When Bonds are not enough Presented by

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Myra Armstrong
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1 Liability-driven solutions for pensions When Bonds are not enough Presented by Vincent de Martel, Director, Structured & Alternative Investments 2 April 2004

2 A changing world for DB pensions... IAS 19 marked-to-market valuations of assets and liabilities Falling equity markets Pension fund no longer considered a separate entity direct impact on sponsor's ratings A move towards higher bond allocations is observed Yes, but is that enough? 2

3 DB Risks - Common Misconceptions Perception Reality Liability risk Asset mix risk Active Risk Source: Leo de Bever, Ontario Teachers' Pension 3

4 In a DB world, bond-matching is challenging UK longest Government bond 2036 Netherlands 2028 Germany 2034 France 2035 With inflation-linkage, even greater rarity... UK Govt Inflation-Linked Bonds Maturity Date Nominal Amount 4% Index-linked Treasury Stock 2004 Oct ,338 2% Index-linked Treasury Stock 2006 Jul ,037 2 ½% Index-linked Treasury Stock 2009 May ,098 2 ½% Index-linked Treasury Stock 2011 Aug ,342 2 ½% Index-linked Treasury Stock 2013 Aug ,597 2 ½% Index-linked Treasury Stock 2016 Jul ,455 2 ½% Index-linked Treasury Stock 2020 Apr ,093 2 ½% Index-linked Treasury Stock 2024 Jul ,751 4% Index-linked Treasury Stock 2030 Jul ,171 2% Index-linked Treasury Stock 2035 Jan ,775 Only 6 countries with significant (>100m$ oustanding) inflation programmes - Canada, France, Italy, Sweden, UK, US Source: DSTA, Deutsche Bundesbank, DMO, 30 March 04 4

5 Pension funds are significantly mismatched in interest rate sensitivity Duration of UK Defined Benefit plans (FTSE 350 companies) 30% 25% Fr eq ue nc y 20% 15% 10% 5% 0% Liability Duration Duration of most commonly used benchmarked indices Duration Bond Benchmark Constituent (Years) FT-SE 5-15 Yr Gilts 6.3 FTSE UK Gilts All Stocks 8.0 Merrill Lynch Corp Bond 8.3 FTSE 5-15 Yr UK Gilts Indexed 9.2 FTSE UK Gilts All Stocks Indexed 10.8 FTSE > 15Yr UK Gilts Indexed 16.2 Source: Barrie & Hibbert, AA IM, February 2004, WM Research September 2003 Over 70% of funds have a duration of liabilities that exceed the longest duration index 5

6 Duration mismatch can cause large changes in solvency levels Duration measures the average remaining life of a stream of bond or pension fund cash flows. Duration measures the price sensitivity to interest rate changes: Examples : Duration Barclays Sterling Gilts 15+ = 13.2 years Typical pension fund duration = 20 years Change in interest rates -2% -1% +1% +2% Barcap Sterling Gilts over 15 years +26.4% +13.2% -13.2% -26.4% Pension Scheme +40.0% +20.0% -20.0% -40.0% Difference (negative means surplus for the scheme) 13.6% 6.8% -6.8% -13.6% For simplification purposes, the effect of convexity has not been shown - the order of magnitude remains the same however Source: Bloomberg, AA IM 6

7 Using swaps to achieve the right matching Principle: the duration of a traditional fixed income portfolio is adjusted by entering into an interest rate swap, in order to match the duration of the liabilities Pays variable rate Receives fixed rate Market counterparty (e.g. investment bank) Diversified bonds portfolio Bonds duration + Swaps = duration Scheme duration Application: UK Pension Scheme - matching portfolio 7

8 4 0 0 Thanks to the swaps, the scheme can be immunised against changes in rates Without swaps Deficit Surplus Liabilities Market value Bonds portfolio AA rate + 1% AA rate unchanged AA rate - 1% 400 With swaps Matched Matched Liabilities Market value Bonds portfolio + swaps 250 AA rate + 1% AA rate unchanged AA rate - 1% Based on an actual solution for a UK pension scheme Actively managed corporate bond portfolio Swap overlay: 8 forward starting interest rate swaps Portfolio duration increased from 9 to 19 years For illustration purposes only 8

9 Asset-Liability Management is a risk management tool BEFORE ALM AFTER ALM Interest rates Inflation Longevity Sponsor default? Source: The Times 27 June

10 Now and beyond... Forget the herd each scheme is different and requires a different asset mix Asset-Liability matching does not necessarily imply a 100% allocation to bonds Pension fund management evolving towards an ALM approach match the liabilities and earn a spread 10

Factors Influencing Asset Allocation. Liability Driven Investment and the role of Swaps. Section 1. Liability Driven Investment and the role of Swaps

Factors Influencing Asset Allocation. Liability Driven Investment and the role of Swaps. Section 1. Liability Driven Investment and the role of Swaps Liability Driven Investment and the role of Swaps 24 Pensions Convention Huw Williams The Royal Bank of Scotland 8th June 24 Liability Driven Investment and the role of Swaps Section One Factors Influencing