De-Risking: Acting quickly when triggers hit

Russell Investments Case Study NOVEMBER 2016 De-Risking: Acting quickly when triggers hit Formulating a de-risking strategy is one of the most important decisions a pension professional can make. However, if this strategy is poorly implemented, it can ultimately be rendered ineffective. In this paper, we look at the practical challenges of de risking and outline a structure for creating an effective de risking platform. Making the most of de-risking strategies with a flexible derivatives platform The value of an idea lies in the using of it. Thomas Edison CUSTOMISED PORTFOLIO SERVICES CURRENCY FIXED INCOME DYNAMIC DE-RISKING PASSIVE REBALANCING CURRENCY While Thomas Edison s famous quote provides a great analogy for many investment situations, it has particular relevance when it comes to pension scheme de-risking. A strategic de-risk is one of the most important decisions a pension professional can make, but for it to be truly effective, it needs to be implemented efficiently. Out-of-market exposure, cash drag and untimely trade execution can quickly erode any potential benefit gained from a well formulated de-risking strategy. Establishing a derivatives-based de-risking action plan and platform can help manage events quickly and efficiently. As discussed in a recent Russell Investments EMEA Communique article, derisking is a strategy where risk is taken off the table 1. A de-risk event is initiated by hitting some trigger point where the exposure to risky or return seeking assets is reduced, in favour of less-risky, liability-hedging assets. As described in that paper, these trigger points are commonly grouped into four categories (Exhibit 1). In practice, however, it is important to understand that pension schemes might use a combination of these trigger types to achieve their objectives. EQUITIES CASH MANAGEMENT DERIVATIVES TRADE EXECUTION TRANSITION MANAGEMENT FX TRADE EXECUTION The challenge of de-risking implementation Each of the four de-risking approaches are commonly used by many pension schemes as they aim to meet their funding-level targets and objectives. Thankfully, there are numerous, well-constructed tools and systems that can help to automate the monitoring of these triggers. Russell Investments believes that the more automated the monitoring of these triggers become, the better. Automation reduces risk and limits the potential influence of emotion from a well formulated de-risking plan. 1. Begley, Crevan. De-Risking Triggers Russell Investments View. Russell Investments EMEA Communique, February 2015. Russell Investments Case Study // De-Risking: Acting quickly when triggers hit 1

Exhibit 1: Common approaches to de-risking TRIGGER TYPE Market Based Time Based Funding Level Based 2 Discretionary De-risking DEFINITION The switching from return-seeking to liability-matching assets is dependent on the relative performance of different asset classes. For example, a switch out of equities into bonds if equities outperform by 15%. The proportion and timing of switching from return-seeking to liability-matching assets is defined for a certain time period. For example, a scheme might specify that it will increase its liability hedging assets from 30% to 50% over the next two years making incremental changes every quarter. The switching from return-seeking to liability-matching assets is dependent on the funding level. For example, a scheme that is 85% funded may decide to wait until it is 90% funded before the next tranche of de-risking would take place. Decisions are made by analysing quantitative and qualitative factors, usually by a risk management or investment committee. The committee will take into account portfolio objectives and then de-risk at an optimum time. Unfortunately, many of these monitoring tools are unable to efficiently implement on the strategy due to each scheme s unique investment structure. For those schemes with relatively straightforward pooled investment holdings (e.g. daily-dealing mutual funds), acting when a de-risk trigger event is hit is much less challenging. The scheme would, on the day of the trigger, simply disinvest from the risky asset holdings and subscribe the appropriate amount in the lessrisky asset 3. However, what happens when schemes holdings are not so straightforward? Specifically, some of these potential challenges could include: What if funds are not daily-dealing but weekly or even monthly? What happens if some of the funds being monitored are priced infrequently? What if there is a mismatch in dealing and settlement dates from the risky asset the scheme is selling from and the less risky asset the scheme is subscribing to? What happens when the manager the scheme is taking assets from and the manager the scheme is giving assets to, hold segregated portfolios? Are there potential efficiencies from using a dedicated Transition Manager to project manage the risks and exposures? What happens when the risky assets are in international securities with holdings in a foreign currency? How does the scheme manage currency exposure and out of market risk? As with most investment decisions, the devil is in the detail, and true implementation efficiency rests with the flexibility of an approach to address the above questions. If left unresolved, these issues can impact the speed and effectiveness of a de-risking event and ultimately create a cash drag on performance and introduce unrewarded risks. The following section provides further detail on the risk of not acting on triggers quickly, resulting in the potential loss of opportunity to capitalise on an improved funding level. Missing opportunities for risk reduction Risk reduction is all about timing. When a trigger of any design is hit and is not acted upon quickly, there is a potential loss of opportunity to capture an improved funded status. Opportunity in this instance can quite simply be considered as the time a scheme has to take action before the funding-level once again falls below the trigger-level. For example, a pension scheme could aim to de-risk 10% of its assets following a breach of a funding-level trigger at 80% on a Monday, only for markets to move significantly by Friday causing their funding level to drift to 78% and well back below the trigger. This can result in a missed opportunity to capitalise on a risk reduction benefit. Unsurprisingly, the time that an opportunity takes to revert is relatively short. We can readily observe this through an analysis of the historical returns and funding levels based on the asset allocation for a typical UK pension scheme, resulting in the loss 2. Funding level is defined as assets divided by liabilities and is a measure of the scheme s ability to meet future pension benefit payments. 3. In practice, this is a little more complicated when considering trade and exposures dates, geographic locations and the date at which asset are valued. Russell Investments Case Study // De-Risking: Acting quickly when triggers hit 2

Exhibit 2 The daily notional exposure gained by using derivatives 100% Notional market value (GBP million) 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 Time (Days) Source: Russell Investments. Data accurate as of 31 Dec 2014 based on a historical analysis from 1 Jan 2004. of opportunity to capture improved funded status 4. In Exhibit 2, we illustrate how quickly a pension scheme s funding ratio moves back to pre-trigger levels once a de-risking trigger has been breached. In as many as 60% of cases where a trigger was breached, opportunities were lost in as little as four working days. In as little as two days the probability of missing an opportunity is around 50%. Two days is an incredibly short time in the world of investment committee meetings, international investments and manager notification deadlines. Furthermore, as many pension professionals use return and funding ratio data that is often days (if not weeks) delayed, there is the added risk that de-risking decisions are made with non-current information. Consequently, a pension scheme could be making decisions to de-risk when, if they had access to accurate Scheme data, they would not be doing so. Considering how quickly it takes for a de-risking opportunity to revert, ensuring that the decisions are able to be acted on quickly is imperative. In addition, we consider that it also highlights the necessity of ensuring there is a method to monitor funding level on a daily basis. In the following section, we outline how a de-risking action plan using a derivatives-based approach can help events be managed more efficiently. Putting it all together creating an efficient de-risking platform We believe that an efficient de-risking platform should take in to account five key components: trigger monitoring, exposure management, currency management, cash management and physical rebalancing. An approach should consider all of these areas in combination to ensure de-risking opportunities are effective and cost efficient. Exhibit 3 below provides details along with worked examples for each of the five key areas of an efficient platform. Benefiting from a flexible risk-reduction platform Risk reduction opportunities are short lived. As we have illustrated, these can decrease by over half in as little as two days, meaning that acting quickly is imperative. An effective solution that can capitalise on these small windows of opportunities requires flexibility. This can be achieved through establishing a platform that takes in to account trigger monitoring; market exposure management; currency management; cash and collateral management; and physical rebalancing. 4. Our hypothetical pension plan begins with an initial funding level of 88.5% and an allocation of 75% matching and 25% growth assets. For our matching assets we use the FTSE Actuaries Government Securities over 15 Year benchmark as a return proxy. For the growth assets, we use a basket of benchmarks to simulate portfolio returns including equity (Europe ex UK (6.0%), Japan (2.0%), UK (7.3%), Global (21.1%), US (44.0%), Asia Pacific ex Japan (3.40%)) and fixed income (corporate credit (16.2%). Our analysis uses daily returns from 1 Jan 2004 to 31 Dec 2014. Russell Investments Case Study // De-Risking: Acting quickly when triggers hit 3

Exhibit 3: The five key components of an efficient de-risking platform COMPONENT PROCESS EXAMPLE Trigger Monitoring Market Exposure Currency Cash and Collateral Physical Rebalancing Establish a systematic trigger-monitoring system to track the market, time and funding-level based triggers on a daily basis. This should be agnostic to the source of valuation for assets or liabilities (e.g. different custodians or actuaries), working in coordination with the scheme s consultant or fiduciary manager. Use synthetic positions 5 to adjust the net exposure of a scheme to ensure that once a trigger is hit, de-risks can be acted on within hours, not days. Furthermore, use a rules and guidelines driven system that validates, monitors and ensures that a scheme s portfolio is in-line with its investment objectives ranging from duration hedging for liability management or rebalancing, to a strategic asset allocation. Provide clear reporting of scheme-wide exposure of physical, synthetic and net positions compared with a scheme s investment objectives. Use currency forwards to ensure any currency hedging is in-line with the underlying asset exposures and adjusted for when a trigger is hit further ensuring that risk reduction is acted on immediately. Furthermore, this can be coordinated in conjunction with a passive currency overlay manager to ensure that aggregate exposure is kept within investment guidelines and no unrewarded risk is introduced into the portfolio. Monitor cash and collateral on a daily basis. As many instruments used to manage exposures, such as futures, are partially funded (e.g. requiring cash or eligible securities for collateral and daily margin settlements) it is necessary that cash is on hand and with appropriate counterparties on time often this can be funded from operational cash left in an account used for benefit payments or capital calls. Excess cash can be equitised (e.g. using synthetic instruments) to ensure there is no drag on a portfolio prior to or following any de-risking. Separating the change in physical holdings from the scheme level allocation (by using synthetic positions) allows for the overall de-risk to occur instantaneously while managing all the activity associated with a complex manager change including manager selection, contracting and funding. The scheme can benefit from a de-risk event, while still working on operational and legal set-up nuances of allocating to a different manager line-up. Once these activities are settled, it will be possible to coordinate with an implementation manager to unwind the synthetic holdings in line with the trading of the underlying physical securities. For example, a scheme with GBP 1bn in assets and liabilities of GBP 1.10bn has daily values to monitor funding-level. Once a trigger is hit say a 95 % funding-level trigger an immediate 5% de-risk can be identified and acted on. Following on with our example, a 5% de-risk ( 50m) from a segregated global equity manager to UK gilts can be completed within hours once a trigger has been hit by using futures to reduce (short) global equity exposure by 50m and increase (long) UK gilt exposure by 50m. This can be done prior to any physical asset rebalancing (which can be implemented when it is cost efficient to do so) ensuring risk reduction opportunities are captured as and when they arise in a cost efficient way. For our example, let us assume that our global equity manager s base currency is in USD and that we have a currency hedge of 75% ( 37m). Using currency forwards, or coordinating with the scheme s passive currency manager, these would be unwound to ensure currency risk was taken off the table in-line with market exposure once a de-risk trigger hits. Continuing our example, for both the global equity (short) and UK gilt (long) positions, the scheme would require to have roughly 5% (circa 5m) in cash on hand to post to the exchange as collateral as well as cash for variation margin for the period 6. Cash positions would be monitored daily and can be funded using excess cash held for operational requirements. Furthermore, excess cash held in the account could also be equitised to ensure that there is no drag on overall portfolio performance plugging any gaps in net exposure versus the target strategic asset allocation. For our 5% de-risk example, assume it takes two weeks to physically disinvest from the segregated global equity manager and invest the proceeds in UK gilt securities. During this time, synthetic positions would be unwound to coincide with the transfer of assets so that was no net change in overall scheme level exposure to each asset class. Also during this twoweek period, any operational requirements (such as the custody account opening) or legal documentation can be finalised. 5. Synthetic positions are defined as any derivative positions that can impact net exposure for a plan, e.g. futures, forwards, swaps or any other exposure management solution. 6. An alternative to posting cash as collateral can be pledging securities, usually government fixed income securities such as Gilts or T-Bills. Russell Investments Case Study // De-Risking: Acting quickly when triggers hit 4

For more information speak to: Nicki Ashton, Head of Strategic Partnerships on (02) 9229 5521 or email nashton@russellinvestments.com Important Information Issued by Russell Investment Ltd ABN 53 068 338 974, AFS Licence 247185 (RIM). This document provides general information only and has not prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Russell Investments or its associates, officers or employees may have interests in the financial products referred to in this information by acting in various roles including broker or adviser, and may receive fees, brokerage or commissions for acting in these capacities. In addition, Russell Investments or its associates, officers or employees may buy or sell the financial products as principal or agent. RIM is part of Russell Investments. Copyright 2016 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred or distributed in any form without prior written permission from Russell Investments. AUST1-2015-07-19-0363 R_CaseStudy_DeRisking_V1F_1611 Russell Investments Case Study // De-Risking: Acting quickly when triggers hit 5