Liability hedging. de-risking and de-stressing

Transcription

1 Liability hedging de-risking and de-stressing

2 Introduction Pension funds do not need to be told that they currently face a multitude of challenges and risks. We believe liability hedging (also known as liability matching) is an effective way to help de-risk the scheme. In this booklet, we explain why pension funds might consider liability hedging, how it works and what are the potential pitfalls to its successful implementation. We also explain that liability hedging is not a single concept but comes in all shapes and sizes depending on the type of pension scheme involved and the attitude of its trustees sponsors and members. The decisions and processes involved are not simple, we concede, but the improvement in the scheme s risk profile is generally well worth the effort spent.

3 What keeps pension fiduciaries awake at night Unprecedented and persistently high levels of volatility in financial markets have added to the already considerable challenges faced by pension fiduciaries. The direct impact of this volatility on schemes is clear: it is harder than ever to forecast future asset, liability and funding levels. As a result, few schemes can be certain that their assets will ultimately meet their liabilities. It is not difficult to imagine that the situation might get worse before it gets better: if austerity measures remain in place and low interest rates persist, the discount rate will fall and liabilities will rise. On the other hand, if these measures are relaxed and fiscal policy becomes more accommodating, higher inflation may result, leading to inflated future benefits claims. Pension schemes are not suffering in isolation: highly-volatile markets are impacting scheme sponsors too, compounding the challenges. While some leading companies are reporting strong revenues and profits, more still are finding that the challenging operating environment is having a negative effect on the P&L and balance sheet. Given this, few sponsors are willing or able to step in and inject new money into pension schemes with widening deficits. The worst-case scenario is that, amid falling confidence and markets worldwide, more sponsors fail. In some cases, pension scheme deficits will even be a catalyst in corporate failures. While relatively few schemes actually collapse, the list of those that have fallen under the auspices of the Pension Protection Fund (PPF) in recent times is sobering. In 2012 alone, the schemes of companies such as Do It All, Woolworths and the Berkshire Pension Fund have all fallen upon the mercy of the PPF. In total, nearly 500 schemes have been transferred to the PPF since it was created in In our experience, schemes with relatively weak covenants, which often include those sponsored by subsidiaries of international companies, are particularly vulnerable. But, in this environment, no scheme can be absolutely certain of being able to provide the promised level of benefits over the lifetimes of their members. Given these risks, some schemes have taken steps to stabilise their funding levels. By matching a proportion of their liabilities, and hedging against adverse changes in interest rates, inflation and longevity, pension schemes and their sponsors can help to ensure that they can pay benefits in even the most adverse of scheme-specific or market-related conditions. To put it crudely, liability hedging means that if the sponsor fails, markets crash, inflation soars or longevity rises, there is a better chance that pensions will still be paid. Liability hedging soothing frayed nerves Liability hedging solutions aim to help neutralise the impact of inflation, interest rates and longevity by matching a proportion of a pension scheme s assets to its liabilities. In practice, this may mean buying longer duration bonds in order to better match the scheme s assets to its liabilities. This is a typical first step for many schemes: easy to understand, easy to execute and effective in broadly reducing risk. To match liability tranches even more closely, derivatives can be used. In fact the use of derivatives to match liabilities is now very common. Overall, there are a considerable number of assets that can be employed to achieve the desired level and specificity of hedging. They include: Government bonds Supranational bonds Corporate bonds Cash Interest rate swaps Inflation swaps Total return swaps Bond futures Bond options Interest rate swaptions Some schemes, particularly those with few or no active members, choose solutions that can entirely hedge their liabilities. These solutions include insurance annuities (buy-ins), synthetic buy-in structures and ultimately full insurance buy-outs. Fiduciaries should not be concerned if the range and complexity of the solutions appear daunting. At Towers Watson we do not advocate complex solutions when a simple one will do. In fact, the complex solution may not always give enough additional benefit compared to a simpler solution. We understand that our clients only have so much time and money a key part of our role is to help them to spend it wisely. On many occasions, the liability hedging solutions we suggest are relatively simple, low-cost and require relatively low governance. Liability hedging de-risking and de-stressing 3

4 Our long experience in devising liability hedging solutions for pension funds means we can successfully implement whatever strategy is right for the scheme. A belief in bespoke All pension schemes are different and hedging solutions should refl ect this. The exact hedging needs will depend on the proportions of active, deferred and retired members, the likelihood of early retirements and salary increases, the funding level and the strength of the covenant. The solution will also reference the current asset mix, the risk preferences of trustees, sponsors and members, and any number of other idiosyncratic factors. The starting point is to formulate a journey plan based on the characteristics of the scheme. Some schemes need to reduce risk while the issue for others is to spend their risk budget in the most effi cient manner. Trustees typically spend a large amount of time on manager selection, but the most important single factor for a scheme is how much risk to take. So whereas some schemes seek a buy-and-hold portfolio that is focused on improving the management of interest rate and infl ation risk, others are looking to sweat the hedging assets by adding diversifi ed alpha and beta risks that could increase expected portfolio returns. If the desire is to utilise the capital in the hedging portfolio to add value through active management and opportunistic beta exposure, then we would construct the portfolio in a different way. All the assets held, other than the minimum required for collateral and margin requirements, can be thought of as assets that can contribute to the fund s diversifi ed alpha and beta exposures in order to add extra return. Our long experience in devising liability hedging solutions for pension funds means we can successfully implement whatever strategy is right for the scheme, taking into consideration the economic cycle and the target risk profile. In short, our bespoke solutions are truly bespoke. Delegation reducing the hassle Of course, arriving at the right de-risking solution and being able to implement it is not always a simple process. A growing number of pension schemes tell us they would prefer a single trusted entity to guide them through the liability hedging process rather than dealing separately with advisers, asset managers, banks and lawyers. If the portfolio is to be largely static, then we might suggest a portfolio of appropriate long-dated fi xed and infl ation-linked high quality government bonds coupled with appropriate interest rate and infl ation swap exposures in order to provide leverage. The intention here is that the portfolio can largely be left for a number of years with little maintenance other than monitoring the exposures and counterparty risks. 4 towerswatson.com

5 Towers Watson s delegated solution reduces the hassle and the resources required by leading the process from start to finish, taking charge of all the transactions and monitoring the asset and liability profile of the scheme. Our pre-negotiated agreement with a leading asset management company considerably speeds up the liability hedging process and improves its overall efficiency. The Investment Management Agreements (IMAs) are pre-agreed for instance, and the power of attorney allows Towers Watson to design the strategy and decide when to implement it, with execution delegated to our chosen fund manager. In this way, there is no slippage in the timeframe. Many schemes are keen to de-risk as soon as possible after making the decision to hedge their liabilities. With a delegated solution, they can execute just three to five days after the delegated agreement is set up. This compares with weeks, or even months where the scheme deals separately with numerous parties. While many schemes seek to de-risk as soon as possible, regardless of asset price levels, implementation may involve a phased accumulation of the relevant assets. This means that the scheme pays a time-averaged price for its hedging assets and also that it does not move market prices through a single large transaction which could increase the purchase price. The fees we have negotiated with our chosen asset manager are highly competitive and this reflects the fact that the asset manager does not have to enter into arrangements with numerous schemes and service each of them individually. For the pension scheme manager, there is far less time spent on administration and negotiation. The scheme also outsources the maintenance of the hedging portfolio, which can be time-consuming even in the case of a static hedging portfolio. By delegating liability hedging to us, pensions trustees and other stakeholders are freed to focus on strategic and scheme-specific issues, which are their core areas of expertise. Show and tell: monitoring and communication Whether a pension scheme implements its own liability hedging solution or delegates the process to an adviser such as Towers Watson, it will seek to know if the solution is meeting its goals. Questions that need to be answered include: How has the value of my assets changed compared to the value of my liabilities? What were the major contributors to this change? Have my liability-hedging assets behaved as expected and improved the match between my assets and liabilities? Is my return-seeking portfolio delivering the returns that were expected and at appropriate risk levels? The most effective way to assess whether the solution is working is through a proactive monitoring approach. Typically, a reporting structure will be agreed with each client at the outset of liability hedging. In addition we recommend trustees monitor the development of scheme funding using Asset Liability Tracker (ALT). This system offers a huge variety of sophisticated functionality that can be tailored to a scheme s individual needs. It provides: Daily valuations of assets and liabilities in relation to scheme-specific assumptions and benchmark indices. Specific trigger points which can be defined by the sponsor and trustees and monitored on a daily basis. Warning s when a trigger status changes. Secure web access for authorised users around the clock. A single platform for sponsors, trustees and advisers to monitor a scheme s risks. Towers Watson we know the issues and take the strain Whether pension schemes wish to execute liability strategies themselves or delegate the process to Towers Watson, we have the proven experience and expertise to make sure this critical risk-reducing exercise meets all the pre-defined aims. Liability hedging de-risking and de-stressing 5

6 We believe we have advised more liability hedging programmes than any other consultant. We have one of the largest dedicated liability hedging teams and have completed transactions worth over 100 billion, including 15 billion in longevity risk deals alone. In total we have helped more than 50 pension schemes to implement derivative overlays. We do not simply provide a single solution to the problem: our consultants look at schemes holistically and work with them to find out exactly what they need and what implications the liability hedging may have for the rest of the portfolio. An off-the-shelf transaction with an asset manager or bank may not include this level of strategic oversight. In addition, we have decades of experience of dealing with counterparties such as banks, and are highly sensitive to the potential risks and pitfalls of dealing with them. We can handle all the documentation and governance issues this involves. The complexity of dealing with counterparties is increasing as regulation evolves, and we can manage the governance of regulatory issues too. We pass on to clients our experience of working with regulators and our understanding of the impact of the many new regulations that are coming into force. This achieves a more efficient solution and means our clients are on top of changing global rules. To sum up, we assess the particular risks and benefits for each client, rather than simply selling a product. We have the experience, capabilities and knowledge to judge whether a product is what the client needs and whether it is competitively priced. Our preference is for simple and transparent instruments that have low initial and ongoing management costs. In our view, one of the biggest risks is to go into a complex product without knowing what action should be taken if things go wrong. In a risk reduction exercise such as liability hedging, that is the last thing that should happen. Conclusion no more sleepless nights Liability hedging is becoming an important element in the pension fiduciary s toolkit to ensure that benefits will be paid over all timeframes. For the liability hedging process to achieve its aims, schemes will increasingly look to ally themselves to experienced and trusted partners. The process is, in our opinion, well worth the resources and time it takes to implement. However, with increasing financial markets regulation, the process will only become more complex. Some schemes will execute their own solutions, but others will seek a single point of contact to guide and support them. Towers Watson works with schemes to build on their in-house strengths and provide guidance and help where there are gaps to ensure that the de-risking process is successful and that pensions fiduciaries sleep better. Further information For further information, please contact your Towers Watson consultant, or Treeve Coomber treeve.coomber@towerswatson.com Nick Horsfall nick.horsfall@towerswatson.com 6 towerswatson.com

7 Case study 1 De-risking using equity and swap options Towers Watson worked with a major FTSE 100 company to design and implement an innovative de-risking strategy using a combination of equity and swap options. Equity risk had been identified as one of the key risks to the scheme, which had more than half of its 1 billion portfolio allocated to globally-diversified equities. In addition, although the sponsor had a strong covenant, the trustees recognised the potential correlation between the risk of a weakening covenant or sponsor default and general equity market conditions. After a strong rally in equity markets the opportunity to lock into higher market levels became more attractive, not only because of higher levels that could be locked into, but also due to particular attractive pricing in equity and swap option markets for this specific strategy. The client wished to move fast. Towers Watson designed a detailed project plan identifying the steps needed for successful implementation, including the milestones, bottlenecks and parties involved. We worked closely with the scheme actuary, its lawyers and its execution manager. Our proactive approach and support meant that the trustee could focus on the high-level decision making. Case study 2 Hedging longevity Longevity hedging was seen as a cash efficient step to reduce this large media company s exposure to the legacy-defined benefit risk. The most suitable solution was a derivative-based contract where the company paid monthly payments to an investment bank. Pension cashflows for up to 100 years were covered for just under 12,000 retired members. The investment bank then laid off the liability to the reinsurance market. We helped the client to investigate a number of payment options for the fees. The security of the counterparty was important so the collateralisation of the transaction and identifying the situations which would trigger a default by either party were critical aspects. The trustee required some flexibility in the hedge to achieve a good fit with existing administrative practices and to be able to add future new members, and wanted flexibility in the contract in case of any future buyout of the fund. These objectives were all achieved. Liability hedging de-risking and de-stressing 7

8 About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of benefits, talent management, rewards, and risk and capital management. Disclaimer This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watson s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. Copyright 2013 Towers Watson. All rights reserved. TW-EU March towerswatson.com