An introduction to Liability Driven Investment John Belgrove 5 June 2006

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

Asset vs. Liability Cashflows: Conventional Approach

Asset vs. Liability Cashflows: Full Cashflow Matching

LDI – low risk approach

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

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

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

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

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

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

Pitfalls of using swaps

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 Typical problem – match not close enough; or some sort of basis risk

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 Hedge fixed payments with LIBOR to fixed Hedged pure IL payments with inflation Can hedge hybrid pension increases with either a dynamic mix or an exotic

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 Vanilla LIBOR to fixed standard product – get Bloomberg quotes

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

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

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” Bank is middleman – always looking for someone to take other side – to extent not possible, it hedges position If find someone to take both sides can price a lot keener If not, there will be bigger spread – so exotics tend to be more expensive “Other side for fixed” - “Other side for inflation” – utility companies

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)

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 If you go down this road it makes sense to measure assets and liabs consistently Term structure rather than flat

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? Two points If put swap overlay on EVERYTHING (equity as well) – tacitly assuming achieve LIBOR on everything Case for not putting overlay on equity (opinions divided)

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)

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)

Possible Structures: Active Approach Equities (60%) Expected return net of fees (in excess of gilts) 4.3% Risk vs LDI 11.0% Market Risk 80% Manager Risk 20% Unconstrained UK Equities 30% Unconstrained Global Equities 30% Bonds (25%) Passive Corporates 25% Liquidity 1 Very Liquid 2 Fairly Liquid 3 Fairly illiquid 4 Very illiquid  Alternatives (15%) Property 5% Private Equity 5% Active Currency 5% Monitoring Commitment Low Medium High 

Attribution: Change In Funding Level

Any Other Questions