Liability Driven Benchmarks for UK Defined Benefit Pension SchemesLiability Driven Benchmark Working Party
Alvar Chambers
21 June 2005
Liability Driven Benchmarks for UK Defined Benefit Pension Schemes
Background Types of Liability Driven Benchmarks Implementation Examples Wider Issues
Background
Trends in investment strategy Peer groups Scheme specific benchmarks with market indices Liability driven benchmarks
Why move to Liability Driven Benchmarks? Maturing schemes, DC for new entrants Equity bear market and falling bond yields Market-based solvency & accounting standards Myners More sophisticated tools and liquid markets
Background
Alternative – buying out liabilities with an insurer Hedge mortality risk as well May not be possible or cost may be prohibitive for
many schemes, particularly if liabilities include deferred pensions
Limitations of Liability Driven Benchmarks Significant uncertainty remains over mortality
experience, other demographic factors
Benchmarking Investment RisksTracking error versus certain cashflows: a measure of investment risk in liability
0%
2%
4%
6%
8%
10%
12%
14%
16%
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Bond allocation
Tracking error (%pa)
Bonds
Swap with no liability risk
Source: Watson Wyatt LLP
Residual Demographic Risks RemainTracking error versus uncertain cash flows:a measure of total investment and non-investment risks in liability benchmark
Bond allocation Source: Watson Wyatt LLP
0%
2%
4%
6%
8%
10%
12%
14%
16%
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Tracking error (%pa)
Bonds (total risks)
Swap (total risks)
Bonds (investment risk only)
Swap (investment risk only)
Roles of Different Parties
Trustees Responsible for investment strategy Often not investment experts
Actuaries/Investment Consultants Advice on asset allocation and implementation
Investment Managers Management of assets within defined objectives
Investment Banks Implementation of large transactions including derivative
hedges
Types of Liability Driven Benchmark
Market Index Immunised Bond Portfolio Pooled Maturity Bucket Funds Cash-flow Matching with Physical Bonds Cash-flow Matching with Bonds and Swaps
Market Index
Poor matching Can split between fixed and RPI liabilities No credit risk if gilts, but can use credit index Easily investible, liquid benchmark Can use mainstream pooled funds Low cost
Immunised Bond Portfolio
Match duration but not yield curve risk Can split between fixed and RPI liabilities No credit risk if gilts, but can use credit Easily investible, liquid benchmark Requires segregated portfolio (may be
uneconomic for small schemes) Low cost for larger schemes
Pooled Maturity Bucket Funds
Fairly good matching within maturity buckets, can split fixed/RPI/LPI
May include credit exposure Liquidity may be restricted Increasing range of funds available Low cost
Cash-flow Matched Bond Portfolio
Good match out to limit of maturity of available bonds Can split fixed/RPI liabilities, dynamic hedge for LPI Can include credit exposure Reasonable liquidity dependent on bonds used Requires segregated portfolio Cost/diversification restricts to larger schemes
Cash-flow Matched Bond & Swap Portfolio
Very good match out to maturity of longest liquid swap Can accurately hedge fixed, RPI and LPI liabilities Counterparty risk, documentation issues Can include credit exposure Liquidity depends on bonds and swaps used Requires segregated portfolio Cost/diversification restricts to larger schemes
Types of Liability Driven Benchmark
Choice of discount curve Gilts vs swaps Allowing for credit risk What are the client’s investment objectives?
No one right answer!
Comparison of discount curves
Sterling Yield Curves as at 31 May 2005
4
4.5
5
0 5 10 15 20 25 30 35 40 45 50Term
Yie
ld
Gilts Swaps AA-rated bonds Source: BLOOMBERG
Implementation
Performance measurement and attribution A) Management against investible benchmark B) Management against expected liability cash flows
on defined discount rate
Who takes responsibility for tracking error between investible portfolio and liability cash flows on agreed discount rate?
Frequency of benchmark review
Implementation including swaps
Is scheme permitted to use OTC derivatives? Legal documentation – ISDA/CSA “Umbrella ISDAs” Counterparty risk and collateralisation Pooled fund approach can make practical for
smaller schemes
Examples
Model Scheme – very simplified 1,000 pensioners aged 60 Level pension £4,000 pa payable in advance PMA92C20 mortality Investment data as at 8 April 2005 Liabilities discounted off swap curve Sufficient cash held to meet first year’s liabilities
Examples - Gilt IndexModel Scheme Cash flows - Over 5 yr gilt index
Annual Cash flow Comparison
-£9,000,000
-£7,000,000
-£5,000,000
-£3,000,000
-£1,000,000
£1,000,000
£3,000,000
£5,000,000
£7,000,000
£9,000,000
Apr-0
5
Apr-0
7
Apr-0
9
Apr-1
1
Apr-1
3
Apr-1
5
Apr-1
7
Apr-1
9
Apr-2
1
Apr-2
3
Apr-2
5
Apr-2
7
Apr-2
9
Apr-3
1
Apr-3
3
Apr-3
5
Apr-3
7
Apr-3
9
Apr-4
1
Apr-4
3
Apr-4
5
Apr-4
7
Apr-4
9
Apr-5
1
Apr-5
3
Projected Liability Cash-flowsProjected Asset Cash-flowsProjected Net Cumulative Cash-flows
Model Scheme net cash flows - Over 5 yr gilt index
-£4,000,000
-£2,000,000
£0
£2,000,000
£4,000,000
£6,000,000
Apr-0
5
Apr-0
7
Apr-0
9
Apr-1
1
Apr-1
3
Apr-1
5
Apr-1
7
Apr-1
9
Apr-2
1
Apr-2
3
Apr-2
5
Apr-2
7
Apr-2
9
Apr-3
1
Apr-3
3
Apr-3
5
Apr-3
7
Apr-3
9
Apr-4
1
Apr-4
3
Apr-4
5
Apr-4
7
Apr-4
9
Apr-5
1
Apr-5
3
Apr-5
5
Net Cash-flows
Source: Insight Investment
Examples - Gilts PortfolioModel Scheme Cash flows - Gilts solution
Annual Cash flow Comparison
-£5,000,000
-£3,000,000
-£1,000,000
£1,000,000
£3,000,000
£5,000,000
£7,000,000
£9,000,000
Apr-0
5
Apr-0
7
Apr-0
9
Apr-1
1
Apr-1
3
Apr-1
5
Apr-1
7
Apr-1
9
Apr-2
1
Apr-2
3
Apr-2
5
Apr-2
7
Apr-2
9
Apr-3
1
Apr-3
3
Apr-3
5
Apr-3
7
Apr-3
9
Apr-4
1
Apr-4
3
Apr-4
5
Apr-4
7
Apr-4
9
Apr-5
1
Apr-5
3
Projected Liability Cash-flowsProjected Asset Cash-flowsProjected Net Cumulative Cash-flows
Model Scheme net cash flows - Gilts solution
-£4,000,000
-£2,000,000
£0
£2,000,000
£4,000,000
£6,000,000
Apr-0
5
Apr-0
7
Apr-0
9
Apr-1
1
Apr-1
3
Apr-1
5
Apr-1
7
Apr-1
9
Apr-2
1
Apr-2
3
Apr-2
5
Apr-2
7
Apr-2
9
Apr-3
1
Apr-3
3
Apr-3
5
Apr-3
7
Apr-3
9
Apr-4
1
Apr-4
3
Apr-4
5
Apr-4
7
Apr-4
9
Apr-5
1
Apr-5
3
Apr-5
5
Net Cash-flows
Source: Insight Investment
Examples - Gilts and Swaps PortfolioModel Scheme Cash flows - Gilts & Swaps Solution
Annual Cash flow Comparison
-£1,000,000
£1,000,000
£3,000,000
£5,000,000
£7,000,000
£9,000,000
Apr-0
5
Apr-0
7
Apr-0
9
Apr-1
1
Apr-1
3
Apr-1
5
Apr-1
7
Apr-1
9
Apr-2
1
Apr-2
3
Apr-2
5
Apr-2
7
Apr-2
9
Apr-3
1
Apr-3
3
Apr-3
5
Apr-3
7
Apr-3
9
Apr-4
1
Apr-4
3
Apr-4
5
Apr-4
7
Apr-4
9
Apr-5
1
Apr-5
3
Projected Liability Cash-flowsProjected Asset Cash-flowsProjected Net Cumulative Cash-flows
Model Scheme net cash flows - Gilts & Swaps Solution
-£4,000,000
-£2,000,000
£0
£2,000,000
£4,000,000
£6,000,000
Apr-0
5
Apr-0
7
Apr-0
9
Apr-1
1
Apr-1
3
Apr-1
5
Apr-1
7
Apr-1
9
Apr-2
1
Apr-2
3
Apr-2
5
Apr-2
7
Apr-2
9
Apr-3
1
Apr-3
3
Apr-3
5
Apr-3
7
Apr-3
9
Apr-4
1
Apr-4
3
Apr-4
5
Apr-4
7
Apr-4
9
Apr-5
1
Apr-5
3
Apr-5
5
Net Cash-flows
Source: Insight Investment
Examples
0ver 5 year gilt index Gilts & Cash solution Gilts, Cash & swapssolution
Asset Breakdown ofsolution
% % %
Gilts 93.01% 90.60% 37.49%
Cash backed swaps 0.00% 0.00% 55.49%
Cash 6.99% 9.40% 7.02%
Total 100.00% 100.00% 100.00%
Risk measures bp of fund value bp of fund value bp of fund value
PV01 of assets relative toliabilities
-0.6 -0.1 0.1
Annualised tracking error 261.5 252.3 25.4
One month VAR 95%confidence interval
124.2 119.7 12.1
Source: Insight Investment
Examples
Extension of model scheme example would add layers of complexity Choice of discount curve Optimisation goals Inclusion of credit, hedged overseas bonds, strips Pension increases (fixed/RPI/LPI annual/LPI
cumulative in deferment/other caps & floors)
Wider Issues
Incorporating active and deferred liabilities Greater uncertainty in liabilities Cumulative LPI in deferment very complex Salary inflation cannot be hedged
Wider Issues
Different types of inflation increases LPI (0,5) LPI (0,2.5) for future accrual GMPs (0,3) LPI with higher cap (3,5) Public sector RPI (0, infinity) Bespoke hedge vs dynamic hedging for caps and
floors
Wider Issues
Schemes with less than 100% solvency Hedge winding up/PPF benefits or total benefits? Scale down liabilities to available assets
(proportionate hedge or hedge fully for x years or combination)
Hedge whole liabilities e.g. using unfunded swap overlay for excess of liabilities over assets
Wider Issues
Incorporating active management into a Liability Driven Investment strategy Passive matching of benchmark, regular rebalancing Active management of bonds/swaps portfolio vs
benchmark “Portable alpha” Retention of diversified beta risk “unconstrained long-term mandates” – are they true
liability driven investment?
Any Questions?