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Key market themes and implications for defined benefit pension liability risk management

27 September 2016

Interest rate market update

David JamiesonSenior Market Strategist, Financial Solutions Group

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20 year European interest rate swaps

Source: Bloomberg. Data as at 31 August 2016.

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16

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20 year global rates

Source: Bloomberg. Data as at 31 August 2016.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Mar-12 Feb-13 Dec-13 Nov-14 Oct-15 Aug-16

%

USUK

Europe

Japan

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US total debt

Debt saturation

Source: Datastream and Insight. Data as at December 2015.

-

5

10

15

20

25

30

35

40

45

50

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

US

D (t

r.)

GDP ($tr.)

Total debt ex financials ($tr.)

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0.2

0.3

0.4

0.5

0.6

0.7

0.8

1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012

Rat

io o

f cha

nge

in N

GD

P to

ch

ange

in d

ebt

US debt productivity

Source: Datastream and Insight. Data as at December 2015.

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100%

120%

140%

160%

180%

200%

220%

240%

260%

280%

300%

0%

5%

10%

15%

20%

25%

1975 1980 1985 1990 1995 2000 2005 2010 2015

US debt and short-term rates

Source: Datastream and Insight. Data as at December 2015.

3 month Treasury bill rate (LHS)

Total debt ex financials/GDP (RHS)

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Interest rate levels

Source: Reuters. Data as at 31 August 2016.

Country 3 months 2 years 5 years 10 years 20 yearsGermany -0.82 -0.63 -0.50 -0.07 0.27

France -0.58 -0.59 -0.39 0.18 0.79

Netherlands -0.63 -0.61 -0.43 0.04 0.35

Denmark -0.69 -0.57 -0.35 0.02 0.50

Italy -0.36 -0.09 0.25 1.14 1.80

Sweden -0.75 -0.65 -0.36 0.10 0.90

Switzerland -1.05 -0.95 -0.81 -0.50 -0.19

Japan -0.25 -0.20 -0.18 -0.07 0.34

UK 0.23 0.14 0.21 0.64 1.14

US 0.33 0.81 1.20 1.58 1.93

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2016 European net bond supply

Source: BAML. Data as at 16 September 2016.

-140

-120

-100

-80

-60

-40

-20

0

20

40

Jan Feb Mar Apr May Jun Jul Aug Sep(est.)

Oct(est.)

Nov(est.)

Dec(est.)

EU

R b

n

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-1.0

-0.5

0.0

0.5

1.0

3 months 1 year 2 years 5 years 10 years 15 years 20 years 25 years 30 yearsTenor

‘Japanification’ of European interest rates

Source: Bloomberg. Data as at 16 September 2016.

Euro swaps

Germany

Japan

Switzerland

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0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

0%

2%

4%

6%

8%

10%

12%

14%

0 5 10 15 20 25 30 35 40 45 50Tenor (years)

Persistently low rates are bad too

Source: Bloomberg. Data as at 31 August 2016. 1 year carry is PV weighted.

1 year carry = 0.75%

Liabilities

1 year carry %PV (RHS)

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A question of risk management

Source: Pension Protection Fund, 7800 index. Data as at 31 July 2016.

-500

-400

-300

-200

-100

0

100

200

300

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

£bn

Funding level

Implications for defined benefit (DB) pension liability risk management

Serkan BektasHead of Client Solutions Group

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DB pension risk management demand remains high and growing

• Interest rate and inflation risk management

• Equity risk management

• Currency risk management

• Synthetic exposures

• Longevity risk management

Affordability of liability hedging is a key consideration, especially for pension schemes that are yet to commence liability hedging programmes

• Trigger programmes to manage the pace of implementation

• Instrument and maturity selection as a way to enhance affordability

• Replacing passive physical investments with synthetic alternatives to provide flexibility and enhance return

• Use of options to cheapen liability hedges and/or provide downside partial protection

Key pension risk management trends

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Ensure hedge size is consistent with downside risk appetite and the overall funding plan

Treatment of hedges under MFS can be a potential consideration

• Hedging of pensioner liabilities as a potential starting point

• Deferred and active liability hedging subject to consideration of long term implications versus MFS

Triggers may be used to guide the pace of implementation

• Market level or funding level triggers to implement or vary pace of hedging

• Alternatively or in addition, time-based triggers, to ensure some minimum hedging is implemented over time

Use of overlays to ensure hedge profile matches liabilities

Size and timing of liability hedge implementation

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Yield difference between government bonds and swaps

Instrument selection: government bond versus swap hedges

Source: Bloomberg. Data as at 2 September 2016.

-100

-50

0

50

100

150

200

2015 2025 2035 2045 2055 2065

Bon

d yi

elds

ver

sus

Eur

ibor

(z-s

prea

d, b

p)

Maturity

Spain

Italy

Germany

Belgium

Netherlands

France

Ireland

Austria

Finland

= Conventional= Index-linked

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Maturity selection: prioritising hedging of more attractive segments of interest rate and inflation markets

Euro nominal swap rates Inflation HICPx swap rates

Source: Bloomberg.Data as at 31 August 2016.

-0.5%

0.0%

0.5%

1.0%

1.5%

0 10 20 30 40 50Tenor (years)

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

0 10 20 30 40 50Tenor (years)

Forward rates

Swap yield curve

Forward rates

HICPx swap curve

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Establishment of a risk management programme, derivative documentation and collateral agreements enables access to synthetic exposures

If desired, physical investments in passive equities and credit may be efficiently replaced with derivative exposures to market indices, with the cash released enabling greater flexibility across the portfolio

Synthetic exposures to replace passive physical portfolios

Receive equity markettotal return

Pay Libor +/- rate

BankPension plan

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• Options, when used with care, can enable efficient strategy implementation

• Use of options for downside risk management of return portfolios is a tried and tested approach

• In addition, options may be used in liability risk management context. For example,

– if a decision is made to hedge liabilities when rates increase, sell an option to enter into the liability hedge at a pre-agreed (higher) interest rate

– the reverse can also be implemented (reduce the size of a liability hedge if rates decline below a certain level) but, in practice, this is rare

Illustrative option strategies

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• All strategies described in this presentation are illustrative and for discussion purposes only

• All risk management solutions should be coherent with your funding plan and strategic objectives

• There is lots of relevant detail: legal documents, collateral, counterparty risks being examples of some

• Effective engagement with your investment, actuarial and legal advisers is key to the design of your risk management solution

Concluding remarks

Important disclosures

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