Liability Driven Investing

1
Liability Driven Investing

• Andrew Welch

2
Liability Driven Investing

• Is not just about buying lots of bonds
• Is not just about locking in deficits
• Does leave scope to seek additional returns
• Is a new risk framework

But why do we need a new risk framework?
3
Remember 2004?

• Investment strategy 70 Equities / 30 Bonds
• Assumed return 7
• Portfolio return 9.5
• Good news?
• Start of 2004 funding level was 77
• End of 2004 funding level was 74

Success at asset level ? success at fund level
4
Definitions of Risk

• Measurable possibility of losing not gaining
  value
• The volatility or variability of returns
• For a pension fund volatility in funding status

But what influences funding volatility?
5
Funding Level
ASSETS
LIABILITIES
FUNDING LEVEL
6
Typical Pension Fund Assets
7
Typical Pension Fund Liabilities

• A set of guaranteed future cash flows
• Mostly linked to inflation

8
Sources of Volatility (1bn)

• Exposure Sensitivity Annual Volatility Ann.
  Impact (m) (m)Assets
• Equity 700 1 15.5 101
• Liabilities
• Interest rates (1000) 20 yrs 1.1 (220)
• Inflation (1000) 20 yrs 1.0 (200)
• Longevity (1000)

9
Are You Being Paid to Take Risk?

• Volatility Rewarded Hedgeable
• Equity market volatility 10.0 ? ?
• Changes in interest rates 22.0 ? ?
• Changes in inflation expectations 20.0
  ? ?

10
Volatility in Funding Level
11
Summary of the Problem
Heavy reliance on Equity Risk Premium
Volatile Funding Level

• Large and unmanaged Liability Risks
• Interest rates
• Inflation

12
A Better Approach?

• Manage pension fund risk as you manage other
  financial risks
• Optimise risk allocation
• Remove unintended and unrewarded risk
• Diversify sources of return

13
Same Target Return but Less Risk
Manager Skill
Cash
Property
Consciously sought
Credit
Equity10.8
Inflation 20
Risk measured relative to the schemes liabilities
Unintended by-product
Interest Rates 22
14
Delivering a Smoother Path to the Funding
Objective
Funding level
LDI
110
Traditional approach
90
TIME
15
Hedging the Financial Risks
HEDGEABLE SOURCES OF RISK
HEDGING INSTRUMENTS
INTEREST RATES
INFLATION
16
Use of Swaps

• Could construct physical bond portfolios to match
  liabilities
• But constrained by available bonds
• And restricts ability to seek returns
• Interest rate and inflation swaps
• Offer the means to fine tune the match
• Free up capital to seek returns
• (Change the investment challenge to outperforming
  cash)

17
Translating Asset Relative Returns to Liability
Relative Returns
18
Significantly Lower Funding Level Volatility
19
What does it look like in practice?
20
Notes

• WE WOULD ALSO POINT OUT
• All features in this pack are current at the time
  of publication but may be subject to change in
  the future.
• Unless otherwise stated, the source of
  information is Insight Investment. Any forecasts
  or opinions are Insight Investments own at the
  date of this document and may change. They should
  not be regarded as a guarantee of future
  performance.
• This document is intended for investment
  professionals only and should not be relied upon
  by private investors. No modifications or
  amendments to this presentation may be made
  without the prior permission of Insight
  Investment. The document is to be used by the
  intended recipient(s) only and the document may
  not be forwarded to a third party without prior
  consent from Insight Investment.
• Depending on the investors currency of
  reference, currency fluctuations may adversely
  affect the value of investments and the income
  therefrom.
• Past performance is not a guide to future
  performance.
• Unit prices may go down as well as up,
  particularly in the short term. The value of an
  investment may fluctuate and cannot be
  guaranteed. Unless otherwise indicated, the
  performance of the pooled funds illustrated is
  calculated on an offer to offer basis with income
  reinvested and net of management charges.
• Trading in derivative instruments may involve a
  higher degree of risk and there can be no
  assurance that the objectives of the portfolio
  will be attained.
• Telephone calls may be recorded.
• ISSUED BY INSIGHT INVESTMENT
• Insight Investment Management (Global) Limited,
  Clerical Medical Investment Group Limited and
  Clerical Medical Managed Funds Limited are
  authorised and regulated by the Financial
  Services Authority and are part of the HBOS
  Group. All companies registered in England and
  Wales. Registered office 33 Old Broad Street,
  London EC2N 1HZ.
• Notes for clients and prospects of Insight
  Investment Management (Global) Limited Issued by
  Insight Investment Management (Global) Limited,
  Reg. No. 00827982.
• Notes for clients and prospects of Clerical
  Medical Investment Group Limited Issued by
  Insight Investment Management (Global) Limited on
  behalf of Clerical Medical Investment Group
  Limited. Clerical Medical Investment Group
  Limited, Reg. No. 03196171.
• Notes for clients and prospects of Clerical
  Medical Managed Funds Limited Issued by Insight
  Investment Management (Global) Limited on behalf
  of Clerical Medical Managed Funds Limited.
  Insight Investment Management (Global) Limited,
  Reg. No. 00827982. Clerical Medical Managed Funds
  Limited, Reg. No. 01580284.
• Notes for clients and prospects of Insight
  Investment Management (CI) Limited Issued by
  Insight Investment Management (CI) Limited.
  Registered Office St. Julians Court, St.
  Julians Avenue, St. Peter Port, Guernsey. Reg.
  No. 1518. Authorised and regulated by the
  Guernsey Financial Services Commission.