Towers Watson Presentation: Liability-Driven Investing - Where are we now?

© 2010 Towers Watson. All rights reserved.

Liability Driven Investing (LDI)Where are we now?

April 22, 2010

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Today’s Presenters

Marko Komarynsky, CFA, Director of U.S. Fixed Income Manager Research

Chris Wittemann, CFA, FSA, CERA, Senior Investment Consultant


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Today’s Discussion

Where we have been

Lessons learned

Where we are now

Implementation considerations

towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.

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Where We Have Been


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What is LDI?

Misconceptions about LDILDI is simply a mindsetSuccessful implementation should be tailored to the governance budget (i.e. time, expertise, and organizational effectiveness) and reflect client context


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July 2007 to December 2008

BarCap Indices Avg. YTM 6/29/07

Avg. YTM 12/31/08

Cumulative Return

US Zero Coupon Swap: 10 Year 5.70 2.65 45.90%



US Government: Intermediate 5.14 1.60 17.97%

US Government: Long 5.29 3.15 35.86%

US Corporate: Intermediate 5.83 7.62 -1.22%

US Corporate: Long 6.52 7.41 -1.45%

US Credit: Intermediate 5.76 6.80 1.39%


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January 2009 to March 2010

BarCap Indices Avg. YTM 12/31/08

Avg. YTM 3/30/10

Cumulative Return

US Zero Coupon Swap: 10 Year 2.65 3.98 -6.98%



US Government: Intermediate 1.60 2.02 0.79%

US Government: Long 3.15 4.55 -11.34%

US Corporate: Intermediate 7.62 3.92 21.50%

US Corporate: Long 7.41 6.20 21.53%

US Credit: Intermediate 6.80 3.68 18.67%


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Historical Spreads

-100

-50

0

50

100

150

200

250

300

350

400Sp

read

(bas

is p

oint

s)Fixed Income Spreads

30 Year AA Spread-Composite Curve 30 Year Swap Spread

Source: Bloomberg


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Lessons Learned


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Lessons Learned

We have witnessed volatile market conditions still searching for some sense of equilibrium

Our advice has become more time-sensitive and more collaborative with specific client objectives and views of our uncertain and complex future

Augmenting stochastic analysis with complementary scenario analysisExploring the tails improves understanding of surrounding uncertaintyThose tails may indeed wag again

Clarifying what is timeless vs. time-sensitive components of LDI investment strategy


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Scenario subset 2•Strong growth•Accommodative financial conditions•Developed govt. debt and debt-driven household spending increase, resulting in asset price and actual inflation

Which Camp Are You In?

Strong Economic

Growth

Accommodative Financial Conditions

Scenario subset 1•Weak growth•Accommodative financial conditions•Reflating policy and excess liquidity feeds into asset price inflation and eventually actual inflation

Scenario subset 3•Weak growth•Constrained financial conditions•Due to the constrained liquidity conditions,recovery potential is reduced and global growth is weak

Scenario subset 4•Strong growth•Constrained financial conditions•Policymakers reduce liquidity but real economic growth continues, with unclear impact on asset price and actual inflation

Constrained Financial Conditions

Weak Economic

Growth


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The Limitations of “On Average”

Strong Economic

Growth

Accommodative Financial Conditions

Constrained Financial Conditions

Weak Economic

Growth

Stagflation

Sustainable ‘V’ recovery

Weak recovery

Central

Sustainable ‘V’ recovery

Stagflation


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Measuring Current Investment Risks

2% fall in pension discount rate

30% fall in equity markets

Sample pension plan’s exposure (in $ millions)to financial shocks?

What could happen?(1 in 20 event or tail event)

Killer pandemic scenario


Measuring Current Investment Risks

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Timeless Components of Liability-Hedging Allocations

Pros Cons

GovernmentFlight to quality during stress, liquidity and long duration securities available (i.e STRIPS)

Low yields and expected returns

Corporate

Higher expected returns from credit risk premium and used in regulatory measurements of the liability

Default/downgrade risk and lack of issuer diversification; correlation with equities in down markets

Non-corporate Credit

Diversification and potentially attractive risk-adjusted returns

Potential headline risks of certain issuers; uncertain role in liability measurement

Synthetics Ability to tailor exposuresHigher governance requirements (i.e. administrative, educational, monitoring)


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Pension Discount Rate Curves Are Not Investable

5.50%6.00%

9.50%

7.00%

5.50%

6.00%5.75%

0 1Time

Yiel

d

Bond A Bond B Bond C Average

How do you invest assets to mirror this? Liability: single payment of 25,000 in ten years

Liability (time 0) = (1.07) -10 * 25,000 = 12,709

Liability (time 1) = (1.0575) -9 * 25,000 = 15,115

Return (%) = 19%


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Where We Are Now


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GIC Market Views as of January 2010Economic Factor Market View

Inflation Low but modestly rising inflation in the US, transitioning from 1.5% to 2.5% over three years. Both short-term inflationary and deflationary scenarios are still possible given current environment.

Long Treasury Yields

Central view is for long Treasury yields to rise very modestly from current levels, but with high volatility, reflecting an increased inflation uncertainty premium.

Swap Spread Swap spreads are currently negative, likely to revert to historical norm of modest positive spread.

Credit Spreads Central expectation is that spreads will stay where they are currently, but will be volatile as uncertainty in the market remains.


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Implications For Returns Follow From This Market View

Liability Hedging Segment Current View*(Relative to Government)

Rationale

Government n/a Expect long Treasury yields to increase modestly

Corporate Neutral to slightly positive Expect credit spreads to neither contract nor widen in the near-term

Non-Corporate Credit Positive This segment still offers some historically high spreads and add diversification

Synthetics: Swaps Negative Swap pricing currently not attractive, but swaption pricing may present an opportunity for plans willing to adopt more sophisticated strategies


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Is an Index-Based Approach Appropriate for Most Investors?

Index exposure to different sectors is unstable and not based entirely on fundamentals, especially during market turmoil

Under current conditions, low weighting to Treasuries provides inadequate protection against “flight to quality” scenariosOnce the “flight to quality” has occurred, Treasuries are overweighted just when they are more likely to underperform credit

Index exposure is a function of amount issued by each creditDo you want your credit exposure to be based on market issuance?


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The Index Has Not Been Static

Low levels of Long Treasury bond issuance. Most bill issuance is rolling of short term debt

Credit spread movement changed the relative market valuations of Treasury vs. non-Treasury bonds

Credit ratings in the investment-grade space have drifted downward

Taxable munis (i.e., Build America Bonds) are estimated to be 20% of the Long Credit Index by the end of 2010 (from 7% at the end of 2009)

Source: treasurydirect.gov


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Should You Simply Focus on High Quality Credit?

Universe by Ratings¹Barclays Capital Long Credit Index Holdings

(1/31/10)

AAA AA A BBB

¹X-axis scaled by numeric rating from highest quality rating to lowest quality rating.Source: Barclays Capital, Moody’s, S&P, Fitch


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A Case for Treasuries

Sources: BarCap and Towers Watson


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Implementation Considerations


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What has Towers Watson done in LDI?

Search activity has been growing – search activity more than tripled in 2009 and we placed $9 billion of client assets in LDI programs for 30 clients – mandates range from cash bonds to more complex derivatives programs

We tend to focus on customized solutions however we realize that they might not always be practical for clients so we have worked withmanagers to help develop attractive standardized programs

Tactical strategies and recommendationsWorked with clients to unwind swap positions in 2009 and placed money into credit strategiesMoving between derivatives and physicalsHelp to craft appropriate guidelines for clients Client education


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LDI StrategiesStrategy Pros ConsPhysical/Cash Bonds Easy to understand

Fewer moving partsLower governanceReporting

Liquidity can be an issueDiversificationLimited duration profile

IR Swaps LiquidityCustomizationTheoretically unlimited durationCost

Higher governanceBasis riskPotential leverageNeed to educate committeeReporting

Credit Swaps Customization Same as IR Swaps plus:No exposure to IR durationPerceived and real risk

Futures Liquidity Basis riskPotential leverageNegative convexity

KRD buckets Easy to implementCollateral managementReporting

Lower flexibilityPotential leverage


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Portfolio GuidelinesAble to customize with a separate account?

Size of investment mandate ($75M to $100M minimum)

Level of governance budget

If not:May result in commingled long duration products

May result in passive lower cost implementation

*Credit markets trade on a bid-ask spread basis (no commission costs). Larger managers may not necessarily receive more beneficial pricing, but may receive larger allocations given relationships with broker/dealers.

Areas to potentially customizeBenchmark

Government/Credit mix

Key rate durations

Non-corporate credit exposure

Credit quality criterias

“Plus” sectors exposure

Issuer limits

Role of synthetics?

Level of active risk allowable to manager

Liquidity/collateral requirements


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PeopleTalented and experiencedSmall decision-making teamsDepth of resourcesCultural alignmentStrong recruitment and trainingHealthy staff turnover

What We Look For In A Manager

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BusinessLong-term focusAccount Management core business areaStable corporate structureStrong compliance/technologyLimitations to growthEmployee ownership

ProcessClear competitive advantageSuperior researchEfficient communicationEvolution of processStrong portfolio constructionTransaction cost monitoring

Client interests

Asset management company interests

Portfolio managerinterests

Alignment of interests

Co-investment

Employee ownership

Performance fees


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How We Do It

Global asset class head signs off

Universe of managers

ASK signs off

FREX 1 checklist

Devil’s advocate

Engagement

Follow-up meetings

Follow-up desk-based research & conf calls

Initial research meetings

Desk-based research

Market knowledge, contacts, publications, databases

Experience/stability of team, fees, process/philosophy,quant analysis (see Supporting Materials)

Meet key people, detail on process, independent thoughts emails

Read manager’s research notes & valuation analysis, further quant

Sit in on internal meetings & stock discussions, meet more people

Fees, capacity framework, vehicles

One Area of Specialist Knowledge (ASK) member makes case against rating manager highly

20 key points to cover before moving to Future Return Expectation (FREX) 1 rating

ASK debates all key issues & decides whether to rate FREX 1


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Conclusions

Who said LDI was boring?

Volatility in the financial markets creates investment risks as well as opportunities

Our role is to help clients make effective investment strategy decisions in real time


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Contact Details

Chris Wittemann191 North Wacker, Suite 2100, Chicago, IL 60606+1 312 525 [email protected]

Marko Komarynsky191 North Wacker, Suite 2100, Chicago, IL 60606+1 312 525 [email protected]

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Disclaimer

The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm or accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments.

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Towers Watson Presentation: Liability-Driven Investing - Where are we now?