Repairing the Pension Deficit using an Integrated Funding and Investment Risk Management Framework

Private & Confidential The-Pensions-Net-Work 20 June 2013

Robert Gardner

Founder and Co-CEO

Redington Ltd

Repairing the Pension Deficit using an

Integrated Funding and Investment Risk

Management Framework

1

Private & Confidential The-Pensions-Net-Work 20 June 2013 2

We live in uncertain times...


People are living longer


The economic outlook remains uncertain

4


Pension schemes remain under pressure


Crisis to recovery: a bumpy ride so far ...

6

20-Year Nominal Gilt Yields 20-Year Breakeven Inflation

Credit Spreads Equity Markets

2.0

2.5

3.0

3.5

4.0

4.5

May 2008 May 2009 May 2010 May 2011 May 2012 May 2013

%

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

May 2008

May 2009

May 2010

May 2011

May 2012

May 2013

%

20

40

60

80

100

120

May 2008

May 2009

May 2010

May 2011

May 2012

May 2013

Reb

as

ed

at

10

0 a

s o

f M

ay 2

00

8

FTSE 100 MSCI World MSCI Emerging Markets

0

50

100

150

200

250

300

350

400

May 2008

May 2009

May 2010

May 2011

May 2012

May 2013

Bp

s


But deficits have grown

7

Buy-Out Deficit

Buy-Out Funding Ratio

Aggregate of PPF eligible schemes

March 2012

60%

Down 7.0%

GBP 675.8bn

Aggregate of PPF eligible schemes

March 2012

Up £208.8bn


1. Transfer to members

Change benefit format, e.g. ETVs, Early

Retirement

2. Transfer to external entity

Buy-In/Buy-out

3. Self Sufficiency

A 7-Step Plan to Full Funding

Choosing the End Game


Preparing for the End GameVUCA


Volatility

Uncertainty

Complexity

Ambiguity

Vision

Understanding

Clarity

Agility

QE Japan

CPAC and RPI

Economy, Politics, Products

Who, what, when, why?

Repair Deficit

Education

S.M.A.R.T

Calls to action

Preparing for the End GameVUCA


Preparing for the End GameThe Seven Steps to Full Funding


Step 1 Description

• A strategic Pension Risk Management Framework sets out funding

objectives, risk budget and other constraints such as liquidity and collateral

requirements

• A Flight Plan charts each plan’s path to full funding and generates required

returns that are used to set investment strategy

Clear Goals and Objectives


The Flight Plan

Map path to full funding

Focus investment strategy decisions

Identify best opportunities


Pension Risk Management Framework

1414

Objective Measurement (Assumed) Performance Indicators Performance (31 March 2013) RAG

Funding Objectives

Primary Funding Objective:

To become fully funded on a Technical

Provisions (Gilts +100bps) basis by 2023.

Expected Returns > Required Returns

Required Return:

Expected Return:

Difference:

Gilts +140bps

Gilts +125bps

-15bps

Secondary Funding Objective:

To build up a sufficient buffer to withstand an

adverse demographic shock and still return to

full funding by 2023.

Expected Returns > Required Returns to return

to full funding by 2023 (following an adverse

demographic shock)

Required Return:

Expected Return:

Difference:

Gilts +175bps

Gilts +125bps

-50bps

Investment StrategyActual Returns should exceed Expected

Returns (implying outperformance).Actual Returns > Expected Returns

Actual Return:

Expected Return:

Difference:

Gilts + xxxbps

Gilts + xxxbps

xxxbps

Risk Budget

Primary Risk Objectives

The investment strategy should not risk the

deficit worsening by [10%] of liabilities over a 1-

year period (including longevity risk).

VaR95 < 10% of liabilities VaR95: 7.8%

Secondary Risk Objectives

The investment strategy should not risk annual

contributions increasing by more than £10m

p.a. over a 1-year period (including longevity)

CaR95 < £10mVaR95: £8.2m

Hedging StrategyNominal/Inflation hedge ratio should be

maintained within +/- [5]% of the funding ratio.

Funding Ratio (Ongoing Basis) 106%

Nominal Hedge Ratio (Ongoing Basis) 90%

Inflation Hedge Ratio (Ongoing Basis) 90%

Liquidity

Maintain sufficient eligible collateral to meet

potential margin calls on derivative positions

and cover one-year’s worth of benefit payments

Total available liquid assets £[xxx]m

One-Year Collateral Requirement + One-Year

Cash Flow £[xxx]m

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


Funding Objectives

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Relative importance of contributions vs. returns in funding the deficit

depends on the funding and risk objectives set out in PRMF

Time


Schemes face demographic, operational, insolvency and investment risks

‘Reduce deficits and improve member security by designing, developing and

delivering investment strategies that manage risk effectively and generate

outperformance’

Question: What is the risk in a 1-in-20 downside scenario?

Risk Objectives

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Risk: Trustee Perspective Risk: Sponsor Perspective

Deficit Value (VaR)

Required Contributions (CaR) Funding Ratio (FRaR)

Required Return on Assets (RRaR)


Sponsor Covenant Load

Estimate the sponsor Covenant Load by combining cash contributions with

the value of the sponsor’s implicit support of the scheme’s investment risk

A PRMF which integrates funding considerations will explicitly consider the

covenant load and the risk of contributions increasing in a downside

scenario

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Sponsor Covenant

Load

Cash Contributions over Horizon

Investment Return over

Horizon

CaR over Horizon


Integrating Funding and Investment Risk

1818

Time HorizonC

on

trib

uti

on

s

Risk

Co

ntr

ibu

tio

ns

Time Horizon

Req

uir

ed

Retu

rns

Risk

Req

uir

ed

Retu

rns

Time

Horizon

Co

ntr

ibu

tio

ns


Integrating Funding and Investment Risk

1919


Implementing an Integrated PRMFCase Study: The journey of a small scheme (a)

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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

Recap:

- What is the end game?

- What is the most efficient investment strategy for meeting the

investment and funding objectives?

- How will the investment strategy be implemented?

- How will the investment strategy be adjusted over time?

Case Study: The journey of a small scheme (b)

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

Contacts

Robert GardnerFounder and Co-CEODirect Line: 0207 250 [email protected]

LinkedIn: http://linkd.in/134mv6HTwitter: https://twitter.com/robertjgardner

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Repairing the Pension Deficit using an Integrated Funding and Investment Risk Management Framework