1. Credit: A Core Building Block
for DB Schemes Investing in a
Low Yield Environment
Robert Gardner
Pete Drewienkiewicz
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 1

2. 7 Steps to Full Funding TM
Mission Statement
To assist our clients achieve full-funding with the minimum level of risk
Design an efficient investment
strategy
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 2

3. The Flight Plan
Flight Plan
4,000 Liability
Basis
3,500
3,000
£mm
2,500
Contributions & Asset
Returns
2,000 Time Horizon
1,500
1,000
2012
2013
2013
2014
2014
2015
2018
2018
2019
2020
2020
2021
2021
2025
2025
2026
2015
2016
2017
2017
2022
2022
2023
2024
2024
liability (swap flat)
liability (swap flat) asset (swaps(swaps flat)
asset flat)
100% - Swaps Flat by 2026
Required Returns Libor + 300bps
Expected Returns Libor + 200bps
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 3

4. Credit Spread and Gilt Yield Evolution
600 20-Year Gilt Real Yield Sterling IG 15+ Corporate Spread IG Spread + Real Yield
500
400
300
bps
200
100
0
-100
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 4

5. The Pension Risk Management Framework
Objective Measurement Performance Indicators Performance RAG
RR: Libor + 300bps
Primary Funding To reach 100% funded on a swaps flat Expected Returns (ER) > Required
ER: Libor + 200bps
Objective basis by 2026 Returns (RR)
Difference: -100bps
AR: Libor + 210bps
Investment Actual Returns should exceed Actual Returns (AR) > Expected Returns
ER: Libor + 200bps
Strategy Expected Returns (ER)
Difference: +10bps
The investment strategy should not risk
Risk Budget the deficit worsening by £600mm over VaR95 < £600mm VaR95: £700mm
a 1 year period
Funding Ratio (swaps flat) 70% n/a
Nominal and inflation hedge ratio
Hedging
should be maintained within +/- 5% of Nominal Hedge Ratio (swaps flat) 50%
Strategy the funding ratio
Inflation Hedge Ratio (swaps flat) 85%
Maintain sufficient eligible for the
Total available eligible collateral £900mm
purposes of covering margin calls that
Collateral may arise from the Scheme’s current
derivative positions over a 1 year Remaining collateral after VaR95 event £600mm
period.
RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 5

6. Calls To Action
Objective RAG Comments Call to Action
Expected Returns are 100bps below the Required
Primary Funding  Amend/adjust the investment strategy to increase
Returns to reach 100% funded on a swaps flat basis by
Objective Expected Returns
2026
Investment
Actual Returns are 10bps above the Expected Returns  No Action Required
Strategy
The current investment strategy risks the deficit
Risk Budget  Reduce risk in the investment strategy
worsening by more than the £600mm Risk Budget
The nominal and inflation hedge ratios are below and
 Increase nominal hedge ratio
Hedging Strategy above the target hedge ratio (i.e. the funding ratio),
 Decrease inflation hedge ratio
respectively
Maintains £600mm collateral in excess of what might be
Collateral  No Action Required
required after a VaR95 event
Summary
 The Scheme needs to simultaneously:
1. Increase Expected Returns to equal (at a minimum) the Minimum Required Returns, but should aim to target
the Required Returns; and
2. Reduce the risk it is exposed to (as measured by VaR95); while
3. Maintaining sufficient levels of eligible collateral to withstand a VaR95 event.
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 6

7. Credit as a Core Building Block for Flight Planning
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 7

8. Credit Spread Evolution: January 2007
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 8

9. Credit Spread Evolution: January 2009
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 9

10. Credit Spread Evolution: December 2012
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 10

11. Annual Returns of Credit Sub-Asset Classes
80%
Sub Financials
High Yield
60% Emerging Markets
Investment Grade
40%
ABS
Leveraged Loans
20%
0%
-20%
-40%
2004 2005 2006 2007 2008 2009 2010 2011 2012
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 11

12. Volatility in Returns of Credit Sub-Asset Classes
30%
Sub Financials
High Yield
25%
Emerging Markets
Investment Grade
20% ABS
Leveraged Loans
15%
10%
5%
0%
Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012
Rolling annualised standard deviation of monthly returns
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 12

13. Absolute Return Credit Strategies
Key Features: Reasons for Popularity:
• Unconstrained fixed income mandate • Ability to generate returns from both credit and
interest rate cycles
• Cash or credit return-generating base with derivative
overlays • Pressure to allocate away from traditional corporate
bond mandates given low gilt yields
• Low volatility target
• Identification of weaknesses in market cap
• Focus on strict risk management weighted bond indices
• Increased demand for Libor + return strategies to
back LDI portfolios
Credit Spread Cycle
Interest Rate Cycle
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 13

14. Liquid & Semi-Liquid Credit Strategies
Step 4. Description Implementation-to-date
• Credit consists of a range of sub-classes with
different risk-return characteristics.
• 14% to Liquid Credit (corporate bonds (passive))
• Includes Alpha oriented mandates where the
• 2% to Semi-Liquid Credit Strategies (distressed
manager can operate in the entire fixed
debt, fixed income arbitrage, relative value credit)
income universe. This enables the manager to
take advantage of relative value between
• Total exposure 16%
different instruments, aiming to earn long run
risk premia throughout the credit and economic
cycle.
Considerations:
The 7 Steps to Full Funding TM framework and the PRMF act as a prompt to the scheme to dynamically shift its
credit allocation to target spreads at appropriate levels (i.e. above the scheme’s required returns).
Dynamically altering the scheme’s allocation could potentially be achieved by allocating to an ‘absolute return’ credit
mandate, or via the use of specialist managers.
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 14

15. Illiquid Credit Strategies
Step 5. Description Implementation-to-date
• We believe there are a number of opportunities
available which can provide “long-dated,
inflation-linked” cash flows at a higher yield
than traditional matching assets (we call them
“Flight Plan Consistent Assets”). • Total 0%
• Typically, these assets tend to fit well with the
overall objectives of pension schemes when
assessed in the context of a scheme’s PRMF
Considerations:
Assess possibility of making allocations to the following opportunities to increase credit diversification and
expected returns:
• SME lending
• Secondary UK PFI and core infrastructure refinancing
• Social housing
• Secured leases
• Ground rents
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 15

16. Large Client: Credit Portfolio Restructuring
This slide gives details of a credit portfolio review New Allocation
undertaken by Redington in February and March 2012.
18%
Original Credit Allocation
25%
14%
18%
47% 10%
38% 10%
20%
GBP Corporate Bond Buy & Hold
Manager 1 Manager 2 Manager 3
Alpha Orientated Manager
Mgr Asset Class Benchmark Flight-Plan Consistent Assets
1 GBP Long-dated Buy & Hold portfolio
corporate bonds High Yield/Leveraged Loans
2 GBP Corporate Bank of America/Merrill Lynch
bonds Sterling Non-Gilt ex Insurance ABS
3 GBP Corporate Bank of America/Merrill Lynch
bonds Sterling Non-Gilt ex Insurance "Conventional"
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 16

17. Large Client: Credit as an Equity Replacement
Sample Equity Replacement Portfolio Portfolio Weightings: Whole Scheme
Risk Parity Current Allocation Replacement Portfolio
20%
Long / Short
40% Credit 15%
25% 25%
20% Direct Lending 50%
(SMEs)
20% 35%
Distressed Debt 50%
Equities Credit Alternatives
Sources of Funding
Developed
Equity
• Overall risk in the return-seeking
EM Equity
assets bucket reduced by a fifth
• Overall expected return on scheme
assets increased by more than 10%
Private Equity
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 17

18. Overcoming the Governance Hurdle: Sample Report
Market Value by Maturity Bucket
30%
26.6%
24.2%
USD EUR GBP Total
25% Credit Credit Credit
21.1%
20%
Market Value
Market 26.3 9.6 64.1 100
15% Value (%)
10.9% 10.2%
10%
7.0%
5% Yield to 4 11.9 5 5.4
Worst (%)
0%
< 5 yrs 5 - 10 yrs 10 - 15 yrs 15 -20 yrs 20 - 25 yrs 25+ yrs
Market Value and Libor Spread by Country Duration 13.6 0.6 7.8 8.7
800 (yrs)
Portfolio Benchmark
700 Netherlands
UK
600
Spain Spread 3.4 0.5 5.4 9.3
Libor Spread (bps)
Denmark
France
500 Italy Switzerland Duration
400 Germany Contribution
Australia Japan United States
(yrs)
300
Jersey Chan Isle Finland Libor 177.9 799.5 236 274.8
200 Norway
Spread
100 (bps)
0
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 18

19. Conclusion
• The credit universe is large and diverse, and offers pension funds a large
range of tools for increasing the return on scheme assets in a risk-controlled
way.
• Having a robust Pensions Risk Management Framework and Flight Plan
means that pension funds can move quickly to access attractive
opportunities as and when they emerge.
• Market dislocation subsequent to the 2008 and Eurozone crises means that
an investment strategy that spans the entire credit spectrum is now more
important than ever.
• Methods of implementing credit allocations differ according to scheme size
and governance requirements. Potential solutions exist for both large and
small pension funds.
ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 19

20. 13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk
Contacts
Pension Consultant of the Risk Management Firm
Year 2012 of the Year (2011, 2012)
Robert Gardner Pete Drewienkiewicz
Founder & Co-CEO Director | Head of Manager Research
Direct Line: 020 7250 3416 Direct Line: 020 3326 7138
robert.gardner@redington.co.uk pete.drewienkiewicz@redington.co.uk
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