2009 Annual Meeting ● Assemblée annuelle 2009 Halifax, Nova Scotia ● Halifax (Nouvelle-Écosse) 2009 Annual Meeting ● Assemblée annuelle 2009 Halifax, Nova Scotia ● Halifax (Nouvelle-Écosse) Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires

1 Liability Interest Rate Risk Value of the Funding Objective is Very Volatile! Annualized 3-Year Returns Market Value of Liabilities

2 Defining the Investment Objective Risk Budgeting Framework PV Maximum Contribution Increases Plus PV Maximum Benefit Reductions Other Investment Risks PV Expected Risk Premiums >=>= Liability Interest Rate Risk Risk Budget Risk Capital Return on Risk Budget

3 Liability Interest Rate Risk A Risk Worth Accepting? Policy (Strategic) Decisions –Committee level decision –Secular direction of interest rates –Changed infrequently (long-term horizon) Active Interest Rate Strategies –Manager level decisions –Tactical in nature (shorter-term horizon) Considerations –Ability to forecast direction of interest rates –Expends risk budget (bets are often huge) –Evaluate relative to other available strategies

4 Asset / Liability Hedge Ratio Options to Increase Asset / Liability Hedge Ratio Increase fixed income allocation –reduces expected return on assets –limited impact given funded status Duration extension –introduces yield curve risk –plan already has a long duration Overlay program –Use of swaps and forwards

5 Fixed Income Overlay Programs Primary Implementation Instruments Interest Rate Swaps Total Return Swaps Bond forwards Government of Canada bond futures Use of leverage is key to overlay strategies –While mechanics vary by instrument, full market exposure can be obtained without requiring the full amount of capital –“Freed-up” capital can be redeployed in other areas while maintaining desired asset/liability hedging ratio (e.g. equities, alternative asset classes, etc.)

6 Determining Appropriate Mix of Instruments Relative Factors to Consider Thorough assessment of various factors will determine suitable mix Market exposures –duration and term structure contributions –sector/credit exposures –credit risk look-through – notional versus net Market/liquidity conditions –supply/demand valuation impact –financing/counterparty spread cost impact Operational Risks –potential m-t-m cash flow differences –relative flexibility

7 Fixed Income Overlay Program Aligning the Investment Problem to Today’s Reality Today’s investment reality –Short-term mark-to-market measures (e.g. solvency and accounting) turn the investment problem from a long-term to a short-term problem The revised investment problem –Overlay offsets the market value volatility in liabilities Largely eliminates potentially huge capital gains and losses –Overlay costs short-term interest rate on notional value –Non-fixed income assets now need to beat cash Economic characteristics of a cash benchmark –Very little / no market value volatility –Increased volatility in annual financing cost Trade-off for eliminating amortization costs of large capital gains and losses

8 Beyond Immunization Two LDI Examples Duration extension using fixed income overlay –Used to increase Asset/Liability hedge ratio –Existing structure (e.g. equity allocation) maintained Portable alpha –Liability “beta” is hedged –Alpha sources added to meet return target

9 Duration Extension Traditional Portfolio Bond Portfolio Sell Bonds Interest Rate Swap Note: Financing and other costs are ignored + Expected Rate of Return (%) Equity Portfolio Bond Portfolio Equity Portfolio Interest Rate Swap Liabilities 60 / 40 Equity / Bond AssetsLiabilities

10 Portable Alpha Definition Portable alpha is the process of separating market returns from skill-based returns and then pairing alpha generated in one asset class with the beta from another asset class Beta Source (e.g. Bond portfolio) Alpha Source (e.g. Hedge Fund) + Example

11 An Inconvenient Truth Alpha Does Not Grow on Trees! Portable alpha does not create alpha – you still have to identify a manager that can consistently add value over time through their investment skill Required attributes of the alpha source: –Stable –Uncorrelated with market –Uncorrelated with other alpha sources –Sufficiently large to exceed fees and other transaction costs

12 Portable Alpha Strategy for LDI Portfolio Example Bond Portfolio Sell Bonds Interest Rate Swap Hedge Fund Return Bond Portfolio Note: Financing and other costs are ignored + + Expected Rate of Return (%) Interest Rate Swap Liabilities AssetsLiabilities

13 LDI Examples Key Takeaways Available tools allow A/L hedge ratio to be set at any desired level LDI framework does not require reducing expected return Approach helps optimize investment efficiency relative to liabilities –Explicitly identify risk/return profile of key components of investment strategy –Take risk where rewarded –Minimize unintended or undesired bets Caveats: –LDI does not manage underwriting risk: e.g. longevity –While solvency and accounting help bring transparency to the economic risk of the pension plan, investment strategies can be directed toward but cannot fully hedge these liability measures

14 Implementation Considerations Fees and Other Expenses - Portable Alpha Example Structure –Overlaying a hedge fund manager on a long bond portfolio Assumptions –Hedge Fund generates gross return of 10.0% –Hedge fund fees: 2% + 20% above T-Bills –T-Bills yield 4.0% –Transaction costs of 0.5% Costs –2.0% investment management fee (flat portion) –0.8% performance fee [20% of (8% - 4%)] –4.0% financing cost –0.5% transaction costs After-fee alpha of 2.7%

15 Implementation Considerations Other  Leverage  Counterparty risk  Beta replication comes with tracking error  Margin maintenance  Exposure maintenance and rebalancing  Restrictive SIPPs  ISDA agreements and futures trading accounts  Trustee knowledge and comfort level

16 Options for Smaller Plans Pooled Fund Approach Liability is limited to the amount invested in the pooled fund Modest oversight requirements and fewer demands on internal resources Lower minimum asset size ISDA agreements and futures trading accounts are not required (these are done within the pool) However: –Customization is reduced

17 Final Comments LDI is about managing risk relative to liabilities –Absolute level of risk relative to liabilities –Managing where risks are taken Interest rate risk generally not considered a high quality source of alpha Overlay programs –Brings investment problem back to beating cash –Positions the plan for introducing alternative sources of return Implementing LDI correctly requires increased co-ordination between actuaries, investment consultants and investment managers