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10th November 2008
The Art of Risk Management
Risk Budgeting
Longevity Risk
Practical Applications
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• Trustees and sponsoring employers are much more risk-aware as a result of changes in both pensions regulation and accounting requirements imposed on the sponsor.
• Initially, focus was primarily on funding levels and, to a lesser extent, the volatility of employer contributions. This has
been extended to cover assets and liabilities as well as governance issues. • This focus on risk reinforces the need to understand and quantify the components and sources of the risks in detail,
leading to the development of a risk management policy that: • Transfers un(der)rewarded risks; • Diversifies rewarded risks, and; • Accesses returns as efficiently as possible.
Risk Budgeting
Executive Summary
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Risk Budgeting
Regulatory Guidance
TKU Scope Guidance - Extract
"When we first introduced the levy, we tried to make it simple as its implementation represented a major challenge for us, particularly as we had limited information about the risks we were exposed to. We now have a far better understanding of those risks - and this has led to a recognition that we need to achieve greater fairness when we calculate the levy.” The risk-based element of the levy will recognise “a scheme's contribution to the long-term risks that PPF faces, even from well-funded schemes”. -Martin Clarke, Director of Financial risk at the PPF
Risk Budgeting
Further Regulatory Comment
...and the PPF
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Risk Budgeting
Financial Services Regulation
Even Financial Regulators Have Trouble Getting Risk Treated Seriously
“If a year and a half ago, the FSA had wanted higher capital adequacy, more information on liquidity, had said it was worried about the business models at Bradford & Bingley and Northern Rock, and had wanted to ask questions about remuneration, the fact is that we would have been strongly criticised for harming the competitiveness of the City of London, red tape, and over regulation.”
-Lord Turner, Head of FSA - FT 16/10 ‘08
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Risk Budgeting
Ignorance and Denial
Costs of Ignoring Risk
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"Surrender to the reality that volatility exists, or volatility will introduce you to the reality that surrender exists.”
-Famed commodities trader Ed Seykota
“The first step in the risk management process is to acknowledge the reality of risk. Denial is a common tactic that substitutes deliberate ignorance for thoughtful planning.”
-Charles Tremper
“Know when to hold ‘em, know when to fold ‘em”
Limit poker is a science, but no-limit is an art. In limit you are shooting at a target. In no-limit, the target comes alive and shoots back at you. - Crandall Addington, Texas Oil Millionaire
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Risk Budgeting
Understanding Risk
The Rules
• Each player bets a minimum amount to get things going.
• Then each player receives two cards. A player’s cards are for the player’s eyes only. An initial bet is placed by each player depending on the quality of these two cards. At this point you can decide that you want out and fold.
• The Flop: The dealer then places three cards face up in the middle of the table. Based on these three communal cards and the two in your hand, you have a five card hand. Betting then takes place.
• The Turn: The dealer turns over another single card. Another round of betting takes place.
• The River: The dealer places a final card face up on the table.
• Using the seven cards (5 communal and 2 cards known only to each player), betting continues until everyone drops out, or the remaining player is called by one or more other players.
• The player with the best five card holding wins the pot.
Risk Budgeting
Texas Hold’em Poker
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Confident
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WHAT ARE THE PROBABILITIES?
Risk Budgeting
A Case Study – Limited Information
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Very Confident
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WHAT ARE THE PROBABILITIES?
Risk Budgeting
A Case Study – Enhanced Data
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95.2%
4.76% 0%
WHAT ARE THE PROBABILITIES? 11
Risk Budgeting
A Case Study – What You Would Like to Know
100% 0%
0%
POKER IS NOT A GAME OF CHANCE, IT IS A GAME OF PROBABILITIES 12
Risk Budgeting
A Case Study – Probabilities Not Certainty
A Tail Event
Pension fund strategy
ALTERNATIVE ASSETS
CASH
Risk Budgeting
A Case Study
EQUITIES
BONDS
PROPERTY
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In the real world, the unexpected does happen and pension funds have to be prepared...
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1. List the main risks you have to consider when running your pension fund.
2. Break down your risks into three categories:
• Liability Risk;
• Asset Risk;
• Scheme Risk.
Risk Budgeting
Understanding Risk
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What are your main risks?
In our last training session on Pension Funding Risks, trustees identified 13 risks:
Liability risks
Asset risks
Scheme risks
Risk Budgeting
Understanding Risk
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What are your main risks?
Risk
Inflation
Interest Rates
Mortality
Equity Market Risk
Property
Duration Mis-Match
Credit
Counterparty
Reinvestment
Liquidity
Employer Covenant
Legislation Changes
Additional Cost from PPF
Risk Budgeting
Understanding the Importance of Risk
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The Flight Plan
Risk Budgeting
The Flight Plan
Fully funded Pension Scheme
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Sponsor Trustees
The End Game
• Solve for Return to
reach target funding
level;
• Then solve for
minimum risk.
• Solve for Risk;
• Solve for maximum
return given risk;
• Solve for probability
of reaching target
funding level.
• Solve for Risk (employer covenant review);
• Set risk budget using 3 lenses;
• Seek to optimise risk adjusted return (Fuel Efficiency);
• Be proactive in changing market conditions;
• Apply regular risk monitoring and risk
management.
Redington Approach
Virtuous Circle
Risk Return
Fuel Efficiency
Risk Budgeting
Stakeholders Aims
Risk Budget
• The total amount of risk that a scheme should run has to take account of the: • size of the scheme relative to the corporate – impact on balance sheet;
• size of the deficit relative to the liabilities and the corporate sponsor;
• strength of the employer (but bear in mind that corporate strength can change over a
decade, year or even a month!);
• number of years in which to pay off deficit;
• nature of the scheme: e.g. open/closed, mature, young;
• risk appetite of the employer;
• balance between future contribution level stability and excess asset return to reduce deficit;
• investment experience of the trustees.
Risk Budgeting
Considerations of a Robust Risk Budget
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Conclusions Identify
the Risks
Quantify the Risks
Understand Your Risk Appetite
Develop a Robust Risk
Budget
Shut Down Unrewarded
Risks
Implement a Strategic Asset
Allocation
Risk Monitoring
Risk Budgeting
Concluding Remarks
Contacts
Dawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 3415 [email protected] Robert Gardner | Partner Direct: +44 (0) 207 250 3416 [email protected] Redington Partners LLP 13 -15 Mallow Street London EC1Y 8RD Telephone: +44 (0) 207 250 3331
www.redingtonpartners.com THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT
Contacts
Disclaimer
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 Partners 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 Partners does not owe any party a duty of care in this respect.
Redington Partners are investment consultants regulated by the Financial Services 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.
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