An introduction to Liability Driven Investment

1. An introduction to Liability Driven Investment John Belgrove 5 June 2006

2. Old Approach Vs. New Approach Liabilities Benchmark Assets Benchmark risk Conventional Tracking error Benchmark risk Liability-driven Tracking error Too much focus on this

3. Asset vs. Liability Cashflows:Conventional Approach

4. Asset vs. Liability Cashflows:Full Cashflow Matching

5. LDI – low risk approach

6. Low risk approach • “Risk” - possibility that assets and liabilities don’t move in tandem in response to market movements • Construct assets so that as far as practicable assets move in line with liabilities in response to changes in market conditions

7. Asset v liability cashflows • Pure bond solution in previous slide • is very lumpy • is short on duration

8. Introduction to swaps • A swap can be thought of as a positive holding in one asset and a negative holding in another • We construct swap to • PAY AWAY to counterparty the cashflows from the bonds (or cash) actually held • RECEIVE from counterparty the cashflows that (as far as practicable) replicate liability cashflows

9. No swap overlay Bond receipts Cash inflows Cash outflows Pension payments Source: Barclays Capital

10. Swap receipts Cash inflows Cash outflows Swap payments With swap overlay Source: Barclays Capital

11. What do swaps add? • Can be more bespoke – can construct in many flavours, which aren’t readily available in physical space • Zeroes • fixed/real/LPI • Currency • Address lumpiness of bond portfolio • Mitigate (not fully) short duration in bond portfolio

12. Pitfalls of using swaps

13. Understanding • Trustees don’t understand what can often be a complex solution • Mistaken belief that they are fully hedged • Surprise on seeing volatility from quarter to quarter • Consultants need to explain the residual risk and manage expectations

14. Nature of swap market • To implement LDI need • at the very least, vanilla swaps, both • LIBOR to fixed • Inflation • possibly something more exotic • LPI 0 to 5 • LPI 0 to 2.5 • etc

15. Nature of swap market • Vanilla LIBOR to fixed • very liquid • many banks in market • transparent pricing (Bloomberg quotes etc) • narrow spreads • easy to get in and out

16. Nature of swap market • Vanilla inflation • fewer players (say 4 or 5; 2 dominate) • limited scope to diversify counterparty risk (albeit limited due to collateralisation) • but fairly liquid

17. Nature of swap market • Exotic • as previous slide but more so • LPI 0 to 5 becoming more liquid • anything more fancy still illiquid • less transparency • wider spreads • harder to unwind

18. Role of banks; supply of suitable swaps • Bank seeks to find natural counterparty • aim that your pay leg is A N Other’s receive leg • aim that your receive leg is A N Other’s pay leg • bank hedges residual risk • the lower that risk, the better terms they can offer • partly why vanilla swaps more liquid • terms can vary depending on availability of “other side”

19. Suitability of match • Vanilla swaps give less precise match • pure inflation swap doesn't hedge vs deflation • “manufacture” hedge from fixed and inflation • hedge sensitive if cap/floor near inflation level • so hard to hedge e.g. LPI 0 to 2.5 • Exotic swaps give closer match – still not perfect • how do you match future retirees? • Either kind offers substantially longer duration than physical assets (but can still be short)

20. Basis risk • Be clear what is meant by “liabilities” • Example – one client sought to manage volatility of FRS17 funding level • AA physical plus swap overlay • residual noise due to volatile AA/swap spread • This is arguably accounting tail wagging strategy dog

21. Swaps and high return strategy • Suppose you execute a swap to turn liability cashflows into LIBOR • If achieve LIBOR on the physical, and liability cashflows pan out as expected you’re fine • Risk of not getting LIBOR on the physical – e.g. if put swap overlay on equities • At total scheme level can argue that equity noise swamps the risk reduction given by the swap – swap approach overengineered?

22. Risks: Removable Risks • Interest rate risk • Inflation rate risk • Duration risk • Convexity risk (full cashflow matching) • Counterparty risk (via daily marking-to-market), although not completely removed (replacement risk)

23. Risks: Non-Removable Risks • Reinvestment risk for the very long-dated liabilities(>50y) • Salary inflation risk for active liabilities • Demographic related risks (mainly longevity risk) • Change in benefit payments • Change in membership (withdrawals, redundancies, etc) • Covenant risk – Company default on payments • Contributions above/below benefit accrual • Actuaries valuation assumptions (yield curve risk) • Data risk (cashflow model)

24. Unconstrained UK Equities 30% Unconstrained Global Equities 30% Passive Corporates 25% Monitoring Commitment Property 5% Low Medium High Possible Structures: Active Approach Equities (60%) Bonds (25%) Liquidity 1 Very Liquid 2 Fairly Liquid 4 Very illiquid 3 Fairly illiquid  Alternatives (15%) Private Equity 5% Active Currency 5% 

25. Attribution: Change In Funding Level

26. Any Other Questions