Liability aware investing

Transcription

1 August 2017 Liability aware investing The benefits of integrating your liability hedging and growth portfolios

2 This document is for investment professionals only and should not be distributed to or relied upon by retail clients. It is only intended for use in jurisdictions where the relevant investment vehicles are authorised for distribution or where no such authorisation is required..

3 Liability aware investing 03 Introduction Defined benefit (DB) pension schemes are facing mounting pressures from regulatory constraints and difficult investment conditions. At Standard Life Investments, we have devised a unique, innovative investment approach that seeks to address some of these challenges. In this paper we demonstrate that by integrating the growth and liability hedging elementsof a pension scheme s portfolio, we can deliver clear advantages in terms of: a higher performance target a scheme can reduce risk relative to its liabilities while maintaining the expected portfolio return simpler governance requirements We achieve these benefits by combining a pension scheme s hedging and growth requirements into a single integrated solution, rather than in separate funds (currently the more common approach). Our suite of Integrated Liability Plus Solutions funds has been designed to capture the benefits of integration to deliver more efficient and easier to implement investment solutions to pension schemes.

4 04 Liability aware investing The DB pension landscape Most DB pension schemes have now closed to new members and are increasingly closing to all accrual. The fiduciaries responsible for such schemes often have a goal to steer it to a self-sufficient position, such that the security of members benefit promises is no longer dependant on the fortunes of the sponsoring employer. For some, this will mean securing liabilities via an insured buyout. In this environment, many fiduciaries have sought to de-risk the scheme s investment strategy by matching the assets held to the liabilities. Matching can be considered both in terms of the pattern of cashflows delivered, and also in ensuring that the balance sheet value of the scheme s assets and liabilities move more closely in line with one another as market conditions fluctuate. Given that most schemes have a shortfall in their assets against their long-term funding target, exposure to growth assets remains an important factor in deficit recovery plans. Efficient use of derivatives One of the most powerful investment techniques employed by pension schemes in recent years (either directly or within pooled funds run by the schemes invwestment managers) is to use derivative instruments. Derivatives enable more effective risk management and efficient portfolio management (for example, by allowing greater portfolio diversification) by providing exposure to either: For pension schemes, one of the key advantages of using derivatives has been that they were unfunded, i.e. no upfront payment was required. However, new legislation is changing this to a position where derivatives must be partially funded see below. Derivative contracts are valued daily and margin (collateral) is required to be posted to the counterparty should the value of the contract to the scheme fall. Therefore, the pension scheme needs to hold a sufficient pool of eligible collateral (usually in the form of cash or high-quality sovereign bonds) to be able to meet margin calls that might arise periodically on the derivative contracts. The unfunded (or partially funded) nature of derivatives means that the pension scheme can gain leveraged exposure to its chosen investment (see Appendix A). Being able to access leverage means that pension schemes can hedge their liabilities to the desired level, while simultaneously preserving most of their capital. This capital can then be invested in return-seeking assets. This has been possible on either a fully segregated basis (where a scheme holds a derivative overlay on its portfolio supported by a pool of eligible collateral), or through the use of leveraged pooled liability hedging funds (known as LDI funds). Commonly, the chosen level of liability hedge is designed to protect the scheme s funding level (i.e. the ratio of assets to liabilities). Changes in the value of the liabilities are matched by the hedging derivatives. Any positive performance from the return-seeking assets then directly improves the scheme s funding level. growth assets e.g. by using equity futures liability hedging assets e.g. by using interest rate and inflation swaps to offset (or hedge ) movements in the value of liabilities. Swaps (and similar gilt-based instruments) do this by replicating the characteristics of bonds, but in a fashion more bespoke to the liabilities (see Appendix A).

5 Liability aware investing 05 The new derivatives landscape New legislation governing the use of derivatives, such as the Dodd-Frank Act in the US and the European Markets Infrastructure Regulations (EMIR), has placed more stringent requirements on risk controls. In particular, many forms of derivative must now be cleared through a central exchange (rather than the previous system where over-the-counter contracts were agreed directly between the investor and the counterparty bank)*. Furthermore, variation margin calls posted to the exchange must now be in the form of cash. Additionally, for certain derivatives (such as interest rate swaps), there is a new requirement for the investor to post initial margin at the inception of a contract. This must be held in ring-fenced cash or high-quality bonds, which cannot be used for any other purpose until the contract is settled. For typical long-dated swaps used by pension schemes, this could be around 5% of the value of liabilities being hedged against nominal interest rate changes. Currently, inflation swaps are not subject to mandatory central clearing and are not expected to be in the near term. There have been further constraints resulting from the Basel III regulatory framework governing the amount of capital that banks are required to hold against their operations. Yield-enhancement techniques that pension schemes (or their investment managers) have sought to capture, such as the use of repo financing**, are now under pressure as banks have become less willing to transact this low-margin, capital-intensive business. Inefficiencies arising from holding separate growth and liability hedging funds To date, a pension scheme that wanted to hold both growth and liability hedging exposures through derivatives in pooled funds has been required to buy units in two separate funds. For example, assume Fund G ( Growth ) targets a LIBOR + 5% performance objective and uses a range of derivatives (as well as physical assets) to implement the manager s growth strategies efficiently. Fund H ( Hedging ) uses swaps to hedge movements in the value of investors liabilities. Each fund is required to hold its own pool of cash to support the derivatives used. In the event of adverse market movements, each fund must meet margin calls from its own collateral. The required level of collateral is usually set according to the expected volatility (riskiness) of the fund in question. This ensures it is able to meet margin calls in the event of reasonably large market movements. Should the collateral held in one of the funds fall below that fund s acceptable threshold, then for reasons of prudent risk management the manager may ask the investor to top up the cash held to maintain the same level of market exposure, or otherwise reduce the level of exposure. Such top ups would normally be met by selling other assets held elsewhere in the scheme s investment portfolio. Thus, there is a potential inefficiency from each of funds G and H being required to hold its own pool of collateral without any recourse to the other fund, which may be holding a sufficient amount of unused collateral. * Pension funds currently have a temporary exemption from the central clearing requirements until ** Repos, or sale and repurchase agreements, are a form of collateralised borrowing used to leverage sovereign bond exposure. Overall, the leveraged exposure to markets sought by pension schemes is becoming harder and more costly as well as more operationally intensive to manage. In short, the new rules mean LDI funds that use leverage are required to hold higher amounts of cash. This causes a potential performance drag on a pension scheme s overall asset portfolio, because more of its assets must be held in cash to obtain the same amount of liability protection. Clearly, in order to avoid the performance drag associated with holding large amounts of cash, it is important to use any cash in the most effective way possible.

6 06 Liability aware investing The benefits of an integrated approach Integrated Liability Plus Solutions (ILPS) In an effort to overcome these inefficiencies and make optimal use of a pension scheme s assets, we have devised a unique, integrated fund structure that combines liability hedging and return-seeking assets in a single solution. In practice, this means that funds G and H (in our example) are amalgamated, effectively giving access to a common pool of collateral. We are able to create this solution by leveraging our recognised multi-asset capability in constructing absolute return portfolios. To build these portfolios, we make extensive use of derivatives for efficient portfolio management and our positions are supported by significant amounts of cash for prudent risk management purposes. There are two key benefits of this integrated approach a higher performance target - by effectively pooling the collateral, a lower overall amount of cash is required than if two separate funds are held. This allows the pension scheme to retain a similar amount of exposure to both its desired growth assets and its liability hedging assets from a lower capital base. In practice, this means the scheme is able to access a higher overall performance target on its entire investment portfolio than it could if it held separate funds. As a result, the scheme can reduce risk relative to its liabilities, while maintaining its expected portfolio return. simpler governance an integrated approach offers the investor efficiency gains from simpler governance requirements. A common feature of leveraged LDI funds is that, in circumstances where the value of the liabilities and therefore the value of the LDI assets falls substantially, the manager may ask investors for more capital to maintain risk tolerance levels. Conversely, the manager may distribute capital to investors if the value of liabilities and LDI assets increases substantially. Within an integrated structure, capital requests (for risk management purposes) that would otherwise be met by selling other scheme assets (requiring action on the part of the investor to issue dealing instructions, etc.) are more likely to be met from the additional collateral held. So, returning to our example, Fund H would have access to any unused collateral in Fund G (and vice-versa). ILPS: an integrated approach Liability hedging Portfolio Traditional approach rebalancing required Cash Our integrated approach more efficient use of collateral Liability hedging tools (swaps/gilts) Source: Standard Life Investments + Efficient use of cash / collateral Cash Growth Portfolio Growth Portfolio

7 Liability aware investing 07 Summary Derivatives have provided very powerful tools for risk management and efficient portfolio management for DB schemes. New legislation governing the use of derivatives means that higher amounts of cash are required to support the risks involved. Therefore, it is important to use cash held as effectively as possible. In this paper we have demonstrated that by integrating the growth and liability hedging elements of a pension scheme s portfolio, we can deliver clear advantages to DB schemes in terms of: a higher performance target a scheme can reduce risk relative to its liabilities while maintaining the expected portfolio return simpler governance requirements We achieve these benefits by combining a pension scheme s hedging and growth requirements into a single integrated solution, rather than in separate funds (currently the more common approach). Our suite of ILPS funds has been designed to capture the benefits of integration to deliver more efficient and easier to implement investment solutions to pension schemes. Our suite of ILPS funds has been designed to capture the benefits of integration to deliver more efficient and easier to implement investment solutions to pension schemes.

8 08 Liability aware investing

9 Liability aware investing 09 Appendix A Appendix A: The use of swaps by pension schemes Fixed interest Counterparty Notional value for swap Swap Pension scheme Cash (notional value for swap) Floating (variable) interest Source: Standard Life Investments. A pension scheme may enter an interest rate swap contract with a counterparty bank, where the scheme pays a floating (variable) rate of interest, say LIBOR, on an agreed ( notional ) amount of capital, and receives a fixed rate of interest on the same amount of capital over the term of the contract. By holding the capital in cash (assumed to generate the required LIBOR interest of the pay leg of the swap), in combination with the swap contract, the scheme has effectively replicated a fixed interest bond. (When a scheme buys a bond, it will receive its capital plus a fixed amount of interest at the end of the term). Accordingly, the market value of the swap contract will change on a daily basis in line with the change in price of a similar bond. Because of the unfunded nature of swap contracts (the contract starts with zero value to either party), a pension scheme can gain leveraged exposure to the value of the bond by agreeing to swap interest payments on, for example, double the amount of cash held (for 2x leverage), thus doubling the sensitivity of the assets to movements in bond prices. This has allowed schemes to hedge changes in the value of their liabilities using a smaller proportion of their capital. The scheme s remaining capital is then available for investment in other (growth) assets with a higher performance target (for example, LIBOR + 5% p.a.). Leveraged liability hedge Swaps have therefore been used to protect (or hedge ) movements in the value of pension schemes liabilities, which are generally linked to the market value of a suitable matching bond portfolio. By holding a suitable combination of cash and swaps, the scheme can create a portfolio to generate cashflows that fully match the projected liability cashflows. From a valuation perspective, the value of the assets and liabilities should move completely in tandem. By design, the swap portfolio matches the offsetting change in the value of the scheme s liabilities. If the value of the swap contracts increase in favour of the pension scheme (i.e. bond prices increase and yields fall), the counterparty will post this difference as collateral to the scheme. Similarly, if the contracts fall in value, the scheme must post collateral to the counterparty. Cash (supporting hedge) Growth assets Source: Standard Life Investments Liability hedging

10 10 Liability aware investing Appendix B In developing our integrated solutions, we carried out a series of analyses, which underline the performance and governance advantages of our integrated approach. For instance, we simulated the possible frequency of capital requests or distributions that might be made to investors under an integrated approach. We compared this to a non-integrated structure that assumed the two components, funds G and H, could be accessed separately. In recognition that capital requests are more likely to occur in a rising interest rate environment, for the purpose of this analysis we reversed the actual path of interest rates between 2008 and end-2015 (a period during which rates generally fell). Our analysis is based on hedging of nominal interest rates, since they tend to be more volatile than real rates. We show the associated liability leverage of each structure over the period (see Chart 1). Our simulation studies also clearly demonstrated the performance advantages achievable using an integrated approach. Using the same historical data series (with the actual path of interest rates), we simulated a non-integrated portfolio structure (i.e. using typical pooled LDI solutions in combination with the Standard Life Investments Global Absolute Return Strategies Fund) alongside our integrated solution. Both are constructed to hedge liabilities to the value of an example scheme s assets. For each, we measured the resultant funding levels (see Chart 2). Clearly, the integrated solution (shown by the orange line) attained a higher funding level compared to the non-integrated fund structure (blue line). In fact, the results indicate that by using an integrated approach, a pension scheme could access an overall performance target that is over 1% per annum higher (net of all fees). Chart 2: Simulated performance comparison Under the simulation, the integrated solution would have made two cash distributions and no capital requests to investors. The non-integrated structure would also have made two distributions but would have made five capital requests, requiring action on the part of the investor. Thus, our work would suggest that the liability leverage multiple is likely to be more stable under the integrated structure. Chart 1: Capital requests and distributions Liability leverage 3.5 Funding level % % p.a Yr Nominal Swap Yield (RH axis) Integrated Solution Non-integrated LDI + Absolute Return Solution Source: Standard Life Investments. Representative example scheme cashflows (all nominal) assumed. Non-integrated LDI + Absolute Return solution assumes 3x leveraged external LDI fund (supported by cash), with remaining assets invested in GARS Fund. Integrated solution assumes 50% investment in ILPS Liability Aware III Nominal Profile Fund, with 50% invested in GARS Fund. Performance simulation gross of fees. Assets are assumed to be rebalanced quarterly to hedge liabilities to the full value of scheme assets Integrated structure Non-integrated capital request Integrated structure cash distribution Non-integrated solution Non-integrated cash distribution Source: Standard Life Investments. Nominal interest rate history between 1 January 2008 and 31 December 2015 reversed.

11 Liability aware investing 11 To find out more about our ILPS solutions, please speak to your usual contact, or visit our website: The value of an investment is not guaranteed and can go down as well as up. An investor may get back less than they invested. Past performance is not a guide to the future. This material is for informational purposes only. This should not be relied upon as a forecast, research or investment advice. It does not constitute an offer, or solicitation of an offer, to sell or buy any securities or an endorsement with respect to any investment vehicle. The opinions expressed are those of Standard Life Investments and are subject to change at any time due to changes in market or economic conditions.

12 Important information Aberdeen Standard Investments is a brand of the investment businesses of Aberdeen Asset Management and Standard Life Investments. Unless otherwise indicated, this document refers only to the investment products, teams, processed and opinions of Standard Life Investments as at the date of publication. Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. It is authorised and regulated in the UK by the Financial Conduct Authority and is the Investment Adviser and Distributor for Standard Life Investments Liability Solutions ICAV. Standard Life Investments (Mutual Funds) Limited is registered in Scotland (SC123322) at 1 George Street, Edinburgh EH2 2LL. It is authorised and regulated in the UK by the Financial Conduct Authority and is the Authorised Investment Fund Manager for Standard Life Investments Liability Solutions ICAV. Standard Life Investments Liability Solutions ICAV is regulated by the Central Bank of Ireland and is an open-ended umbrella fund with segregated liability between sub-funds registered in the Republic of Ireland (no. C142122) at 70 Sir John Rogerson s Quay, Dublin 2, Ireland Standard Life, images reproduced under licence Visit us online aberdeenstandard.com INVBGEN_16_1670_Why_Integrate_UKI_TCM 0218