1. Private & Confidential 21st Century LDI 2 July 2013
21st Century Liability Driven Investment
David Bennett – Head of Investment Consulting, Redington
2 July 2013
2. Private & Confidential 21st Century LDI 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
4. Private & Confidential 21st Century LDI 2 July 2013
-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
5. Private & Confidential 21st Century LDI 2 July 2013
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
7. Private & Confidential 21st Century LDI 2 July 2013 7
0
200
400
600
800
1,000
1,200
1,400
1,600
Demand Supply
GBPBillions
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
8. Private & Confidential 21st Century LDI 2 July 2013 8
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
9. Private & Confidential 21st Century LDI 2 July 2013
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%
PercentageofTotalLiabilities
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
Millions
Liabilities Assets (Current Expected Return)
Sample Flight Plan Analysis
Impact of
60bp
forward
curve
shift
10. Private & Confidential 21st Century LDI 2 July 2013
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
PercentageofTotalLiabilities
Impact on Risk of Increasing Hedge Ratio from 50% to 80%
11. Private & Confidential 21st Century LDI 2 July 2013
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%
12. Private & Confidential 21st Century LDI 2 July 2013 12
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
ParRate
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
13. Private & Confidential 21st Century LDI 2 July 2013
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
14. Private & Confidential 21st Century LDI 2 July 2013
Hedging Strategies
14
40%
50%
60%
70%
80%
90%
100%
HedgeRatio
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
15. Private & Confidential 21st Century LDI 2 July 2013
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
17. Private & Confidential 21st Century LDI 2 July 2013
40
45
50
55
60
65
70
75
80
1M 3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
Swaptionvolatility(bps) 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)
DV01(£)
Swaps Collar Payer
4.60 4.49
3.25
3.59
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 StructureLIBOR Curve – Spot vs. 10Y Forward
18. Private & Confidential 21st Century LDI 2 July 2013
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
20. Private & Confidential 21st Century LDI 2 July 2013 20
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
21. Private & Confidential 21st Century LDI 2 July 2013 21
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
22. Private & Confidential 21st Century LDI 2 July 2013 22
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%
24. Private & Confidential 21st Century LDI 2 July 2013
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
26. Private & Confidential 21st Century LDI 2 July 2013
60%
65%
70%
75%
80%
85%
90%
95%
100%
Fundinglevel
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
27. Private & Confidential 21st Century LDI 2 July 2013
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
28. Private & Confidential 21st Century LDI 2 July 2013
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
david.bennett@redington.co.uk
Contact
