Pension Risk Management

Transcription

1 Data as of June 30, 2010 Presented to: UBS Institutional Presented by: Bradley D. Jacob Sean F. McShea

2 What is? 1. represents an enterprise risk management oriented approach to asset allocation, which uses Liability Driven Investing (LDI) as the foundation of the process. 2. LDI incorporates a market consistent approach to both the assets and liabilities. 3. There are many different ways to implement LDI, but the common theme involves structuring the fixed income portfolio in a manner that reduces funding level volatility and risk to the balance sheet by minimizing Surplus Volatility. 4. Risk management bases asset allocation decisions and investment strategies around the balance sheet capacity to take risk, and the desired risk budget of the plan sponsor. Page 2

3 Asset Allocation in a Risk Management Framework 1. Asset Allocation in a risk management framework cannot rely solely on Mean- Variance Optimization (MVO) because: A. Liabilities: MVO does not build a pension plan s liabilities into the model B. Serial Correlation: Monthly performance influenced by previous month C. Fat Left Tails: MVO typically uses 2 standard deviations, resulting in negative skewness (distributions concentrated on the right tail) D. Correlation Breakdown: Assumes linear relationship between asset classes in bull and bear markets. 2. Rather than using MVO to find the portfolio with the highest probability of achieving ROA objectives at the lowest relative volatility, risk management asset allocation consists of answering four questions, specific to each individual plan sponsor. Page 3

4 Asset Allocation in a Risk Management Framework The four questions of asset allocation are: Risk Measure 1. What percent in fixed income? Capacity of plan sponsor to take risk 2. What duration should the fixed income portfolio have? Desired risk budget based on surplus volatility 3. What percent in non-bonds? Remainder of assets after fixed income allocation 4. What style of non-bonds? Allowable asset classes (IPS), MVO Conclusion: Understanding and quantifying the risk capacity and desired risk budget of the plan sponsor should act as the foundation for asset allocation, rather than using MVO as the end-all. Page 4

5 Risk Management for XYZ Corp 1. The XYZ pension liability has a duration of years. A. Duration represents the sensitivity to interest rate changes. With a 1% change in interest rates (the yield curve), the liability value will move approximately 12.64% in the opposite direction. B. In order to minimize funding volatility, the duration of assets should be in line with the duration of the liability. This is the start of. 2. The current duration of the bond portfolio is approximately 4.50 years, which is significantly shorter than the liabilities. Extending duration of the bond portfolio in accordance with the liabilities will reduce funding level volatility derived from asset and liability returns. Page 5

6 Stack There are 10 key risks a plan sponsor should understand. XYZ s risk stack is as follows: Page 6

7 XYZ Liability Term Structure Page 7

8 XYZ Interest Rate Sensitivity Page 8

9 Pension Leverage: Assets Cannot Make Up the Gap Alone Page 9

10 What is Surplus Volatility? 1. Surplus Volatility is defined as the funding volatility derived from the return difference of assets and liabilities. A. Surplus can be positive or negative, and is expressed in standard deviations. A. 1 standard deviation = 68.3% of results B. 2 standard deviations = 95.0% of results C. 3 standard d deviations = 99.7% of results B. To manage fat tail events, i.e., 08 to 09 credit crisis, 00 to 02 stock market bubble, etc., we need to be concerned with 3 and 4 standard deviation events. 2. The current Surplus Volatility of XYZ is : A. 3 σ = $68.25 million B. 4 σ = $91.00 million 3. This means that the difference between the pension plan s assets and liabilities can go up or down $91.0 million during fat tail events. Page 10

11 Current Surplus Volatility Page 11

12 Reducing Surplus Volatility Relative to the Balance Sheet 1. Reducing Surplus Volatility through a risk management strategy will help preserve the integrity of the balance sheet. 2. There are three strategies that can reduce Surplus Volatility at the current funding ratio and current allocation: A. A bond portfolio structured against the Barclays Capital Government/Credit Long index B. A bond portfolio structured against the 0 to 15 year liability duration cells. C. A bond portfolio structured against the full liability term structure, 0 to 30 years. 3. Benefits: A. G/C Long hedges PPA interest rate risk better than an Aggregate strategy. B. 0 to 15 Credit hedges PPA volatility more effectively. C. 0 to 30 Government/Credit hedges total t interest t rate risk (PPA & economic) more effectively. Page 12

13 Strategy Summary Page 13

14 Aggregate versus Liabilities The current Aggregate strategy does not effectively hedge the interest rate risk of the pension plan s liabilities. Page 14

15 XYZ Recommended Surplus Volatility Page 15

16 Surplus Volatility Reduction 1. The 3 standard deviation (3 σ) Surplus Volatility for the current and proposed strategies is: A. Current Barclays Aggregate 3σ Surplus Volatility = $68.25 million B. Government/Credit Long 3σ Surplus Volatility = $62.64 million C. LDI 0 to 15 Credit 3σ Surplus Volatility = $62.66 million D. LDI 0 to 30 Government/Credit 3σ Surplus Volatility = $57.60 million 2. Restructuring the current weighting to fixed income and implementing a risk management strategy can reduce Surplus Volatility by $5.6 to $10.7 million. 3. Increasing the current weighing to fixed income and implementing a risk management strategy can further reduce Surplus Volatility. Page 16

17 Surplus Volatility Relative to the Balance Sheet Current 3 σ surplus volatility represents 121% of net assets, and 226% of total cash. Page 17

18 Risk Management Conclusion 1. An enterprise risk management oriented approach to asset allocation looks at asset and liability volatility in a market consistent framework, relative to the XYZ balance sheet. 2. Adopting a risk management strategy will reduce funding level volatility and assist in preserving the integrity of the XYZ balance sheet. 3. Restructuring the current weighting to fixed income and implementing a risk management strategy can reduce Surplus Volatility by $5.6 to $10.7 million. Increasing the current weighing to fixed income and implementing a risk management strategy can further reduce Surplus Volatility. Page 18

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20 Disclaimers Page 20