21st Century LDI

Private & Confidential 21st Century LDI 2 July 2013

21st Century Liability Driven Investment David Bennett – Head of Investment Consulting, Redington

2 July 2013


Executive Summary

History, Key Events and the Evolution of LDI

Spending the “Risk Budget”: Equities versus Interest Rates

o Risk Impact of Hedging to the Funding Ratio

To Hedge or Not to Hedge?

o The Impact of Roll-Down and Carry

o Developed Government Bond Yields: How low can UK yields go?

Alternative Hedging Strategies:

o Time-Diversified Hedging

o Swaption and Swaption Collar Strategies

o Illiquid Credit

Preparing for Central Clearing

LDI in a Wider Strategic Context: Pension Risk Management Framework and Case Study

2


History

3


-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5 %

30-Year Gilt Real Yield (%)

Source: Bloomberg, Redington

4

History


Boots pension scheme shifts out of

equities and into bonds

2001

• Head of Corporate Finance, John Ralfe, recognises

pension fund liabilities are bond-like in nature

• Allocation before rebalancing: 75% equities, 20% bonds,

5% cash

• Allocation after rebalancing: 100% long-dated AAA

sterling bonds, half of which is inflation-linked

Friends Provident hedges interest rate

and inflation risk with swaps

2003

• First non-bank to implement LDI hedging strategy

• Locked in a 2.1% real yield on 30-year index linked

gilts – the real yield today is below 0%

• Conventional wisdom at the time: “equities are the

biggest source of risk to a scheme’s funding level, and

real yields cannot drop below 2%”

Lehman Brothers collapses and new

opportunities arise

2008

• Lehman Brothers collapse shows robustness of

collateralised swaps

• The gilt/swap spread inverts

• Pension funds can take advantage of spread dislocation

and hedge via gilts instead of swaps

Key events in LDI

Eurozone Debt Crisis boosts safe haven

demand for Gilts

2010-2013

• Eurozone turmoil increases the appeal of Gilts as a safe

haven asset

• Gilt real yields turn negative for the first time ever at

the longer-dated tenors

• Despite recent optimism that policymakers may be able

to contain the crisis, real yields have remained below

zero, partly due to stubbornly high market inflation rates

5


The Evolution of LDI

6

Private & Confidential 21st Century LDI 2 July 2013 7

0

200

400

600

800

1,000

1,200

1,400

1,600

Demand Supply

GB

P B

illio

ns

PPF 7800 Aggregate Scheme Liability Index-Linked Gilts Outstanding

Corporate Linkers RPI Swaps Outstanding

Source: Barclays, Pension Protection Fund, Redington

Potential demand for long-dated linkers

outweighs available stock of RPI-linked

assets and RPI swap market capacity

• The Pension Protection Fund 7800 Index of DB

schemes estimated aggregate liability of

£1,385bn at end of March 2013

• £280bn (inflation-uplifted notional) of index-

linked gilts outstanding

• £32bn of corporate linkers by market value (as

measured by Barclays GBP non-govt inflation

linked index)

• £100bn* of RPI Swaps outstanding

*Rough estimate from Barclays, based on general consensus

Market for Gilt-Based Hedging


LDI 1.0

Liability Immunisation

LDI 2.0

The LDI “Manager”

LDI 3.0

Holistic ALM

• Interest rate and inflation

swaps

• Nominal and Index-linked

Gilts

• Gilt repo and TRS

• Bifurcation of interest rate

and inflation hedging

• Unfunded asset

exposures (e.g. Equity

futures)

• Corporate linkers

• Asset Swap Strategies

• Swaptions

• Sophisticated option overlays

• Flight Plan Consistent Asset

• Opportunistic Illiquid Assets

(e.g. Utility company inflation

swaps)

Evolution of LDI

Active LDI management


Target Full Funding Date: 2030

Option 1: Increase equities from 40% to 60% (blue line to blue dotted line)

Option 2: Leave equities unchanged –ca.60bps increase in forward

curve (red line to red dotted line) is required to achieve the same target

funding date

Spending the “Risk Budget”: Equities versus Interest Rates

9

2.1% 4.6%

0.6% 1.2%

18.8%

4.8% 10.3%

22.1%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

Pe

rce

nta

ge o

f To

tal L

iab

iliti

es

Risk Type

Interest

Rates

Expected

Return:

Gilts +3%

(Equity

Risk

Premium)

What rise in

forward

rates would

give the

same

benefit as

the ERP?

Equities

Risk Budget (e.g. 20% Value-at-

Risk)

What is the most

efficient use of

the Scheme’s

risk budget?

Sample Risk Attribution Chart

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

2,800

3,000

Mill

ion

s

Liabilities Assets (Current Expected Return)

Sample Flight Plan Analysis

Impact of

60bp

forward

curve

shift


Hedging Strategies

10

Hedging to the Funding Ratio

• Increasing the interest rate and inflation hedge ratios to the funding ratio minimises the funding ratio impact of real rate volatility

• This means the outperformance required from the Scheme’s assets remains relatively stable if real rates change

• The “risk budget” freed up by hedging real rate exposure can be recycled in order to increase the expected return

• Insofar as a Scheme can reliably increase expected return (for example, by investing in illiquid credit), hedging up to the funding

ratio effectively “lock in” margins over the required return

3.3%

3.6%

2.5% 1.9%

7.5%

11.4%

3.4%

5.5% 9.3%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Credit Risk Interest Rate Risk Inflation Risk Diversification Total

Perc

enta

ge o

f T

ota

l Lia

bili

tie

s

Impact on Risk of Increasing Hedge Ratio from 50% to 80%


Government Bond Yields in Developed Markets

Whilst the 30-year UK government bond yield has fallen significantly since 2007, there remains scope for further

declines if compared to other developed markets, with German yields over 100bps lower and Japanese yields over

170bps lower.

11

30-Year Government Bond Yield

Source: Bloomberg

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

%

UK US Japan Germany France

UK: 3.62%US: 3.62%

Japan: 1.85%

Germany: 2.52%

France: 3.34%


0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

0 10 20 30 40 50

Par

Rat

e

Tenor

6m LIBOR Curve

par 1y fwd 3y fwd 5y fwd 10y fwd

• Carry occurs as a result of the

market pricing in rising short-term

rates. It is easiest to explain in the

context of a receiver par swap

(say 20 years)

• In the first year, the fixed leg is

larger than the floating leg – this

is the coupon income

• If rates follow the forward curve,

then the remainder of the swap

will have negative PV, to balance

the coupon income

• However, if rates do not rise as

priced in, the remainder of the

swap will have positive PV, as it

will be a 19y swap paying the 20y

rate; this is roll-down

Carry = coupon income + roll-down

Roll Down and Carry


0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

0 5 10 15 20 25 30 35 40

Roll Down and Carry – Example

Gilt ZC ZC 5y'

Payment of £100m

13

2.55%

3.73%

• Imagine a payment of £100m in 20

years’ time

• The PV of this cashflow is £56m

• In five years’ time, the PV is

projected to be £58m based on

forward curve discount rate of

3.73%

• However, if rates don’t change the

PV is projected to be £69m

• This means if rates are unchanged

rather than rising as is priced into

the forward rates, the value of the

cashflow will grow by 3.51% per

annum

• To win the “we expect rates to

rise” bet, rates have to rise to

exceed the forwards

Tenor

Roll Down and Carry


Hedging Strategies

14

40%

50%

60%

70%

80%

90%

100%

Hed

ge

Ratio

Original Plan

Plan After 1st Trigger

Plan After 2nd Trigger

Time-Diversified Hedging

• GOAL: To achieve full funding in x years; HEDGING OBJECTIVE: 100% hedged once fully funded

• SOLUTION: consider increasing hedge ratios over time

• This can be done by using fixed, periodic hedging increments combined with a trigger framework to hedge

opportunistically

• Triggers can be based on scheme-specific metrics such a funding level or required returns – agnostic regarding

catalyst for improved funding

Time-Based Hedging Combined with “Go Faster” Opportunistic Hedging


Overview: Swaptions

15

Swaptions are options to enter into swaps

• The buyer of a receiver swaption has the right but not the obligation to enter into a swap where the option buyer

receives a fixed rate in exchange for paying a floating rate

• A payer swaption gives the buyer the right but not the obligation to enter into a swap where the option buyer

pays a fixed rate in exchange for receiving a floating rate

Receiver swaptions rise in value if swap rates fall; payer swaptions rise in value if swap rates rise

Potential uses

• Where a pension fund has exposure to falling interest rates, but expects rates to rise and therefore does not want to

lock in current levels, the purchase of a receiver swaption can offer protection against falling rates below the strike of

the swaption

• Similarly, if a pension fund has decided to hedge interest rate risk in a rising rate scenario, a premium can be earned

by selling a payer swaption with a high strike relative to current levels

• The combination of buying a low strike receiver swaption and selling a high strike payer swaption is known

as a collar

Swaption strikes can be determined in the context of the impact of interest rate moves on the required rate

of return to achieve full funding


PAYOFF

16

Settlement 31-May-10

Maturity 31-May-40

Payer Strike 5.25%

Receiver Strike 3.75%

Payer Notional £1,806m

Receiver Notional £1,451m

Implied Rate Payer Swaption Receiver Swaption NET

1.00% 0.0 1,032 1,032

1.25% 0.0 905 905

1.50% 0.0 786 786

1.75% 0.0 675 675

2.00% 0.0 570 570

2.25% 0.0 473 473

2.50% 0.0 381 381

2.75% 0.0 295 295

3.00% 0.0 214 214

3.25% 0.0 138 138

3.50% 0.0 67 67

3.75% 0.0 0.0 0.0

4.00% 0.0 0.0 0.0

4.25% 0.0 0.0 0.0

4.50% 0.0 0.0 0.0

4.75% 0.0 0.0 0.0

5.00% 0.0 0.0 0.0

5.25% 0.0 0.0 0.0

5.50% -66.0 0.0 -66

5.75% -128.4 0.0 -128

6.00% -187.5 0.0 -187

6.25% -243.4 0.0 -243

6.50% -296.4 0.0 -296

6.75% -346.6 0.0 -346

7.00% -394.3 0.0 -394

Example Swaption Collar Trade

Payoff Profile


40

45

50

55

60

65

70

75

80

1M 3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y

Swap

tio

n v

ola

tili

ty (b

ps)

17

Aim

• Increase protection

against interest rates

without locking in current

low level of rates

The Strategy – Swaption Collar

• Scheme buys a receiver swaption (offering protection against falling

rates) and sells a payer swaption (giving up some rate upside in

order to lower cost of the strategy). The strategy has two attractive

characteristics:

• PV01 profile: the interest rate sensitivity of the collar rises as

rates fall and decreases when rates rise, providing more

protection when it is needed and less when it is not

• Taking advantage of market expectations: if market

expectations of futures interest rates and volatility are met, the

value of the collar is projected to remain relatively stable over time

Outcome

• Attractive addition to

Scheme’s portfolio of

hedging assets

• The strategy has

outperformed an interest

rate swap with the

equivalent initial PV01

Source: F&C Investments

Higher volatility increases

the value of the swaption

Case Study: Swaption Collar Strategy Implemented in 2012

Buy Here

Sell Here

3 year DV01 profile

-700,000

-600,000

-500,000

-400,000

-300,000

-200,000

-100,000

0

-100 -80 -60 -40 -20 0 20 40 60 80 100 120 140 160 180 200

Rates shift (bps)

DV

01 (

£)

Swaps Collar Payer

4.60 4.49

3.253.59

0.0

1.0

2.0

3.0

4.0

5.0

0 10 20 30 40 50

%

10Y Forward Curve Spot

Swaption Collar PV01 Payoff Profile Volatility Term Structure LIBOR Curve – Spot vs. 10Y Forward


Enhancing Returns – Investing in Illiquid Credit

18

Higher-Rated

Lower-Rated

“Shorter-Dated” “Liability Matching”

Infrastructure

CRE Debt

Ground Rents

Long Leases

Aircraft Finance

Direct Lending

Distressed Debt

Checklist Description CRE Debt Infrastructure

Debt

Flight Plan Beneficial impact on

Scheme returns

Hedging Hedging benefits

Risk Budget Beneficial impact on

Scheme risk ?

Collateral Impact on collateral

requirements

Relative Value Risk/return relative to

other opportunities

Implementation

/ Complexity

Time and governance

bandwidth required

Liquidity Demonstrable illiquidity

premium

Mark-to-market

divergence

Resulting from hedging

characteristics being

marked to market

Illiquid Credit Opportunities

250bps over

Gilts after

defaults 350bps over

Gilts after

defaults

Illiquid Asset Checklist

Allocation to CRE debt out of credit

Enhance expected returns

Contractual cashflow

generation

Long-term investment in

infrastructure debt

Enhance expected returns

Liability-matching


Preparing for Central Clearing

19


All standardised OTC derivatives will be cleared through

central counterparties (CCPs)

Harmonised framework for the

provision of clearing services within Europe

Non-cleared derivatives will be

subject to strengthened management requirements,

including the need to collateralise positions

All OTC and exchange traded derivatives will be reported to trade repositories (TRs)

EMIR: Central Points

EMIR: Preparing for A Changing Market Environment

• European policymakers are introducing regulation

(termed “EMIR”) to reform the swaps market in

order to enhance resilience and increase

transparency

• These changes will make the swap market more

similar to the futures market, with trades cleared

through a central counterparty (CCP)

• Introduces additional rules and constraints that

pension funds should be aware of and prepare for


Important information for pensions funds:

• Limited exemption from EMIR’s headline measure – the requirement to

clear OTC derivative contracts – until at least August 2015

• HOWEVER: For new trades there is no exemption from Initial Margin,

providing more incentive for these trades to be cleared early rather than

make use of the pension fund exemptions

• The other key provisions – the risk mitigation and reporting

obligations – will apply to pension funds. The EMIR obligations will take

effect on a phased basis from the beginning of 2013

Important questions for pension funds:

• Are you going to use your exemption from EMIR?

• Are your CSAs dirty or clean?

• How much free collateral do you have?

• What plans have you put in place for central

clearing?

* Timeline based on ESMA estimates

Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014

ESMA publication of

draft technical

standards

EMIR: Preparing for A Changing Market Environment

Technical standards

come into force

CCP Application

Deadline

NCA Authorisation of

CCPs

ESMA to submit draft

RTS on the clearing

obligation

Notification for the

clearing obligation

Reporting start date

(IRS, CDS)

Reporting start date

(all other asset

classes)

Key:

Technical standards – overall set of rules and regulation

Over-the-Counter (OTC) derivatives clearing

Central Counterparty Clearing (CCP) entities

Trade Repositories (TR) – maintains trade records


Collateral Drag Example

Gold

Soft Commodities

EM Linkers

REITs

Index-Linked

Corporates

Network Rail

Long Lease

Property

Utility Swaps

Infrastructure

Debt

A B

Overall Expected Return: Libor + 250

N.B. Collateral drag effect only occurs if collateral needs require the scheme to sell return seeking assets that were a part of the strategic asset allocation.

80%

20%

Matching Asset (£80Mn) Expected Return: Libor + 312.5

Overall Expected Return: Libor + 250

Collateral (£20Mn) Initial Margin

Variation Margin Prudence Margin (Asset Manager)

Inflation hedging derivative

Matching Asset (£100Mn) Expected Return: Libor + 250

Pension Fund X has £100 million to invest, requiring a return of Libor + 250bps and an inflation hedge. The scheme

has two options:

100%


Pension Risk Management

23


RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away

24

Objective Measurement (Assumed) Performance Indicators Performance (May 12) RAG

Funding

Objective

To reach full funding on the Technical

Provisions discount basis by [2023]

Expected Returns (ER) > Required Returns

(RR)

RR:

ER:

Difference:

Gilts + xxxbps

Gilts + 73bps

xxxbps

Investment

Strategy

Actual Returns should exceed Expected

Returns (implying outperformance)

Actual Returns (AR) > Expected Returns

(ER)

AR:

ER:

Difference:

Gilts + xxxbps

Gilts + 73bps

Xxxbps

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: [xx]%

Hedging

Strategy

Nominal/Inflation hedge ratio should be

maintained within +/- 5% of the funding

ratio.

Funding Ratio (Technical Provisions basis) 84%

Nominal Hedge Ratio (TP basis) xx%

Inflation Hedge Ratio (TP basis) xx%

Collateral

Maintain sufficient eligible for the

purposes of covering margin calls that

may arise from the Scheme’s current

derivative positions over a 1 year period.

Total available eligible collateral >£[100]m

Potential collateral call after VaR95 event <£[100]m

Pension Risk Management Framework


Case Study

25


60%

65%

70%

75%

80%

85%

90%

95%

100%

Fu

nd

ing

le

ve

l

Original Strategy Dynamic De-Risking Strategy

26

De-Risking Triggers

De-Risking Triggers

De-Risking Trigger

Re-Risking Triggers

Not Just A Real Yield View


Key Conclusions

Ensure that real rate exposure is “right sized” to the Pension Fund

o Does the potential funding level benefit from rising (forward) rates justify the risk being

run?

Assess the true cost of not hedging in a static rate environment

o To win the “we expect rates to rise” bet, rates have to rise to exceed the forwards

Review the full range of hedging strategies and instruments

Ensure that existing LDI programmes are prepared for Central Clearing

27


13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk

About Redington

28

Redington is an independent investment consultancy with a mission to design, develop and

deliver the best investment strategies for its client to reach their funding goals with the minimum

level of risk. We combine the practicality of an investment banking approach to investment

consulting with the best of actuarial analysis, which delivers clients clear, actionable advice. Our

clients trust us with over £250 billion of assets, and we advise ten of the 25 biggest pension

funds in the UK.

Recent Publications

IRIS: Monitor Risk. Measure Progress. Stay on Track.

Industry Awards

Investment Consultant of

the Year (2013)

Risk Management Firm

of the Year (2011, 2012,

2013)

Best Consulting Firm

of the Year

Pension Consultant

of the Year – 2012.

2013

Investment Consultant

of the Year Specialist Investment

Consultant of the Year

David Bennett Head of Investment Consulting

Direct Line: 0203 326 7147

[email protected]

Contact

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