Diversified Growth Funds & implications for actuarial assumptions

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1 Diversified Growth Funds & implications for actuarial assumptions

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4 Part 1: Actuarial return and discount rate assumptions Subtitle: But Mother, look! The Emperor isn t wearing any clothes!

5 Is it reasonable to ignore risk and then advise on the implications of how much risk is taken?

6 Pay 20%!

7 Pay 20%!

8 Pay 20%!

9 Equity return? An actuary might say: The ERP is 3% This answers the budgeting question An investment adviser might say: Expected arithmetic return is 6% real The distribution is X The standard deviation is 20% (25% now reverting to 15%) Geometric real return is 4.8% The correlation with bonds is Y Etc.. This helps answer the risk question

10 Relative Frequency Thousands Relative Frequency Thousands Return distribution % 0.0% 5.0% 10.0% 15.0% 20.0% Annualised % p.a., Nominal Target Return Relative Frequency Equity 8.1% p.a. over 20 years % 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% Annualised % p.a., Nominal Target Return Relative Frequency Euro bonds 3.9% p.a. over 20 years

11 Relative Frequency Thousands Return distribution 50% equity 50% bonds Traditional actuarial methodology suggests simple average ½( ) = 6.0% % 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% Annualised % p.a., Nominal Target Return Relative Frequency Assuming rebalancing, there is a diversification benefit 6.4% p.a. over 20 years Naïve assumptions are OK for long term budgeting but not for risk assessment

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14 Actuarial Margin for prudence Contribution rate Likelihood of insolvency

15 Level of risk Contribution rate Likelihood of insolvency

16 Relative Frequency Thousands Actuarial Margin for prudence Pension fund case study: 45% pensioners 50% bonds 50% equity 60% Confidence Discount rate 5.8% Target Return Relative Frequency % 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% Annualised % p.a., Nominal If 50% Confidence were used equity allocation would be 40%!! This is the opposite of prudent!

17 Case study 2 Poorly funded plan Weak covenant High probability of sponsor failure Need high return to improve funding level Possible strategy: Put 80% in bonds for 5 years (say) even if this means assuming 10% p.a. return on equities By then, the sponsor will either have recovered (and can pay more) or folded If wound up soon benefits protected If sponsor survival risk can be increased

18 Part 2 - Diversity There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don't know. But there are also unknown unknowns. There are things we do not know we don't know. Donald Rumsfeld, then US Defence Secretary

19 Risk and return assumptions Risk Return

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21 m at risk Diversify return premia Source: Towers Watson ERP Illiquidity Insurance Credit Skill Currency Inflation Term

22 m at risk Diversify return premia Source: Towers Watson ERP Illiquidity Insurance Credit Skill Currency Inflation Term

23 Asset classes Bonds Cash Government bonds Corporate bonds Alternative credit Equities Equities Hedge funds Hedge funds Private markets Private markets beta Private markets alpha Other Currency Insurance Commodities Volatility

24 Asset classes Return driver Equity risk premium Cash Government bonds Corporate bonds Alternative credit Credit risk premium Illiquidity risk premium Equities Insurance risk premium Term risk premium Hedge funds Inflation risk premium Currency risk premium Private markets beta Private markets alpha Skill risk premium Currency Insurance Commodities Volatility

25 Return drivers Return driver Equity risk premium Cash Government bonds Corporate bonds Alternative credit Credit risk premium Illiquidity risk premium Insurance risk premium Term risk premium Inflation risk premium Currency risk premium Equities Hedge funds Private markets beta Private markets alpha Multiple return drivers Skill risk premium Currency Insurance Commodities Volatility

26 Return drivers: manager analysis Return driver Active equity manager A Passive ILG manager B Private equity manager C Hedge fund manager N Total portfolio Equity risk premium Credit risk premium Illiquidity risk premium Insurance risk premium Term risk premium Inflation risk premium Currency risk premium Skill risk premium Use active management where it can be justified

27 What types of strategies are available? Fund type 1) Beta Only leveraged and unleveraged 2) Manager Skill Only (Portable alpha) 3) Manager Skill and Active Asset Allocation 4) Manager Skill and Active Asset Allocation (Alternatives Only) Reduced appeal Increased appeal 27

28 Beta-Only strategies Traditional Balanced Fund Typical Multi Asset Fund Domestic/Global Bonds Domestic/Global Equities Domestic/Global Bonds Emerging Market Bonds High Yield Bonds Emerging Market Equities Buy-Write Real Estate Infrastructure Inflation Linked Bonds Investment Grade Corporate Bonds Domestic/Global Equities Domestic/Global Equity Sectors Commodities (inc Gold) Private Equity Hedge Fund Beta 28

29 Alpha-Only strategies Excess Return (can be positive or negative) Excess Return (can be positive or negative) Total return of underlying vehicles Market Return Market Return hedged out through use of futures or other derivative instruments Return achieved in an alpha only strategy above cash return 29

30 Alpha + Beta strategies 80% Sample asset allocation 70% 60% 50% 40% 30% 20% 10% 0% Equity EMD C'dities HYD Abs olute Return Infra - structure Property PE Inv Grade Bonds Conver - tibles Cash Potential Range Current Weight Actual Range Since Inception 30

31 Alpha + Beta Variation 100% Asset Allocation Comparison of Multi-Asset Products at as 30 June % 80% 70% 60% 50% 40% 30% 20% 10% 0% Aviva Fulcrum JPMAM Schroders F&C Morgan Stanley Barings Investec Fidelity BlackRock MASF BlackRock DDG Baillie Gifford Cash Other Hedge Funds Commodities Infrastructure Private Equity Property Convertible Bonds High Yield Credit (inc loans) Investment Grade Credit Emerging Market Debt Developed Market Bonds Emerging Market Equities Developed Market Equities 31

32 Comparison of typical DGF strategies Type of strategy Key criteria Diversity Liquidity Fair fees Alignment of interests Best in class active managers Beta-only? n/a Alpha+beta??? Alternatives only???? 32

33 DGF examples Easier but likely to be inferior risk/reward trade-off More complex but risk/reward trade-off may be improved In-house underlying funds Spectrum of use of external management External funds Passive management Spectrum of active management Active management Mainly equities and bonds Spectrum of increasing percentage of alternatives Only alternatives Indirect exposure to alternative asset classes through listed companies Spectrum of access to illiquid investments Direct exposure to illiquid investments Simple all-inclusive fee Spectrum of fees Management fee plus fees of underlying managers Static strategic asset allocation Spectrum of tactical asset allocation Unconstrained tactical asset allocation 33

34 Sample risk reduction 65% equity 35% bond Full diversity same return VaR down 30% Ditto with 50% liability hedge VaR down 50%

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36 Investment return (1965 = 100) Fees matter! 500, ,000 Active management can be worth its weight in gold Gross performance 300,000 But too many managers charge too much 1% annual fee 200,000 Performance fees often make it worse 100, % + 20% (relative performance) 2% + 20% (absolute performance) Source: Towers Watson, Berkshire Hathaway Source beta cheaply, pay for alpha where appropriate

37 Conclusions Don t inhibit risk reduction through inflexible and out-dated methodologies Actuarial expertise is in valuation Treat risk and investment strategy separately

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