FOR PROFESSIONAL CLIENTS ONLY LIABILITY DRIVEN INVESTMENT

Transcription

1 FOR PROFESSIONAL CLIENTS ONLY LDI ESSENTIAL ESSENTIAL GUIDE GUIDE THE BACK ESSENTIALS TO BASICS OF LIABILITY DRIVEN INVESTMENT

2 Contents Understanding the liabilities 3 Interest rate and inflation swaps 17 Liability driven investment 37 THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

3 Executive summary In this guide for institutional investors, we provide an introduction to liability driven investment (LDI). Our aim is to help investors build a base from which they can develop a deeper understanding of this approach to investment, as well as encourage them to consider what LDI could mean for their scheme s investment strategy. Prepared by BlackRock insights@blackrock.com blackrock.co.uk This guide will undoubtedly raise additional questions in the minds of readers please contact your account manager for further information on any of the topics covered or to provide feedback. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [1]

4 [2] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

5 Understanding the liabilities THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [3]

6 ONE THING BEFORE WE GET STARTED: THE TIME VALUE OF MONEY A pension fund is a complex financial entity and the key to understanding its mechanics is the time value of money. This simply concerns calculating the present value (or value today) of a payment to be made in the future. Time value of money and the actuarial valuation In undertaking a valuation, the actuary uses a snapshot of the current membership of a pension fund. For each member, the actuary projects into the future what benefits that member is expected to receive and when the actuary expects them to be paid. The fundamental question is: how much should we put aside today to meet the future liability? This is where the time value of money comes in. If a pension fund is expecting to pay a benefit of, say, 1,000 in five years time, how much should be set aside today? Now, if money can be invested in a cash account guaranteed to earn a rate of 4% per annum, we could set aside: 1,000 = 1,000 = x 1.04 x 1.04 x 1.04 x 1.04 (1.04) 5 If we set aside this amount, we would be certain to meet the payment. Risk and return Instead of cash, what if we could invest in corporate bonds which offered an expected return of 6% over the next five years? Then we would only need to set aside 1,000/ (1.06) 5 = So we would need to set aside less today, but there is a risk that if corporate bonds fall in value, we will not be able to meet the future payment. This is where we start to balance higher expected returns with higher expected risks. We will come on to risk in more detail later. Equities might be expected to return 9% over the next five years. If we invested in equities, we would only need to set aside 1,000/(1.09) 5 = This is substantially less, but equities fluctuate in value and again we might not be able to meet the future payment (or, if equities do better than expected, we may have more than 1,000 at the end of year five). See figure 1. [4] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

7 FIGURE 1. TIME VALUE OF MONEY ( ) 1, % 1, Time Value today (present value) 5 years time Value today 5 years time Actuarial valuation assumptions Historically, the actuary had freedom to make assumptions about future investment conditions based in part upon how a pension fund invested its assets. If the pension fund was 70% in equities, expected to return 9%, and 30% in bonds, expected to return 6%, the actuary might assume the appropriate rate to discount future payments is (9% x % x 0.3) = 8.1%. However, risk was not fully factored into this calculation. Today the picture is different. The actuary has much less scope to make assumptions and the discount rate is prescribed by accounting standards to a large degree. Under IAS 19 1, for example, there is a necessity to discount all future liability cashflows using the rate that could be earned on high-quality (AA-rated) corporate bonds. For other purposes, government bond or swap rates are more appropriate. We will come back to this later. 1 IAS 19 is the set of accounting rules for employee benefits set out by the International Accounting Standards Board. These define how pension liabilities should be measured within a company s annual accounts. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [5]

8 UNDERSTANDING THE LIABILITIES A pension fund s liabilities are the benefits paid to members and consist of a series of cashflows that the fund must pay out in the future. The cashflows are usually calculated by the actuary and are based upon the aggregate forecast of all the benefits for all members. Typically, the expected cashflows are based on a snapshot of existing members and will not take account of future joiners. Pension fund liabilities are long-dated. Their calculation involves forecasting far into the future (70 years or more) to estimate what payments will be made, as well as the value that these distant payments should have today (by discounting to a present value using the time value of money). To understand what drives pension fund liabilities, let s take an example of a person aged 45 with 10 years of service in a pension fund that accrues a pension of 1/60th of final salary for each year of service (see details below). Aged 45 Salary 18,000 per annum 10 years of service 1/60th scheme Accrued pension of 10/60 of salary ( 3,000) What do the projected benefits look like? The actuary would make a number of assumptions regarding longevity, wage inflation, price inflation etc. Figure 2 shows three components of the future benefits: The dark blue bars show the benefit already accrued (10/60 of salary or 3,000 per annum) The light blue bars show the projected additional pension payments per annum stemming from wage inflation between now and retirement (we ve assumed a 6,000 salary increase between now and retirement increasing the pension by 1,000) The grey bars show the impact of price inflation once the pension is in payment as it will be increased in line with inflation (often subject to a minimum floor of 0% a year and a maximum cap of 5%) [6] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

9 FIGURE 2. FUTURE BENEFITS ( ) 5,000 4,000 3,000 2,000 1,000 0 Time Age 65 (20 years time) Price inflation Wage inflation Accrued benefit In general, the actuary will not take account of future service. The objective of the valuation is to decide how much should be set aside today for benefits that have been accrued to date 2. The next step is to calculate a present value for the member s future payments. Each year s expected payment is brought back to a present value (the time value of money again) and the total represents how much should be set aside for a particular member. FIGURE 3. PRESENT VALUE FOR FUTURE PAYMENTS ( ) 10,000 This is the present value of the member s liability 8,000 6,000 4,000 2,000 0 Time Age 45 (Now) Age 65 (20 years time) Present value of liability cashflows Price inflation Wage inflation Accrued benefit 2 There is a distinction between what is often called the Accrued Benefit Obligation (ABO) and the Projected Benefit Obligation (PBO). The main difference is that the latter will include allowance for future salary increases, the former assumes that salary is unchanged until retirement. The ABO will give a lower value to the liabilities than the PBO. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [7]

10 A full valuation will do this for every member and the aggregate value is the pension fund s total liability. This is often compared to the market value of assets to arrive at the funding level. Funding level = Market value of assets Value of liabilities Looking across a whole scheme, the liabilities can be represented as a series of projected future cashflows. A typical aggregate cashflow profile is shown in figure 4. Each bar represents the amount expected to be paid from the pension fund in a particular year. FIGURE 4. CASHFLOW PROFILE ( ) Time Expected cashflow ( ) As can be seen, the expected cashflows often rise steadily from current levels before tapering away as current members retire (if they haven t done so already), draw pensions and eventually die. We can split the aggregate cashflows into those we are expecting to pay to existing pensioners and those payable to active and deferred members. Over time, defined benefit schemes have closed to new members and, in some cases, to the accrual of new benefits. Consequently, most pension funds have a small and declining pool of liabilities in respect of active members. In figure 5, the grey shaded area on the left is the proportion of cashflows payable to pensioners and the light green shaded area on the right is the liability ascribed to active and deferred members. [8] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

11 FIGURE 5. PENSIONERS AND ACTIVES/DEFERREDS Expected cashflow ( ) Time Pensioners Expected cashflow ( ) Actives/deferreds Liability sensitivities Liability cashflows are based upon the benefits to be paid from a pension fund. They can be split between those payments that are linked to inflation and those that are fixed. A fixed payment is where a pensioner receives a proportion of final salary at retirement with no future increases. An index-linked pension usually delivers payments with annual increases linked to inflation. This latter form of benefits represents the majority of pension fund liabilities for many UK schemes. Figure 6 overleaf shows future liability cashflows split between: Limited Price Indexation (LPI) benefits are linked to inflation subject to a floor of 0% (pensions cannot be reduced) and cap of 5% 3 (pensions will be increased with inflation up to 5% but if, for example, inflation is 6% for a particular year, the pension will only rise by 5% for that year) Retail Price Inflation (RPI) benefits linked to inflation without a cap but might have a floor of 0% Fixed payment cashflows that do not depend on inflation levels 3 Caps and floors vary depending on the benefits of a particular fund. Many pension funds will have some liabilities which are capped at 3%, often expressed as LPI (0%, 3%). New liabilities accruing are often capped at 2.5% i.e. LPI (0%, 2.5%). THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [9]

12 FIGURE 6. FUTURE LIABILITY CASHFLOWS Expected cashflow ( ) Year Inflation (LPI) Inflation (RPI) Fixed These sensitivities are very important, as we shall discover later. The extent to which the liabilities are sensitive to inflation should be considered when investing the scheme s assets. In order to manage the risk from inflation being higher than expected, it makes sense to have assets that also reflect that sensitivity. What factors impact upon the value of the liabilities? There is a distinction between the factors that impact upon the level of the promised pension payments in the future (the estimated future annual cashflows) and the factors that we use to estimate the value of these future payments in today s money. The future payments made to beneficiaries change as a result of changes in life expectancy (longevity), discretionary awards (benefits paid in excess of the promised level), member service (length of time accruing benefits in the fund) and inflation The current market value of these aggregate payments is sensitive to changes in the discount (interest) rate. The current market value of the future payments increases when rates fall, and vice versa, in a similar way to movements in the value of bonds What is the real interest rate? Generally, liabilities are quite sensitive to both interest rates and inflation. An important aspect to understand is that interest rates have two components: expected inflation and the real interest rate. The general relationship is as follows 4 : Interest rate = expected inflation + real interest rate 4 The relationship is more accurately stated as (1 + nominal interest rate) = (1 + inflation) x (1 + real interest rate). [10] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

13 Therefore, the return generated by placing money in an investment with a given interest rate includes a component to keep pace with inflation plus the real interest rate which reflects real (after inflation) growth in the investment. For example, a high street bank might quote a 4.6% fixed rate of interest for a oneyear investment. An investor who puts in 100 will therefore get back at the end of the year. If inflation is expected to be 3.0%, then the real interest rate is 1.6% (4.6% 3.0%). The real interest rate reflects the growth in the purchasing power of the 100 investment. Why are real interest rates important? Real interest rates play a very important role for pension funds. The present value of a pension fund s liabilities is usually highly sensitive to the real interest rate. Assume we have to pay a benefit of 100 increased by inflation at the end of 10 years. Further, assume interest rates (often called nominal interest rates, which include both inflation and the real interest rate) are 4% and expected inflation is 3%. Therefore, the real interest rate is 1%. The future value of the payment is expected to be 100 increased by inflation i.e. 100 x (1.03) 10 = as shown in figure 7. FIGURE 7. FUTURE VALUE OF PAYMENTS 100 x = ( ) Time Inflation 100 The next question to ask is how much should we set aside today to meet the future payment i.e. what is the present value of the future liability? In this case we will use the interest rate of 4% to estimate the present value (made up of 3% inflation and 1% real interest rate as above). Figure 8 overleaf shows how the present value of is derived. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [11]

14 FIGURE 8. PRESENT VALUE CALCULATION 100 x = ( ) Present value = 100 x = x Time Present value Inflation 100 Therefore, the present value equals: the future value 100 x = , divided by = Now, the can be split between inflation and the real interest rate 5 : 100 x ~ 100 x x What we can see is that the inflation term is on the top and the bottom (the ) and these actually cancel out. In fact, the can be arrived at just by knowing the real interest rate ( 100/ = 90.53). While the reality is more complicated than presented here, the message is that for the majority of pension schemes liabilities, the value of these liabilities is very sensitive to changes in real interest rates. 5 The nominal interest rate of 4% is comprised of inflation and the real interest rate. We have made a minor simplification in that if inflation is 3% and the real interest rate 1%, then the nominal interest rate is 1.01 x 1.03 = = 4.03%, rather than 4%. [12] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

15 How volatile are the liabilities? The future benefits (annual cashflows) include a degree of uncertainty as a result of a number of factors including the incidence of early retirement and improvements in mortality (known as demographic factors ). Such factors cause estimation errors but it is changes in interest rates that give rise to the significant volatility of the cost of providing these benefits. Historically, the volatility of liabilities was masked, as only triennial valuation snapshots were carried out. A greater focus on the disclosure of the liabilities has shown that the volatility of the liabilities may be even higher than that of the assets. Figure 9 shows the perception that persisted for many decades. The market value of assets could clearly be seen to be very volatile when viewed on a daily, monthly or quarterly basis. Since the liability value was only considered very infrequently, often only every three years as part of an actuarial valuation, there was a tendency to assume that this value was relatively static in the interim. In practice, liabilities are highly volatile, with their long-term nature making them particularly sensitive to changes in the value of interest rates and inflation. Small changes in interest rates, especially real interest rates, have had a significant impact when applied over such a long-term horizon. What is important is whether the assets and liabilities fluctuate in the same direction or move in opposite directions (which can change the funding level substantially). FIGURE 9. PERCEPTION REALITY (%) (%) Time Assets Time Assets Valuation Time Liabilities Time Liabilities THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [13]

16 Same liabilities, different value? These days, there are quite a few ways to value the liabilities of a pension fund. The differences arise principally due to the use of different discount rates to convert the future values to present values. Some of the variations are shown in figure 10. FIGURE 10. DISCOUNT RATES Expected cashflow ( ) Statutory Funding Objective? Accounting (IAS 19)? Pension Protection Fund? Swaps? Buyout? Time Expected cashflow ( ) Let s examine some of these: Statutory Funding Objective most trustees are probably familiar with this valuation method. The Pensions Act 2004 introduced the Statutory Funding Objective, which requires that schemes have enough assets to meet the value of their liabilities (or technical provisions ). The method and assumptions are determined by the trustees and must be prudent and appropriate to the fund. These will be determined with advice from the scheme actuary, must be agreed with the employer and reviewed by the Pensions Regulator. The method and assumptions are set out in the Statement of Funding Principles. Accounting (IAS 19) assets are measured at market value and liabilities will be valued using the discount rate on long-dated AA-rated bonds. There is no strict regulation regarding precisely which AA bonds to use. Some valuations will use the discount rate from a single AA bond or index; others will use a range of AA bonds to derive the rate used. Generally, a single discount rate will be selected to bring all payments back to present values. [14] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

17 Pension Protection Fund (PPF) this is often called a Section 179 valuation. It values a pension fund s liabilities assuming it enters the PPF, so there are caps on pensions and other restrictions reflecting the benefits the PPF would pay. The discount rate for the liabilities is based on gilts. Swaps liability cashflows can be valued using swap rates. Generally, this type of valuation is very useful when setting investment strategy, since swap rates provide an investable rate for every future point in time. Swap discounting is widely used for investment purposes. Buyout this reflects the value an insurance company would put on the liabilities if the trustees wanted to transfer the liability to the insurance company. Historically, actuaries have used assumptions to estimate what the buyout cost might be. However, as the buyout market has become more active, it has become more difficult to estimate this cost. Buyout prices have changed dramatically depending on the desire of insurance companies to do this type of business. Some buyout companies give guidance or a formula for what the indicative buyout cost would be, but often it is possible to get a precise valuation only when a quote is provided. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [15]

18 [16] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

19 Interest rate and inflation swaps THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [17]

20 UNDERSTANDING SWAPS Derivatives, particularly interest rate and inflation-linked swaps, are increasingly in demand to help pension funds effectively manage their risks and returns. In the UK, a strong two-way market in inflation-linked swaps has developed, although this market is typically less liquid than the interest rate swap market. The growth of the interest rate and inflation swap markets has been partly driven by the limitations of gilts. In particular, index-linked gilts cannot be combined to accurately match liabilities, do not offer protection against deflation and expose a fund to reinvestment risks. As explained previously, pension fund liabilities are often linked not just to inflation, but to inflation with a cap at 5% and a floor at 0%. This has established demand for Limited Price Indexation (LPI) swaps, with embedded caps and floors. Introduction to swaps Swaps are a potent tool for pension funds as they offer the ability to transfer risks to other parties. The proportion of pension funds that have entered into swap arrangements has grown rapidly. Over the next few years we expect this growth to continue as more trustee boards become comfortable with these more sophisticated risk management tools. What is a swap? A swap is an agreement between two parties (one usually being an investment bank) to swap one stream of payments for another. Swaps are individually tailored contracts (sometimes referred to as OTC or over the counter ) and can be based on any terms agreed by the two parties. Swaps based upon interest rates and currencies have existed for over 30 years. An evergrowing list of instruments is now being included such as inflation, credit, equity market returns and commodities. Swaps generally involve an exchange of a fixed set of cashflows, known in advance, for a variable ( floating ) set of cashflows that depends on the future path of some variable. Figure 11 shows a simple example of a swap. On the left we have one party willing to swap fixed cashflows based on 5% of a particular amount, say 100. These cashflows are exchanged for payments based on a floating interest rate applied to the same amount. Based on expectations about future interest rates, these are expected to be 4, 6 and 5. [18] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

21 FIGURE 11. SIMPLE SWAP EXAMPLE ( ) 10 8 Fixed cashflows e.g. the fixed interest payments on 100 5% (i.e. 5) Floating cashflows e.g. floating interest payments on 100 principal Time SWAP Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 6 Fixed Floating Some terminology The four most important things to know about a swap are the term, the notional principal, the fixed leg and the floating leg. FIGURE 12. SWAP TERMINOLOGY Fixed leg Can be based on just about anything where there is a future expectation Fixed leg x x x x x Term Anything from a few months to 50 years. Cashflows can be swapped quarterly, annually, at expiry etc. Pay fixed x y y y z Pay floating Notional principal Payments are based on this amount, although it does not change hands Floating leg Floating leg Usually a cash rate called LIBOR (London Inter-Bank Offer Rate) THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [19]

22 An important rule An integral part of any swap is that, at the outset, the present value of each future stream of cashflows is equal. This means that the expected fixed and floating cashflows have an equal present value you would not enter into a swap where one side was worth more than the other. After the swap has begun, the fixed payments will not change, while the floating payments will fluctuate with actual interest rates. Thus, one party will gain at the expense of the other as interest rates change. Pension funds usually use swaps to hedge (reduce) risk. As we shall see, although a pension fund may make a loss on a swap, this is usually balanced by a reduction in the liabilities. Similarly, a gain on a swap will often be offset by a rise in the liabilities. A basic swap example A swap is just that an agreement to exchange something for something else. Pension funds usually want to gain more inflation exposure as their liabilities are dominated by inflation sensitivity. Pension funds could seek to buy index-linked gilts, but the market is relatively small and index-linked gilts are inflexible. Instead, the pension fund could enter into a swap with a counterparty where the pension fund would swap something in exchange for inflation exposure. Let s assume expected inflation for the next 10 years is 3% (inflation expectations can be observed in the market so all parties will agree on this). The pension fund could contract with a counterparty, usually an investment bank, to pay a fixed rate of 3% per year (which is the expected inflation figure) in return for actual inflation which would float. The percentages would be applied to a notional principal, which does not change hands. Let s assume the notional principal is 100. FIGURE 13. SWAP EXAMPLE Fixed (at expected inflation) Pension fund Counter party Floating (actual inflation) [20] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

23 In this example, the pension fund would pay 3 each year to the counterparty. In return, the actual inflation rate each year would be multiplied by 100 to calculate the payment to the pension fund. We have assumed actual inflation turns out to be 3%, then 4% for 3 years before falling to 2%. Therefore, the pension fund has exposure to actual inflation over the period. For the preceding example there are three possible outcomes: Inflation = expectations Inflation is higher than expectations Inflation is lower than expectations These are shown in figure 14. FIGURE 14. SWAP OUTCOMES Inflation = expectations Inflation higher than expectatons Inflation lower than expectations Fixed (at expected inflation) Fixed (at expected inflation) Fixed (at expected inflation) Pension fund Counter party Pension fund Counter party Pension fund Counter party Floating (actual inflation) No net impact on either party Floating (actual inflation) Pension fund gains on swap Liabilities will have grown Floating (actual inflation) Pension fund makes loss on swap Liabilities will have fallen Clearly, if inflation meets expectations, then neither party gains nor loses. If inflation is higher than expectations (more than 3%) then the pension fund will gain on the swap. However, when inflation increases, the future liabilities will also increase, so the gain on the swap is offset by a rise in liabilities. Risk has been reduced. If inflation is lower than expectations (less than 3%) then the pension fund will make a loss on the swap. However, when inflation decreases, the liabilities will also decrease, so the loss on the swap is offset by a fall in liabilities. Again, risk has been reduced. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [21]

24 The IBM/World Bank swap In August 1981, IBM and the World Bank entered into one of the first large-scale swap transactions. This swap has the reputation for kick-starting the swaps market because it was performed by two prestigious organisations. It was the first long-term swap undertaken by the World Bank, now one of the biggest users of swaps. The background to the swap, in brief, was that IBM had embarked on a worldwide funding programme some years earlier, raising money in deutschmarks and Swiss francs. The money was remitted back to the US for general funding, which introduced currency risk as IBM converted US dollars into deutschmarks and Swiss francs to pay coupons. The World Bank was a prolific borrower in deutschmarks and Swiss francs at the time but was finding that the cost of borrowing was rising as its borrowing volume increased. The solution was a swap agreement whereby IBM converted its deutschmarks and Swiss franc liabilities to US dollars, and the World Bank, through IBM raising funds, gained access to cheaper funding. Both parties achieved their objectives. Swaps are part of a structure Swaps must always be viewed as part of an overall structure in isolation their benefit can be hard to deduce. While an actual swap contract will only bind the pension fund and counterparty, both sides have other financial interests outside of the swap. The pension fund will have its liabilities and the counterparty will usually have entities from which it sources its side of the swap, for example a utility that has inflation-linked revenues. FIGURE 15. OVERALL STRUCTURE Liabilities Pension fund pay receive Counter party Investment banks source inflation from utility companies, supermarkets, Private Finance Initiatives etc. [22] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

25 Investment banks have been effective in sourcing inflation (i.e. finding entities that wish to pay inflation and receive a fixed rate). This is the opposite of what a pension fund needs, so the whole arrangement is mutually beneficial. A utility company with revenue linked to inflation but financed through fixed rate loans or debt will often want to pay inflation and receive a fixed rate as this will reduce its risk. What does the investment bank do? Investment banks are different from high street banks. An investment bank does not deal with retail customers, instead focusing on large transactions involving companies and professional investors. Investment banks entering swaps do not generally seek to profit from taking on explicit risks per se, but instead look to hedge their swap position by entering into an opposing transaction either with another counterparty or by using physical instruments directly. The terms of the swap will include a margin (fee) for the service provided by the investment banks. Types of swap Pension funds generally enter into two types of swap inflation swaps and interest rate swaps. FIGURE 16. TYPES OF SWAP Inflation swap Swap fixed cashflows for realised inflation cashflows Interest rate swap Swap fixed cashflows for floating cashflows (floating cashflows usually based on short-term interest rates) Pension fund pay fixed receive inflation Counter party Pension fund pay floating receive fixed Counter party THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [23]

26 Swap cashflows The cashflows of a swap usually take one of two forms: 1. Par swaps Par swaps involve a regular payment of the fixed and floating legs. Usually each time there is a floating payment there is a corresponding fixed payment, as shown in figure 17. FIGURE 17. PAR SWAP PAYMENTS ( ) Floating: pay quarterly LIBOR payments Fixed: receive quarterly fixed payments Time Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Floating Fixed Par swaps have traditionally been the most common. 2. Zero coupon swaps Zero coupon swaps occur where the parties do not exchange cashflows throughout the term and exchange only at expiry, as represented in figure 18. [24] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

27 FIGURE 18. ZERO COUPON SWAP PAYMENTS ( ) Swap fixed for floating No payments exchanged over term Time Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Floating Fixed How is the fixed rate determined? If we consider a basic floating-for-fixed interest rate swap, the most obvious difficulty in setting the fixed rate is the fact that the future stream of floating rate payments is unknown at inception. The fixed rate is always equal to the expected value of the floating rate 1. So if the expected value of the floating side of a swap is 4%, this becomes the fixed rate and the swap becomes a fixed 4% versus floating payments which have an expected value of 4%. Many swaps will have a fixed rate that is based on the expected value of LIBOR. LIBOR is not a risk-free rate and reflects the counterparty risk in the inter-bank market. Using swaps to replicate an index-linked bond Pension fund liabilities are closely linked to inflation. Traditionally, pension funds seeking assets sensitive to inflation would purchase index-linked gilts, although the size of this market is only a fraction of the size of pension fund assets. Pension funds have therefore looked to other places for inflation-sensitive assets and a combination of interest rate and inflation swaps can provide a return similar to that of an index-linked gilt. Figure 19 overleaf shows how an interest rate swap and inflation swap can be combined. An index-linked gilt has two components of return: a real yield fixed at the outset and actual inflation. In this example, the return each year from the index-linked gilt is 1% + inflation multiplied by the principal. 1 Although actual rates will include a small margin for the investment bank. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [25]

28 FIGURE 19. COMBINING INTEREST RATE AND INFLATION SWAP Index-linked gilt Interest rate swap Fixed real yield (e.g. 1%) Pension fund pay floating (LIBOR) receive fixed e.g. 4% Counter party Components of return Inflation swap Actual inflation Pension fund pay fixed e.g. 3% receive actual inflation Counter party Let s assume expected inflation is 3%. To emulate an index-linked gilt there are two steps necessary: Step 1 Enter an interest rate swap exchanging LIBOR (a type of floating shortterm cash rate) for a fixed rate of, say, 4%. Expected short-term interest rates over the term are therefore expected to be 4% Step 2 Enter an inflation swap. In this case expected inflation is 3%, so we swap a fixed 3% against actual inflation Entering an interest rate swap has the effect of fixing both the real yield and inflation. The inflation swap exchanges fixed inflation for actual inflation. The net effect is that the real yield has been fixed at 1% (we receive fixed 4% and pay fixed 3%) and we receive actual inflation just like an index-linked gilt. [26] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

29 Meeting future payments In chapter 1 we introduced the example of a benefit of 100 increased with inflation payable after 10 years. In that example we assumed interest rates were 4% with a real interest rate of 1% and expected inflation of 3%. The future expected value of the benefit is 100 x inflation = 100 x = In this example we shall use a swap rate to discount the cashflow, rather than an interest rate. Note that the swap rate may be different from this interest rate but, for simplicity, let s assume the swap rate is 4%, rather than a slightly higher number. The present value of the liability is discounted by the swap rate = / ( x )= FIGURE 20. DISCOUNTING WITH SWAP RATE ( ) 100 x = Present value = 100 x = x Time Present value Inflation 100 We could use swaps to make certain this payment was met, no matter what the course of future interest rates and inflation. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [27]

30 Assuming we have assets of available (i.e. we are not underfunded) the two steps necessary are: Step 1 enter an interest rate swap with a notional value of This will provide a fixed payment of in 10 years and, when added to our original 90.53, we have a certain This step locks in a real rate and expected inflation Step 2 at the outset enter an inflation swap with a notional value of 100. This will provide exposure to actual inflation. We will pay a fixed rate of 100 x expected inflation = 100 x = at expiry 2. This payment is made from our starting capital of 90.53, plus our we received under the interest rate swap FIGURE 21. TWO-STEP PROCESS Interest rate swap Inflation swap Pension fund pay floating (LIBOR) receive fixed Counter party Pension fund pay fixed receive 100 uplifted by actual inflation Counter party Whatever happens to interest rates and inflation, we will be able to meet our benefit payment of 100 increased by inflation. Assume inflation was 2% in reality over the 10 years. The actual benefit we would need to pay is 100 x = Our interest rate swap would still leave us with and we would exchange this under the inflation swap for (the benefit payment). This is shown in figure In practice the notional principal does not change hands, so we would pay the rather than [28] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

31 FIGURE 22. INFLATION EXAMPLE ( ) 100 x = Interest rate swap We have paid LIBOR for 10 years We receive back a fixed Inflation swap We have to pay 100 x = We get back 100 x = Time % 100 If inflation was 10%, everything in figure 22 would be the same except the two figures circled in orange, which would be 100 x = The benefit would still be met. The conclusion is that our asset and liability are matched. Swaps and collateral Entering into a swap arrangement involves being exposed to the creditworthiness of the counterparty. In practice, this risk can be significantly reduced via collateralisation. For an actual loss on a swap to occur, two things must happen. First, the investment bank must default and, second, the swap must have a positive value to the party that does not default (pension fund). To mitigate this risk, swaps can be collateralised. This means that when one party owes money to the other, it is passed across as collateral (in securities of equivalent value) prior to payment. In practice, swaps are usually valued daily and collateral payments are calculated accordingly. Most swaps include thresholds such that there is no need to transfer small amounts of money, which would be inefficient for both parties. Collateralisation has profound implications for the credit risk exposure a pension fund takes on when it enters a swap. In the event that the investment bank defaults completely, the collateral means that no money has been lost up to that point. A new swap could be struck with another counterparty, although this may be challenging and the costs of replacing the position are subject to the appetite of other counterparties to undertake the position and associated costs. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [29]

32 Swaptions A swaption is an option in which the buyer has the right but not the obligation to enter a swap on terms that are fixed when the option is bought. As markets move, the swaption may or may not become valuable to the buyer. If the market moves unfavourably, the swaption will expire without the buyer exercising the right to enter the swap and the buyer has lost the premium. If the swaption has some value at expiry, then the buyer will exercise their right to enter the swap (although often they will settle for cash and not enter the actual swap). For pension funds a swaption could be designed that increased in value if interest rates were to fall. In this way the swaption would rise in value as would the liabilities, hence risk would be reduced. Pension funds can also sell swaptions. If interest rates were to rise, the swaption would be exercised against the pension fund, but the liabilities will have fallen. Longevity swaps For pension funds, the risks associated with further increases in longevity have moved up the agenda. This reflects a widespread focus on offsetting unrewarded or unintentional risks. Bulk annuity buyouts used to be the only available route for managing longevity risk. However, greater demand has spurred multiple new entrants into the buyout market and provoked innovative forms of risk transfer, including buy-ins and, now, longevity swaps. Under such a swap arrangement, a scheme effectively forgoes the impact (positive or negative) of changes in future longevity in return for retaining today s estimate of future longevity. Uncertainty is replaced by certainty, via a structure that is similar to an interest-rate swap. Alternative hedging strategies Since the end of the financial crisis, sterling swaps have traded at a premium to government bonds (gilts), leading many LDI investors to look for other ways to hedge inflation and interest rate risk. Leveraged gilt strategies such as repurchase agreements and gilt total return swaps are effective alternatives. They offer LDI investors a more cost-efficient way to hedge with gilt exposures because they require no cash investment and benefit from the yield pick-up over swaps. However, like conventional swaps, they can also provide a more flexible way to hedge than by using physical gilts. In addition, LDI investors have found that synthetic equity strategies are a flexible way to free up physical cash to increase their gilt exposure. [30] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

33 Repurchase agreements In a repurchase agreement repo, one party will sell an asset with an agreement to buy back that asset at an agreed price on a specified future date. Repos are short-term contracts with a typical maturity from overnight to several months, although maturities of up to several years are possible. The largest and most liquid repo market is in gilts. Repos allow investors to exchange gilts (or other assets) for cash and to buy them back at a premium at a later date. The exchange of legal title on the gilts reduces credit risk for the counterparty, which means repo investors can typically buy back the gilts at a sub-libor rate. The difference between the price paid to repurchase the asset (the forward price) and the price at which the asset is sold (the spot price) is analogous to the interest rate on a loan. This is known as the repo rate and varies according to supply and demand in the market. Typically the rate that applies for government bonds is the general collateral ( GC ) repo rate. FIGURE 23. REPO STRUCTURE Start of contract Pension fund cash government bond Counter party End of contract Pension fund government bond cash + interest Counter party THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [31]

34 Repo markets provide a number of uses for LDI investors. Investors that wish to extend hedging through the gilt market could repo out an existing gilts portfolio and use the proceeds to purchase additional gilts. As the investor retains economic exposure to the gilt assets repo-ed out, this means the investor achieves a leveraged exposure to gilts. If the investor does not have an existing gilt portfolio but wishes to extend hedging through the gilt market they can, alternatively, purchase gilts on a repo basis. This transaction combines a simultaneous gilt purchase and repo transaction. The repo transaction provides capital to purchase the gilt which is then used as collateral in the repo transaction. Repo markets can also provide short-term capital to assist with cashflow management and are an efficient way to invest cash on a collateralised basis, albeit at a sub-libor rate. Repo agreements are often rolled over at expiry to cover the required payment due. Investors face the risk that they may not be able to roll over the agreement, and market movements may make cash requirements larger than expected. Any rolling of a repo with a different counterparty generates settlement risk. Investors must also be aware of counterparty risk, although collateralisation limits the impact of counterparty default. Gilt total return swaps A gilt total return swap (TRS) exchanges cashflows linked to the return of a gilt, or number of gilts, in return for a set of cashflows linked to a cash rate (typically LIBOR) plus a financing spread. Gilt TRS have similar risk/reward characteristics to a direct physical investment in a gilt, basket of gilts or a gilt index. As with interest rate and inflation swap contracts, gilt TRS do not require any initial outlay to enter the position. This is because, at the inception of the contract, each cashflow has an equal present value. Any difference between the two cashflows is exchanged at the expiry of the contract. This allows LDI investors to gain exposure to a bond-like asset without requiring any initial capital outlay, providing an investor with the ability to leverage their portfolio. Gilt TRS contracts are over-the-counter (OTC) instruments. Terms can be tailored to meet investors needs and often differ from the maturity of the underlying gilt. A typical term for a gilt TRS is between 6 months and 3 years, at which time a new contract would need to be struck to maintain the exposure. A simple TRS payment structure is highlighted in figure 24. [32] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

35 FIGURE 24. GILT TRS STRUCTURE Client return leg gilt total return financing leg 3M LIBOR ± spread Counter party Transaction costs are incurred on the financing leg of the TRS, with no explicit fee being charged. This spread to LIBOR is dependent on a number of factors, including supply and demand and the extent to which the counterparty uses its own balance sheet to finance the contract. Like repo agreements, investors face the risk that they will not be able to roll the contract into another at expiry. If this happens, the investor will need to meet any cash requirements owed on the contract. The investor is also exposed to counterparty risk, but this is mitigated by collateralisation. Collateral is passed daily between counterparties depending on each counterparty s mark-to-market position. Synthetic equity Equity exposure can be achieved synthetically (using derivative instruments) with risk/reward characteristics similar to a direct physical equity investment. The most common forms of synthetic equity exposure are achieved through the use of either exchange-traded future contracts or equity TRS. Both methods enable investors to gain exposure to equities without paying cash, freeing up assets for investment in other assets, such as gilts. Exchange-traded futures An exchange-traded future contract is entered into through an exchange and provides a return based on that of an underlying equity index. Before entering a position, investors must post initial margin to cover any losses originating from their position over time. Equity future contracts on major benchmark indices are highly liquid. In order to construct a global benchmark such as the MSCI World, an investor would need to invest in the underlying constituents based on their market capitalisation weights. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [33]

36 Equity total return swaps An equity TRS exchanges cashflows linked to the return of a basket of stocks in return for cashflows linked to a cash rate (typically LIBOR) plus a financing spread. In practice, only the difference between the two cashflows is exchanged at the expiry of the contract. Equity TRS have similar risk/reward characteristics to a direct physical investment in a basket of stocks. As an OTC product, each TRS contract can be tailored. For investors looking for global exposure, a TRS referencing the MSCI World Index provides relatively good liquidity. An investor can also build their global exposure through the use of regional or single country indices if they wish to hold a custom global benchmark. A typical term for an equity TRS is between 6 months and 3 years, at which time a new contract would need to be struck to maintain the exposure. A simple TRS payment structure is highlighted below. FIGURE 25. GILT TRS STRUCTURE Pension fund return leg equity index total return financing leg 3M LIBOR ± spread Counter party Synthetic equity within a portfolio Synthetic equity strategies allow LDI investors to replicate an existing physical equity portfolio. They can then use the cash that was previously locked into this physical portfolio to buy gilts and benefit from the yield pick-up relative to swaps. In figure 26 we show how the use of synthetic equity can achieve the same overall exposures as a traditional portfolio of equities, gilts and swaps. Both portfolios have a 50m exposure to equities (either physical equities or synthetic equities) and a 75m exposure to interest rate and inflation assets (either gilts or swaps). However, in Portfolio B the leverage is gained through the use of synthetic equity instruments rather than swaps (see Asset Exposure), allowing more of the physical assets to be invested in gilts. [34] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

37 FIGURE 26. PORTFOLIO A Asset exposure Physical assets Gilts 50m Equity 50m Gilts 50m Equity 50m Swaps 25m FIGURE 27. PORTFOLIO B Asset exposure Physical assets Equity 25m Equity 25m Gilts 75m Synthetic equity 25m Gilts 75m Synthetic equity investment carries with it the risks inherent in a physical equity investment in addition to specific instrument risk. In equity futures, investors will need to post initial margin, which varies between contracts and is a function of market volatility. Mark-to-market losses require additional (variation) margin to prevent the contract being closed out by the exchange. In equity TRS, as with gilt TRS, investors are exposed to counterparty risk, which is mitigated by collateralisation. There are also currency risks dependent on the contract traded and an investor s mark-to-market position. THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [35]

38 [36] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT

39 Liability driven investment THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT [37]

40 LIABILITY DRIVEN INVESTMENT (LDI) LDI is an investment philosophy, not a product. LDI is about developing investment strategies that achieve desired risk-and-return targets relative to liabilities. The foundation of a liability-driven approach involves assessing the sensitivities of both the assets and the liabilities to a range of factors. These include inflation, interest rates, equity markets and so on. The key is to understand the level of risk relative to liabilities encapsulated in the asset portfolio. In the early days, LDI was narrowly defined and generally involved structuring bond portfolios to meet the cashflows paid to pensioners. LDI strategies are now widely defined and encompass an holistic framework by which assets are managed relative to the liabilities. Outperforming the liabilities plays a central role, particularly given most pension funds desire to plug funding gaps. A common question is whether it is necessary to adopt an investment objective in the form of liabilities + x% to pursue a liability-driven approach? The answer is no, although if some of the assets are allocated towards matching the liabilities then it makes sense to assess these assets relative to the change in liabilities. The majority of UK pension funds currently have a scheme-specific benchmark e.g. 40% UK equities, 20% overseas equities, 30% bonds and 10% property. These strategies are designed to outperform the liabilities and, based on certain assumptions, it is possible to convert a scheme-specific strategy into a liability-driven equivalent. A typical investment strategy of 60% equities and 40% in matching assets is equivalent to targeting a return on liabilities +2% to 3%. The liability profile and current assets In chapter 1 we noted that when we use a real interest rate, the present value of pension fund liabilities that are linked to inflation is not sensitive to changes in inflation. In our example a 100 benefit is payable in 10 years and is increased by inflation but it will always have a present value of [38] THE ESSENTIALS OF LIABILITY DRIVEN INVESTMENT