liability-driven solutions for pensionsmerrill lynch corp bond 8.3 ftse 5-15 yr uk gilts indexed 9.2...
TRANSCRIPT
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Liability-driven solutions for pensions
When Bonds are not enoughPresented by
Vincent de Martel, Director, Structured & Alternative Investments
2 April 2004
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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?
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DB Risks - Common Misconceptions
Perception Reality
Liability risk
Asset mix risk
Active Risk
Source: Leo de Bever, Ontario Teachers' Pension
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In a DB world, bond-matching is challengingUK longest Government bond 2036Netherlands 2028Germany 2034France 2035
With inflation-linkage, even greater rarity...UK Govt Inflation-Linked Bonds Maturity
DateNominal
Amount £
4% Index-linked Treasury Stock 2004 Oct-2004 1,3382% Index-linked Treasury Stock 2006 Jul-2006 2,0372 ½% Index-linked Treasury Stock 2009 May-2009 3,0982 ½% Index-linked Treasury Stock 2011 Aug-2011 4,3422 ½% Index-linked Treasury Stock 2013 Aug-2013 5,5972 ½% Index-linked Treasury Stock 2016 Jul-2016 6,4552 ½% Index-linked Treasury Stock 2020 Apr-2020 5,0932 ½% Index-linked Treasury Stock 2024 Jul-2024 5,7514% Index-linked Treasury Stock 2030 Jul-2030 3,1712% Index-linked Treasury Stock 2035 Jan-2035 3,775
Source: DSTA, Deutsche Bundesbank, DMO, 30 March 04
Only 6 countries with significant (>100m$ oustanding) inflation programmes - Canada, France, Italy, Sweden, UK, US
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Pension funds are significantly mismatched in interest rate sensitivity
0%
5%
10%
15%
20%
25%
30%
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24Liability Duration
Frequency
Duration of UK Defined Benefit plans (FTSE 350 companies)
Duration of most commonly used benchmarked indices
Bond Benchmark ConstituentDuration
(Years)FT-SE 5-15 Yr Gilts 6.3FTSE UK Gilts All Stocks 8.0Merrill Lynch Corp Bond 8.3FTSE 5-15 Yr UK Gilts Indexed 9.2FTSE UK Gilts All Stocks Indexed 10.8FTSE > 15Yr UK Gilts Indexed 16.2
Over 70% of funds have a duration of liabilities that
exceed the longestduration index
Source: Barrie & Hibbert, AXA IM, February 2004, WM Research September 2003
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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
-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%
Change in interest rates
For simplification purposes, the effect of convexity has not been shown - the order of magnitude remains the same however
Source: Bloomberg, AXA IM
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Using swaps to achieve the right matchingPrinciple: 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
X
X X
XX
X
Pays variable rate
Receives fixed rate
Diversified bonds portfolio
Market counterparty(e.g. investment bank)
Application: UK Pension Scheme - matching portfolio
Bondsduration
Swapsduration
Schemeduration+ =
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Thanks to the swaps, the scheme can be immunised against changes in rates
2 5 0
3 0 0
3 5 0
4 0 0
LiabilitiesMarketvalue
Bondsportfolio
AA rate unchanged AA rate - 1%AA rate + 1%
Surplus
DeficitWithout swaps
2 5 0
3 0 0
3 5 0
4 0 0
AA rate unchanged AA rate - 1%AA rate + 1%
LiabilitiesMarketvalue
Bondsportfolio+ swaps
Matched
MatchedWith swaps
Based on an actual solution for a UK pension schemeActively managed corporate bond portfolioSwap overlay: 8 forward starting interest rate swapsPortfolio duration increased from 9 to 19 years
For illustration purposes only
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Asset-Liability Management is a risk management tool
BEFORE ALM AFTER ALM
Interest rates
Inflation
Longevity
Sponsor default ?
Source: The Times 27 June 2003
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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
Liability-driven solutions for pensionsWhen Bonds are not enoughA changing world for DB pensions...DB Risks - Common MisconceptionsIn a DB world, bond-matching is challengingPension funds are significantly mismatched in interest rate sensitivityDuration mismatch can cause large changes in solvency levelsUsing swaps to achieve the right matchingThanks to the swaps, the scheme can be immunised against changes in ratesAsset-Liability Management is a risk management toolNow and beyond...