 2013Contents
STEP PAGE

3. Introduction
Gurjit Dehl
Vice President, Education & Research
gurjit.dehl@redington.co.uk
Welcome to the second edition of Outline, Redington’s quarterly collection of
thought-pieces designed to help institutional investors make smarter and more
informed decisions.
The next ten pages feature articles on the key topics and opportunities we think
institutional investors should be considering as they aim to meet their goals,
including our thoughts on the DWP’s smoothing consultation, alternatives to the
Equity Risk Premium, risk-controlled strategies for DB and DC and an example
of dynamic risk management in practice.
We hope you find the articles interesting and helpful as you consider how best
to manage the risk-adjusted return of your portfolios.
For more information on any the topics, please do get in touch.
Kind regards,
Gurjit Dehl
OUT
LINE
2O U T L I N E March 2013Introduction

4. We believe that the DWP’s
recent call for evidence on
“whether to smooth asset and
liabilities in scheme funding
valuations” versus marking-
to-market goes to the heart of
the pension risk management
debate.
To value a pension liability using smoothed
assumptions is akin to diagnosing a patient based
on the average of the last few years of symptoms; it
is highly unlikely to produce the correct diagnosis or
an effective cure.
A practical perspective
The most important argument against smoothing
is that it may lead to further under-funding of
pension schemes, as sponsors seek to reduce
contributions based on a smoothed valuation, and
contribution rates become de-coupled from market-
based funding positions. This may be particularly
detrimental in an employer insolvency situation, as
having a contribution schedule that is unrelated to
market movements increases the likelihood of the
scheme being underfunded on the PPF’s valuation
basis.
Smoothing could encourage “gaming” of the system,
either in choosing to adopt (or not) smoothing
in the first instance, or when moving between
smoothed/unsmoothed valuation bases (if this were
permissible) to select the most favourable basis.
Smoothing may also create confusion as schemes
could report funding positions that move contrarily to
the accounting valuation or to what may be expected
based on market observations.
One driver of the consultation is the Autumn
Statement in which the Chancellor said that “the
Government is determined to ensure that defined-
benefit pensions regulation does not act as a
brake on investment and growth”. However, DB
pension liabilities represent an enormous liability
to UK businesses, very substantially protected in
law. It is unavoidable that these liabilities affect
investment and growth, with or without changes
to pension regulation. There are two main issues
arising from DB pension schemes that may act to
deter investment into companies. First, a pension
deficit represents company debt; smoothing would
simply mean that investors look to other sources,
such as the accounting valuation, for an estimate
of the debt. Second, where a deficit exists, it
usually requires cash deficit repair contributions.
“Smoothing” of cash contributions can be achieved
by amending the deficit repair schedule, which is
already feasible under the current system.
Importantly, it should be possible for trustees and
their sponsoring employers to produce an investment
strategy that runs an appropriate degree of risk (and
hence an appropriate contribution volatility) versus
the strength of the employer. If schemes are instead
able to reduce contribution volatility by smoothing,
there is less incentive to reduce risk economically
e.g. to “hedge” the liabilities. Worse, smoothing
could potentially introduce additional volatility into
the funding positions of well-hedged schemes,
driving schemes to adopt riskier investment
strategies than they otherwise would. It would
be wrong to penalise schemes that have acted
prudently to manage their investment risk,
in favour of schemes that have not.
Smoothing Over The Truth
Karen Heaven
Vice President, Investment Consulting
karen.heaven@redington.co.uk
3O U T L I N E March 2013Overview

5. The Genius Of The AND
Versus The Tyranny Of The OR
Current debate over Defined
Benefit (DB) pensions continues
to capture the attention of the
public 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 Department
for Work and Pensions about reassessing the
valuation methodology, we face two serious
challenges:
1 Repairing DB pension deficits and improving
member security without harming the
commercial future of our corporates.
2 Growing and securing an adequate and
sustainable income in retirement for those
not in a DB pension.
As an industry, I believe we are on the whole
trapped in what Jim Collins describes in his book
“Built to Last – Successful habits of visionary
companies” as the Tyranny of the OR. Collins
defines the tyranny of the OR as the rational view
that cannot easily accept paradox, that cannot live
with two seemingly contradictory forces or ideas
at the same time. The tyranny of the OR makes
people 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 Pension
Regulator’s Trustee Tool Kit, which assumes
risk and return are linear)
In order to fix the pensions problem, we must
instead adopt what Jim Collins and Jerry Porras
call the Genius of the AND: the ability to embrace
both extremes. We can reduce risk of investment
underperformance against liabilities AND maintain
expected return in order to reach full funding.
We must flout the calls of naysayers and shoot
for this ideal.
Redington’s 7 Step Framework to Full Funding™
allows pension funds to embrace the Genius of
the AND, helping stakeholders to accomplish
with trustees and sponsors that which should
not, according to traditional standards, be
possible. The 7 step framework encourages
vision and creativity and yet is grounded in
robust, accountable and disciplined business
principles. It’s not about sitting around dreaming,
it’s about planning and strategising for the best
case scenario, in a world in which the best case
scenario is allowed to exist, even within the harsh
economic environment that surrounds us.
No doubt there is a great challenge in
altering our collective mindset; embracing
new ideas is not an easy task for any collective
of professionals. But we must switch, and switch
quickly.
“ The test of a first-rate intelligence is
the ability to hold two opposed ideas
in the mind at the same time, and still
retain the ability to function.
One should, for example, be able
to see that things are hopeless and
yet be determined to make them
otherwise.”
F. Scott Fitzgerald, The Crack-Up
In the pursuit of pensions and business goals, a
dualistic third approach of generating investment
outperformance and managing risk is ever
present. The habit of making either/or decisions
leads to thinking in the realm of Black OR White
and Risk OR Return. If important decisions are
made through the tyrannical lens of OR, vision is
inhibited, and progress is therefore hampered.
Without dreaming up a goal that could be, it will
never be.
Robert Gardner
Founder Co-CEO
robert.gardner@redington.co.uk
4O U T L I N E March 2013Overview

6. Importance Of Carry
To LDI Strategies
It may seem counterintuitive,
but it is possible to invest in low
yielding assets and generate
attractive excess returns.
Consider, for example, Japanese Government
Bonds (JGBs). Since 2002, 10 year JGBs have
yielded a measly 1.22% p.a., but their total returns
exceeded yields by almost 1.00% p.a. with a
volatility of just 3.88%. This equated to a return of
LIBOR +1.86% per year and in risk adjusted terms,
this made JGBs very attractive assets indeed. If,
for example, they were leveraged such that their
volatility was 10%, then JGBs would have delivered
a mouth-watering LIBOR +5.06% p.a. While some
of their excess return resulted from further, small
declines in interest rates, much of it was generated
by what is known as carry, as JPY rates were
already low and stayed low over this period.
In a fixed income portfolio, carry is defined as the
mark-to-market that results, assuming that nothing
changes in the market except for the passage
of time. Carry is a function of the shape of the
interest rate curve. When the curve is upwardly
sloping, as it is currently, the market is implying
that interest rates are expected to rise in the
future. If the expected rises occur and forward rates
are realised, then carry will be zero. If the expected
rises, on the other hand, do not materialise and
forward rates are not realised, then carry will result
and depending on the steepness of the curve,
it can be significant.
Within the context of UK LDI, an interesting
question to ask is whether carry can have the
same impact here as it has in Japan over the
past ten years. Our current situation certainly
shares similarities; banks are deleveraging,
economic growth is weak, and gilt yields are “low”.
And, not surprisingly, carry in the GBP interest
rate markets is similarly high.
In today’s market environment, most pension
scheme liabilities will grow due to carry, even
if interest rates do not fall further. Using the current
interest rate curve, a typical pension scheme
liability profile would grow on the
order of 2.5% per year as a result of carry.
If the current interest rate environment persists
for the next three years, this means that liabilities
would have grown by almost 8% simply through
the passage of time (service accrual and benefit
disbursements notwithstanding). Unless a scheme
is hedged, this would represent a significant
cost to its funding level.
Up to now, LDI strategies have mostly been
assessed against a backdrop of declining,
not static, interest rates. Given this, it is not
surprising that one of the most common
push-backs on LDI as a strategy is a view
that pension schemes should wait for
rates to return to higher levels before hedging.
Interest rates will eventually rise, but the 2.5%
in annual carry cost, aka potential funding level
erosion, is a very expensive price to pay for the
privilege of waiting.
John Towner
Director, Investment Consulting
john.towner@redington.co.uk
STEP 5
2
O U T L I N E March 2013

7. Estimating The
Equity Risk Premium
The last ten years have not gone
quite the way most textbooks
said they should have. Indeed,
anyone estimating the equity risk
“premium” based on the last ten
years would have to conclude
that it was sizeably negative,
around -3 percentage points.
But in reality, the whole idea of the risk premium
is that it is uncertain. It’s the concept of chasing
the two in the bush instead of the one bird in the
hand. But, clearly, sometimes that risk doesn’t
pay off; the historical, realised risk premium
should fluctuate wildly and sometimes be negative
even over long periods.
What is indisputable is that over the very
long term – 100 years, say – equities have
spectacularly outperformed bonds. Between
1900 and 2011, the UK was hit by the Great
Depression, nearly bankrupted by two world
wars, lost the Empire, and was then again struck
by the recent recession; yet according to the
Barclays Equity-Gilt Study 2012 focusing on that
period, the equity markets still showed a realised
inflation-adjusted risk reward of 300bps. For the
US, from 1926, the figure was 4.54%.
However, using simple
historical data to
estimate the equity
risk premium has two
serious drawbacks.
The first is that it
depends enormously
on which time period
one chooses. Even
over long periods
(10+ years), there is
substantial variation:
The reason for this substantial variation is the
domination of a few extreme results within the
equity return data. So five good years and one
bad day can create a bad five years of returns. To
put this in context, Professor Javier Estrada from
IESE Business School finds that “Outliers have
a massive impact on long-term performance.
On average across all 15 markets [considered],
missing the best 10 days resulted in portfolios
50.8% less valuable than a passive investment;
and avoiding the worst 10 days resulted in
portfolios 150.4% more valuable”.
The second problem is that using historical
data means that any estimate of the equity risk
premium would be highest just before a market
crash, and lowest before a rally. If one were to
use the estimate to make investment decisions,
the investor would be underweight for all the good
days and overweight for all the bad days, losing a
lot of money as a result.
In the long term, equities seem likely to
outperform bonds. As an investor, one may well
feel they are worth the risk. But to any individual
or pension fund dependent on earning that
premium, the question becomes: “how reliant can
you afford to be on an estimate that you expect
to be highly uncertain?” And, “is there a way I can
earn these returns in a more reliable way?”
Alexander White
Analyst, ALM Investment Strategy
alexander.white@redington.co.uk
Source: Data, http://www.econ.yale.edu/~shiller/; Calculations, Redington
Frequency of 10 Year Rolling Annualized Returns of US equities from 1871
STEP 6O U T L I N E March 2013
3

8. Equity Replacement Strategies
Estimates of the Equity Risk
Premium (“ERP”) vary from
gilts +3% to 5%. Can this be
achieved using other asset
classes?
ERP estimates depend on whom – and when – you
ask. Many studies produced over the last few years
highlight the equity market’s failure to deliver its
expected ERP. Evidence also shows how excluding
the best or worst months can have a dramatic
impact on returns.
Most pension funds rely on equities as the
biggest contributor to expected return – the risk
contribution is even greater.
Hence, increasingly trustees are asking: “What is
the equity risk premium?”, “Can I rely on it?”, and
“Can I earn it more reliably?”
We believe alternative assets can be found that
can deliver equity-like expected returns more
reliably, with no more risk. A classic opportunity
arose in Q408/Q109 when investment grade credit
spreads ballooned such that credit offered ERP-
like expected returns. However, credit spreads
have tightened such that, today, it is doubtful if
even high yield bonds could offer gilts +3% (net of
conservative expected default losses).
What opportunities are
available today?
It turns out that there are many: starting with High
Yield and Leveraged Loans, spread tightening
means that – net of (conservative) expected losses
– HY cannot match a 3% ERP. Due to markedly
superior recovery rates in default, leveraged loans
remain a candidate.
At first sight, a conservative trustee might baulk at
the idea of a sub-investment grade loan; however,
analysis shows that the risk-adjusted expected
return is attractive relative to equities.
Moving down in liquidity, we find senior, secured
lending opportunities where banks have been
forced out of the market due to increased capital
requirements (Basel III) and balance sheet costs.
Specifically, commercial real estate lending and
SME lending can conservatively match the 3% to
5% ERP.
Credit markets remain severely impacted by the
financial crisis and ongoing bank balance sheet
deleveraging and, in skilled hands, the resulting
dislocations can be “harvested”. The best long/
short credit managers have demonstrated their
ability to earn ERP-like returns with a fraction
of the equity market volatility.
Nearly all of the opportunities highlighted above
have investment horizons of 3 to 7 years, whereas
the ERP is typically assumed to be earned over
horizons of at least 10 years. Pension schemes
typically 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” the
equity market and get the right entry levels, then
this could be an issue.
However, given the massive impact of “outlying”
days (i.e. the best and worst) and the difficulty
of calling entry levels, we believe that diversifying
into assets that offer a more reliable ERP-like
return over a shorter horizon – irrespective of
timing of entry level – can benefit many pension
scheme portfolios.
David Bennett
Managing Director, Investment Consulting
david.bennett@redington.co.uk
STEP 7O U T L I N E March 2013
3

9. Risk Parity Rationale
Attractive alternatives to capital-
based allocations are gaining
traction. Risk Parity offers one
risk-controlled route for investors.
Traditionally, investors have allocated assets
based on capital values: 50% of a portfolio
may be in equities, 30% of it in bonds and 20%
in other asset classes including alternatives. While
this seems to be a diversified portfolio,
it is startlingly undiversified when viewed through
the lens of risk. An average UK
pension fund holding 44% of its assets in equities
has portfolio risk overwhelmingly stemming from
equities: c.87% of total risk.
This imbalance is not healthy; the portfolio
becomes beholden to the performance of
equities. Using 40 years of data, for a portfolio
consisting of 60% equities and 40% bonds, the
correlation of yearly returns between the equity
component and the overall portfolio is 95%.
For this reason, traditional balanced portfolios
suffered large drawdowns during the financial
crisis mirroring the performance of equities.
Risk Parity – A Solution
Risk Parity strategies have gained prominence
due to their superior long-term risk-adjusted
performance, weathering the financial crisis better
than traditional portfolios. Their aim is to balance
risk evenly across asset classes (most commonly
across equities, bonds and commodities). This
allows Risk Parity-based portfolios to perform in
a variety of environments, and not just those in
which equities perform well.
As the risk levels of different asset classes
change, Risk Parity strategies reweight to maintain
the overall balance.
The benefits to allocating by risk rather than by
capital value are plain. Risk Parity strategies
are more consistent performers as economic
conditions change – the aim of true diversification.
During the high inflation period of the ‘70s, when
equities and bonds both performed poorly, it was
a Risk Parity strategy’s exposure to commodities
that bolstered return while a traditional balanced
portfolio would have foundered.
A feature of many Risk Parity strategies is the use
of leverage to increase risk to a level comparable
to that of a traditional balanced portfolio (a
volatility of about 10%). If a Risk Parity strategy
did not use leverage, the overall risk would usually
be too low for most investors, resulting in returns
below those required. In fact, investor aversion to
leverage may be one of the key reasons for Risk
Parity outperformance. As many investors hesitate
to use leverage, they typically overweight higher-
risk assets, such as equities, in order to achieve
target returns. This leaves lower risk assets
relatively undervalued and may explain why low
volatility assets have tended to outperform high
volatility assets over the long-term. Risk Parity
strategies overweight these undervalued assets,
providing a possible pathway towards sustainable,
higher risk-adjusted returns (higher Sharpe ratios).
In an increasingly risk-focused world, Risk Parity
strategies represent a powerful way for pension
funds to achieve their funding goals with minimum
risk.
Aniket Das
Associate, Manager Research Team
aniket.das@redington.co.uk
STEP 8O U T L I N E March 2013
3

10. The deleveraging of banks
has created an attractive
opportunity in the Commercial
Real Estate Debt space.
The media hype surrounding bank deleveraging is
unlikely to subdue in the near future as Basel III,
a regulation which places a number of significant
constraints on banks’ activity, is just round the
corner; it is scheduled to be introduced gradually
over the next six years. The new law focuses on
three main areas: introducing a minimum liquidity
standard, limiting leverage, and increasing the
level of existing required capital buffers. Given
these more stringent rules, particularly around
minimum capital requirements, capital-intensive
assets like Commercial Real Estate Debt (CRE
Debt) are likely to shift towards non-bank capital,
particularly insurance companies and defined
benefit pension funds.
What is CRE Debt?
CRE Debt consists of fairly illiquid, usually floating
rate loans backed by commercial real estate, such
as offices, retail, hotels, etc. The average term
is 5 years and there are commonly penalties on
prepayment. In the past, investors accessed some
CRE Debt via their investment in Commercial
Mortgage Backed Securities. Nowadays however,
due to regulation and lack of buyer appetite, this
market has dried up.
The Opportunity
At the end of 2010, outstanding European debt
secured by commercial property and due to
mature in the following ten years amounted to
€960bn, according to CBRE. Around 75% of this
is held on banks’ balance sheets, and just over
40% matures in the three year period between
2013 and 2015 (inclusive). Given the reluctance
of banks to offer refinancing, particularly at more
elevated loan-to-value (LTV) ratios, the borrowers
are likely to face a significant funding gap.
As a result of this gap, two key positive shifts in
the CRE lending market have occurred: first, the
typical LTV levels of the senior debt portion have
fallen dramatically, from 75 to 80% all the way
down to 50% to 60%. Second, at the same time,
the lending spread being charged on this senior
debt has widened from approximately LIBOR
+ 50-80 bps to a range of 300-450 bps over
LIBOR.
Before 2007, such levels were hardly attainable
even on mezzanine finance. See diagram below.
These two changes have driven a significant
improvement in the overall risk-adjusted return
available to lenders at the senior debt level. On
top of all this, significant falls in real estate capital
values have already occurred over the past few
years, lending covenants have been strengthened
significantly, and additional equity contributions
from real estate owners have increased. Investors
enjoy another layer of security, too, stemming
from the location of underlying property. About
half of the outstanding European CRE debt is
secured against real estate in core countries such
as UK and Germany.
We believe that pension funds and other
institutional investors such as insurance
companies are in a good position to exploit this
opportunity, reaping attractive risk-adjusted
returns by providing the necessary finance.
Kate Mijakowska
Analyst, Manager Research Team
kate.mijakowska@redington.co.uk
Source: MG
Commercial Real Estate Debt
Typical Capital Structure
2007 Origination
Equity
5 -15 %
Mezzanine / B-note
Senior loan / A-note
LIBOR + 200-300 bps
LIBOR + 50 - 80bps
75-80%
2007
Typical Capital Structure
2010 Origination
Equity
Fall in property values
-13.4% (vs 2007)
15 - 20 %
5 - 15 %
5 - 15 %
20-25 %
Mezzanine / B-note
LIBOR + 700-1200 bps
Senior loan / A-note
LIBOR + 200 - 250bps
60-65%
2010
Typical Capital Structure
2012 Origination
Fall in property values
-11.8% (vs 2007)
Equity
20-30 %
Mezzanine / B-note
LIBOR + 900-1300 bps
Senior loan / A-note
LIBOR + 500 - 800 bps
Stretch - Senior
LIBOR + 300 - 450 bps
50-60%
2012
5 - 15 %
STEP 9O U T L I N E March 2013
5

11. “Human beings can’t run
a mile in under 4 minutes.
It simply isn’t possible.”
Sound ridiculous? It does now!
But for a long time it was the
consensus.
A mental model: an assumption about how the
world worked.
A sub-four minute mile seemed like a physical
feat that humans could not break. But in 1954
Roger Bannister ran a mile in three minutes, fifty
nine seconds and four milliseconds. Suddenly, in
the following three years, sixteen other runners
ran a mile in under four minutes.
Was there some breakthrough in human
evolution? No. The mental model changed.
Could a similar mental model have affected
the defined benefit pension industry?
For decades, schemes focussed on assets
and failed to pay adequate attention to liabilities.
The consequences are still being felt today, with
many schemes experiencing falls in funding
levels as a result of lower interest rates and
their impact on the value of liabilities. Pension
scheme trustees now face increased complexity
in an uncertain economic outlook, volatile market
conditions and upcoming regulatory changes that
have rendered returns uncertain too.
“Everything should be made as simple
as possible, but not simpler”.
Albert Einstein
Pension schemes can simply start the process of
taking control by agreeing and writing clear goals
and objectives. The document in which these
are laid out then becomes the foundation for
any funding, investment and risk management
decisions and actions.
Clear goals and objectives allow the stakeholders
to move away from a traditional asset-based
framework to a risk-based asset and liability
framework; all key factors are considered
simultaneously and, vitally, all decisions are
completely informed.
Once stakeholders have clear goals, monitoring
how the scheme performs against those objectives
is key to continually attaining success. Quality
monitoring should not only feature visual and
numerical analysis, but also explain in plain English
what the analysis actually means so stakeholders
can make informed decisions
as a result.
Regular quality monitoring lets stakeholders
fully understand the sources and drivers of risk
and return by using critical components such as
required return, funding level, liquidity and collateral
requirements. By fully understanding these key
drivers, stakeholders can assess investment
opportunities within the goals
and constraints of their particular fund, and assess
the impact of expected returns versus required
returns.
Alongside good governance, monitoring enables
effective action by providing a clear framework
within which to make decisions. It informs by
highlighting the most relevant scheme metrics, and
good monitoring reports provide obvious signposts
for immediate action. Clear goals
plus easy-to-understand monitoring forms
a powerful blueprint for any investment committee,
CIO or fiduciary manager to follow.
Unsurprisingly, pension schemes that have
taken the time to agree their objectives and
regularly use good monitoring and reporting tools
have clearer accountability within their teams,
and post better results. Decisions are taken in the
context of agreed objectives, and are reassessed
regularly to determine progress and be adjusted
accordingly. With the right monitoring tool in place,
schemes are smart, nimble and more successful.
Teresa Ngone
Vice President, Investment Consulting
teresa.ngone@redington.co.uk
Monitoring Progress
On The Run
STEP 10O U T L I N E March 2013
7

12. Pension schemes are realising
the unpredictability of financial
markets and looking for ways to
manage its volatility while meeting
their return requirements. Is there
a way out?
Here’s the story of a small pension scheme which
has managed this exceedingly well by following
a disciplined and robust approach, delivering an
impressive performance as a result.
Turning back to the summer of 2008, the Scheme
was close to being fully funded on a buyout basis,
but still with over 90% of its assets invested in
equities and less than 5% in bonds. By the time
the trustees knew about the Scheme’s excellent
position, it was too late. In September 2008,
financial markets collapsed and the Scheme
suffered a sharp deterioration in its funding
position, so a buy-out was out
of reach.
The trustees became determined to take control of
the situation and set up a framework to ensure this
didn’t happen to them again. The first step was to
set clear and realistic funding and risk objectives
for the Scheme, then using this, to design a
simple yet efficient investment strategy to achieve
those objectives. The trustees adopted the use of
derivative instruments to achieve efficiency
and simultaneously put in place a dynamic
de-risking programme to monitor the funding level
on a daily basis. They would move from risky assets
to matching assets as their funding level improved
based on pre-set trigger and action points. They
also had a plan to consider re-risking if things were
to go bad.
The initial set-up required time and effort but the
whole Trustee Board was more than willing to
engage and work with the Sponsor and Investment
Consultant to set up the framework and become
comfortable with the dynamic process. Later,
the de-risking programme was automated and
outsourced to their LDI manager.
After one and a half years, the Scheme is now
more than 10% better funded than if it had not
implemented this approach, with a funding level
which is fully protected against interest rate and
inflation movements. It has also reduced its equity
exposure from more than 90% to less than 10%.
The conditions this Scheme faced are the same as
any other. Some may say the Scheme had simply
been lucky when making certain timely de-risking
and re-risking decisions. Maybe that was the case;
however, the decision to re-risk or de-risk was not
based on “market sentiments” but a well-defined
metric we call “required return to full funding”.
In recognition of its work, the Scheme has received
three well-deserved pension awards during this
period.
Neha Bhargava
Vice President, Investment Consulting
neha.bhargava@redington.co.uk
Dynamic Risk
Management In Practice
De-Risking Triggers
De-Risking Trigger
Re-Risking and refresh of triggers Review investment Strategy
De-Risking Triggers
Re-Risking Triggers
STEP 11O U T L I N E March 2013
7654321

13. A Step Change in
“Money Safe” Defined
Contributions Saving
As traditional sponsor-backed
final salary pension provision
in the UK fades into the
background, greater focus
is being placed on Defined
Contribution (“DC”) arrangements
and how institutional investment
strategies could be adapted to
meet the needs of individual
pension savers.
Historically, many DC schemes have adopted
conventional approaches to asset allocation which
feature substantial capital weighted allocations
to equities. However, the volatility of equity
markets in the last 15 years, driven by a series
of substantial falls, has led to disappointing
outcomes for members.
In order to help improve confidence in
pensions saving, the Pensions Minister,
Steve Webb, challenged the industry last
year to think hard about the feasibility of providing
“money safe” products.
We have been incorporating the latest
thinking on rules-based risk control into our
defined benefit clients’ investment strategies.
Commonly known as Volatility Control, this
approach systematically reduces exposure to
markets as their daily volatility increases and
raises exposure as the daily volatility falls.
In driving terms, it means easing your foot off
the accelerator when the conditions you face
get worse – rain, visibility, grip - and pressing
down again as conditions improve.
Highly liquid and transparent, we believe this
methodology has great application for DC and
could be used to offer DC savers
both the potential for improved outcomes and the
ability to provide such “money safe” protection
on member savings pots, all in a cost efficient
manner.
We believe this approach would offer three layers
of risk protection for the member:
- Risk control at the individual
asset class level.
- Risk control and diversification
at the total portfolio level.
- Outright downside protection
on the total portfolio.
By way of example, the graph below show the
net of fees results of traditional DC approaches,
standalone risk controlled approaches and a
“money safe” risk controlled approach. These
calculations are based on a simple model of
DC investment savings over the 25 year period
ending 31 December 2012, with regular monthly
contributions starting at £150 per month,
increasing steadily over time.
Patrick O’Sullivan FIA CFA
Vice President, Investment Consulting
patrick.osullivan@redington.co.uk
Summary of outcomes for various DC approaches
12O U T L I N E March 2013STEP

14. If you would like more details on the
topics discussed, please contact your
Redington representative, the author
or email enquiries@redington.co.uk
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