managing funding ratio risk and return aaron h. meder, fsa, ea senior asset-liability analyst, ubs...

Managing funding ratio risk and return

Managing funding ratio risk and return

Aaron H. Meder, FSA, EA Senior Asset-Liability Analyst, UBS Global Asset Management

October 20, 2006

Not intended for public distribution. For important additional information, please see the Additional Disclosures at the end of the presentation.

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AgendaAgenda

• Current defined benefit challenges• Focus on funding ratio• Funding ratio risk and return management

process• Understanding liabilities• Develop a funding ratio risk budget• Implement risk budget• Monitor risk budget

• Appendix

Current defined benefit challenges

Current defined benefit challenges

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The asset-liability mismatchThe asset-liability mismatch

Source: UBS Global Asset Management, BloombergNote: Typical Asset Return represents 40% S&P 500 Index//10% Russell 2500 Index/10% MSCI EAFE Index/35% Lehman Brothers Aggregate Index/5% 3 Month T-Bills. Typical Liability Return represents the PBO of a typical pay-related defined benefit plan. Discount rate is the yield on the Moody’s Aa Corporate Bond Index. Assumes no contributions. Benefit payments and service cost are excluded from each year’s annual growth.

-20%

-10%

0%

10%

20%

30%

40%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Asset ReturnLiability return

Market-related Asset and Liability Returns 1994-2005

A good year or a bad year?

“Perfect storm”

-30%-20%-10%

0%10%20%30%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Difference between asset and liability returns

Asset-liability mismatch risk causes funding ratio volatility

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The asset-liability mismatch (cont’d)The asset-liability mismatch (cont’d)

Note: Liability represents the PBO of a typical pay-related defined benefit plan, with approximately 2.5% service cost. Discount rate is the yield on the Moody’s Aa Corporate Bond Index. Assumes no contributions. Includes benefit payouts

Sources of asset-liability mismatch

0% 5% 10% 15% 20% 25%

Equity

Interest Rate

Total market-related risk

Residual

Total Pension Risk

Managed through investment policy

Managed through funding and benefit

policies

Source: UBS Global Asset Management, Bloomberg

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Note: Benefit payments were excluded from analysis.Source: UBS Global Asset Management

Liability expected to grow a steady 8%-9%

Key factors:

Passage of time (interest cost) = 5.5%-6.0%

Additional benefits earned (service cost) = 2.5%-3.0%

Fund must generate large enough returns to meet liabilities

0%

2%

4%

6%

8%

10%

12%

14%

16%

100% 90% 80% 70%

3-year5-year10-year

Liability relative return needed to close funding gap over various time horizons

Majority of plans have deficits; greater the deficit, greater the need for return

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Global pension reformGlobal pension reform

• Funding regulations• US: Pension Protection Act

• removes majority of smoothing of assets and liabilities• harsher penalties for being underfunded

• Canada: Pension Benefit Act• Solvency requirements focus on termination liability

• drives contribution requirements

• Accounting regulations• FASB and IASB working towards global

accounting regulations for pensions• Best guess is that they will take away much of

smoothing

Regulators moving to marked-to-market view of asset and liabilities

Our response: Focus on funding ratio

Our response: Focus on funding ratio

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Focus on funding ratio

Minimize FR volatility for a given level of FR return

The funding ratio, not level of assets in isolation, drives pension risk

Pension reform

Funding and accounting reform

begins 2006

Facing the challenges and “attacking the pension dragon”

Facing the challenges and “attacking the pension dragon”

Large return needs

Need for increased returns to keep

contributions at a tolerable level

Reduce the asset-liability mismatch

Causes include duration mismatch and equity market

risk

Challenges Our response

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Funding ratio approach vs. traditional approach

Funding ratio approach vs. traditional approach

Traditional Our approach: Funding ratio (A/L)

Objective Generate high long-term returns that will outperform the liability over the long term

Control the volatility of the plan’s funding ratio and outperform the liability over the long term

Risk measure Volatility of assets Volatility of funding ratio (assets vs. liabilities)

Low risk investment Aggregate bonds Liability mimicking asset portfolio

Process

Starts with assets

1. Develop portfolios that maximizes return and minimizes risk using CAPM

2. Determine acceptable level of asset volatility

3. Implement asset-only efficient portfolio

4. Monitor performance versus peers

Starts with liabilities

1. Analyze liabilities 2. Determine risk budget vs. liabilities 3. Implement combination of liability

mimicking assets with assets that are expected to outperform liabilities

4. Monitor funding ratio of plan

For illustrative purposes only.

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-1.5%

-0.5%

0.5%

1.5%

2.5%

3.5%

4.5%

2% 4% 6% 8% 10% 12% 14% 16%

Funding ratio risk

Fundin

g rat

io ret

urn

Measuring risk and return vs. the liability

Measuring risk and return vs. the liability

Funding ratio risk/return characteristics

Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation

Long Gov’t/Credit

Equities

Traditional 65/35 policy

Asset-only

frontie

r

Aggregate Bonds

Cash

Funding ratio frontier

Liability matching strategy

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Constructing efficient options Constructing efficient options

Hedge liabilities

Hedging component

Interest rate derivatives

Long duration bonds

Return generating component

Global diversification

Active “alpha” and “beta”

Return generation

For illustrative purposes only

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Liability hedging and return generation

Liability hedging and return generation

Combine liability hedging and return generation efficiently


-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

2% 4% 6% 8% 10% 12% 14% 16%

Funding ratio risk

Fundin

g rat

io ret

urn

Liability hedging

Return generation

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Policies structured relative to liabilities

Policies structured relative to liabilities

Need to eliminate uncompensated funding ratio risk


-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

2% 4% 6% 8% 10% 12% 14% 16%

Funding ratio risk

Fundin

g rat

io ret

urn

Return generation

Equities

Traditional 65/35 policy

Funding ratio

frontie

r

Asset-only

frontie

rLong Gov’t/Credit

Aggregate Bonds


Liability hedging

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The funding ratio risk management process

The funding ratio risk management process

ALM

• Understand liability risk and growth

• Understand how assets relate to liabilities

Understand liabilities 1

• Define efficient investment policies in an asset-liability framework

• Determine appropriate risk/return tradeoff

Develop funding ratio risk budget2

• Implement solution that best fits client preferences

• Assess investment policy in context of current market environment

Implement risk budget3

• Dynamically manage risk budget as a function of plan funding ratio

• Specific to each plan sponsors risk tolerance

Manage risk budget4

Source: UBS Global Asset Management

Process: Step 1 - Understanding the liabilities

Process: Step 1 - Understanding the liabilities

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Key pension liability risksKey pension liability risks

Assets Liabilities

Wage growth

Demographic experience (e.g. Longevity)

Inflation

Interest rates

Question: How should we best invest pension assets to cover for pension promises?

?

Answer: By taking compensated risk and hedging the uncompensated ones


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Assets Liabilities

Liability risks: Discount rateLiability risks: Discount rate

Changes in discount rates have a large impact on the value of liabilities

Discount rates determine the present value of the liabilities

If interest rates go down, the value of liability increases

Discounted future cash flows


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-

20

40

60

80

100

120

55 60 65 70 75 80 85

Age

Initial salary assumption Actual salary development

Liability risks: Salary growthLiability risks: Salary growth

Salary growth tends to move with inflation and economic real growth. Investing in equities and other real assets can

mitigate the impact of these risks

Best estimate of cash flows

Uncertainty due to salary

growth

Expected annuity payment, employee age 55


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-

20

40

60

80

100

120

140

65 70 75 80 85 90 95 100 105 110

Age

Initial benefit assumption Actual benefit development

Liability risks: InflationLiability risks: Inflation

The impact of inflation can be mitigated by investing in real rate bonds or other inflation-sensitive assets

There can be ad hoc or contractual benefit adjustments to inflationBest

estimate of cash flows

Uncertainty due to inflation

Expected annuity payment, employee age 65


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Fundamental FactorsReal RateInflation

Real GrowthAsset Risk Premia

Focus on fundamental exposures

Linking liabilities to assets Linking liabilities to assets


Future Real Wage Growth

Future Wage Inflation

Active Accrued

Deferred

Retiree

Liability

Accru

ed

lia

bilit

y

Pro

jecte

d lia

bilit

y

Fundamental Exposures

InflationReal Growth

Interest Rates

Assets that mimic

Real Rate BondsEquities & Other Real Assets

Nominal Bonds

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Correlations between liabilities and cornerstone hedging assets

Linking liabilities to assets Linking liabilities to assets

Nominal Bonds Real Rate Bonds Equities

Future Real Wage Growth

0.25 0.20 0.80

Future Wage Inflation

0.75 0.80 0.20

Active Accrued

Deferred

Retiree

0.25

Acc

rued lia

bilit

y

Pro

ject

ed lia

bilit

y

0.85 0.55

This information is presented for illustrative purposes only and reflects UBS Global Asset Management’s expectations for prospective return and risk using current market assumptions. There is no assurance that these projections will ultimately be realized.

Process: Step 2- Developing a risk budget

Process: Step 2- Developing a risk budget

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Constructing efficient options Constructing efficient options

Hedge liabilities

Hedging component

Interest rate derivatives

Long duration bonds

Return generating component

Global diversification

Active “alpha” and “beta”

Return generation


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Example: Efficient optionsExample: Efficient options


Asset Allocation Current Current + Hedge

Option AHedge Liabilities /

Optimal Return Generation

Option BHedge Liabilities /


Option CHedge Liabilities /


Domestic Bonds 35% 0% 9% 7% 5%

Domestic Long Bonds 0% 25% 25% 40% 55%

Foreign Bonds 0% 0% 6% 5% 3%

Alternative Bonds 0% 0% 8% 5% 4%

Real Rate Bonds 0% 10% 18% 15% 13%

Domestic Equity 55% 55% 9% 7% 5%

Foreign Equity 10% 10% 8% 6% 4%

Emerging Mkt Equity 0% 0% 4% 3% 2%

Private Equity 0% 0% 5% 4% 3%

Hedge Funds (beta-neutral) 0% 0% 5% 4% 3%

Real Estate 0% 0% 5% 4% 3%

Liability Hedging Tools

Liability Hedge Ratio 13% 100% 100% 100% 100%

Asset Return

Market Return (beta) 7.4% 7.4% 6.9% 6.6% 6.4%

Active Return (alpha) 0.5% 0.5% 1.6% 1.3% 0.9%

Total Asset Return 7.9% 7.9% 8.5% 7.9% 7.3%

Funding ratio

Funding ratio return 1.9% 1.9% 2.5% 1.9% 1.3%

Funding ratio risk 12.0% 9.5% 7.0% 6.0% 5.0%

FR Sharpe Ratio 0.16 0.20 0.35 0.31 0.26

Funding ratio efficient portfolios

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0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

2% 4% 6% 8% 10% 12%

Funding ratio risk

Fundin

g rat

io ret

urn

Example: A range of efficient optionsExample: A range of efficient options


Funding ratio risk return characteristics


A

B

C

Current (65/35)Return Generation

Liability hedging

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Example: Comparison of investment policies

Example: Comparison of investment policies


Expected funding ratio (One year, 95% confidence)

70%

75%

80%

85%

90%

95%

100%

105%

110%

115%

120%

Current Current +Hedge

Option A Option B Option C

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Example: Scenario analysis – funding ratio

Example: Scenario analysis – funding ratio


Policy: Current - 65% Equity, 12yr Duration mismatch

-2% -1% 0% 1% 2% -2% -1% 0% 1% 2%

-30% 60% 65% 72% 82% 94% -30% 83% 83% 83% 83% 83%

-15% 67% 73% 81% 91% 105% -15% 87% 87% 87% 87% 87%

0% 74% 81% 90% 101% 117% 0% 90% 90% 90% 90% 90%

15% 82% 89% 99% 111% 128% 15% 93% 93% 93% 93% 93%

30% 89% 97% 108% 121% 140% 30% 97% 97% 97% 97% 97%

Policy: Option B - 20% Equity, 0 yr Duration mismatch Policy: Option C - 14% Equity, 0 yr Duration mismatch

-2% -1% 0% 1% 2% -2% -1% 0% 1% 2%

-30% 85% 85% 85% 85% 85% -30% 86% 86% 86% 86% 86%

-15% 87% 87% 87% 87% 87% -15% 88% 88% 88% 88% 88%

0% 90% 90% 90% 90% 90% 0% 90% 90% 90% 90% 90%

15% 93% 93% 93% 93% 93% 15% 92% 92% 92% 92% 92%

30% 95% 95% 95% 95% 95% 30% 94% 94% 94% 94% 94%

Discount Rate Change (parallel shift) Discount Rate Change (parallel shift)

Equ

ity R

etur

n

Equ

ity R

etur

n

Policy Comparison: Sensitivity of Funding Ratio (%)

Discount Rate Change (parallel shift) Discount Rate Change (parallel shift)E

quity

Ret

urn

Equ

ity R

etur

n

Policy: Option A - 25% Equity, 0 yr Duration mismatch

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Example: Scenario analysis – surplus/(deficit)

Example: Scenario analysis – surplus/(deficit)


Policy: Current - 65% Equity, 12yr Duration mismatch Policy: Option A - 25% Equity, 0 yr Duration mismatch

-2% -1% 0% 1% 2% -2% -1% 0% 1% 2%

-30% ($507) ($391) ($276) ($160) ($44) -30% ($211) ($189) ($168) ($146) ($124)

-15% ($415) ($302) ($188) ($74) $40 -15% ($169) ($151) ($134) ($116) ($99)

0% ($324) ($212) ($100) $12 $124 0% ($126) ($113) ($100) ($87) ($74)

15% ($233) ($122) ($12) $98 $208 15% ($83) ($75) ($66) ($58) ($49)

30% ($141) ($33) $76 $184 $292 30% ($41) ($37) ($33) ($28) ($24)

Policy: Option B - 20% Equity, 0 yr Duration mismatch Policy: Option C - 14% Equity, 0 yr Duration mismatch

-2% -1% 0% 1% 2% -2% -1% 0% 1% 2%

-30% ($194) ($174) ($154) ($134) ($114) -30% ($174) ($156) ($138) ($120) ($102)

-15% ($160) ($144) ($127) ($110) ($94) -15% ($150) ($134) ($119) ($103) ($88)

0% ($126) ($113) ($100) ($87) ($74) 0% ($126) ($113) ($100) ($87) ($74)

15% ($92) ($82) ($73) ($64) ($54) 15% ($102) ($92) ($81) ($71) ($60)

30% ($58) ($52) ($46) ($40) ($34) 30% ($78) ($70) ($62) ($54) ($46)


Equ

ity R

etur

n

Equ

ity R

etur

n

Policy Comparison: Sensitivity of Surplus/(Deficit) ($millions)


Equ

ity R

etur

n

Equ

ity R

etur

n

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Selecting the risk budget Selecting the risk budget

Alternative investment policies

Funding ratio risk budget

Fun

ding

rat

io r

etur

n

Required

return

How much return does client need?

Minimize funding ratio risk for the given required return


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Implementation challengesImplementation challenges

• Aren’t interest rates too low to implement a liability hedge?

• we agree that interest rates are low, but they are not that low

• set up action plan to hedge liability as rates rise

• Liability hedging strategies reduce risk • Investment committee must measure investment

performance based on funding ratio, not against peers

• Client needs to feel comfortable with new types of risk when using interest rate derivatives

• counterparty • collateral and cash flow issues

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Example: Managing the risk budgetExample: Managing the risk budget


0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

80% 85% 90% 95% 100%Funding ratio

(Termination basis)

Fundin

g rat

io risk

budget

Assumption: Plan frozen and goal is to terminate

A

B

C

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Example: Managing the risk budgetExample: Managing the risk budget


0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

80% 85% 90% 95% 100% 105% 110%

Funding ratio

Fundin

g rat

io risk

budget

Assumption: Ongoing plan and goal is to avoid falling below 80% FR

C

B

A

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SummarySummary

• Understand liabilities• Liabilities are bond-like but they are not just bonds

• Develop and select risk budget• Hedge liabilities with long duration bonds + swap• Generate efficient absolute return• Select risk budget that balances funding ratio risk and

return objectives

• Implementation• Implementation of liability hedge can incorporate interest

rate views

• Managing the risk budget• Dynamically manage risk budget as a function of funding

ratio

Sponsors needs to develop and manage a funding ratio risk budget

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2006 Pensioners

SWAPS: An exchange of cash flowsSWAPS: An exchange of cash flows

Fixed benefit payments

Pension Fund Swap counter party

Receive fix

• Net payments are reduced when rates decline and therefore value of SWAP position is increased

• Result is that when rates go down, value of both the SWAP position and liability position increase

• The bigger the SWAP position the less impact interest rate movements will have on the funding ratio

Interest rate swaps can transform your fixed benefit payments into floating payments

Pay floating


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Impact of duration mismatch on funding ratio

Impact of duration mismatch on funding ratio

• The value of the liabilities increases faster than the value of the assets do

Falling interest rates create a deficit

• The value of the liabilities decreases faster than the value of the assets do

Rising interest rates create a surplus

Assets

Liabilities

DeficitVa

lue

AssetsLiabilities

SurplusVa

lue

Currently, interest rate changes cause funding ratio changes


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Impact of swap overlayImpact of swap overlay

• Funding level reduced: liabilities increase relative to assets

• Swap has a positive value which precisely offsets the reduction in funding level

Swap overlay immunizes funding ratio from interest rate changes

Falling interest rates: positive swap value

AssetsLiabilities

SwapV

alu

e

AssetsLiabilities

SwapVa

lue Rising interest rates: negative swap value

• Funding level increased: assets increase relative to liabilities

• Swap has a negative value which balances the funding level once again

Swaps reduce the impact of interest rate movements on funding ratio


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Additional disclosures Additional disclosures Past performance is no guarantee of future results. There is no guarantee that investment objectives, risk or return targets discussed in this presentation will be achieved.

The opinions expressed in this presentation are those of the UBS Global Asset Management Business Group of UBS AG and are subject to change. No part of this presentation may be reproduced or redistributed in any form, or referred to in any publication, without express written permission of UBS Global Asset Management. This material supports the presentation(s) given on the specific date(s) noted. It is not intended to be read in isolation and may not provide a full explanation of all the topics that were presented and discussed.

Information contained in this presentation has been obtained from sources believed to be reliable, but not guaranteed. Furthermore, there can be no assurance that any trends described in this presentation will continue or that forecasts will occur because economic and market conditions change frequently.

The information contained in this presentation should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this information or that securities sold have not been repurchased. The securities discussed do not represent an account’s entire portfolio over the course of a full market cycle.

It should not be assumed that any of the securities transactions or holdings referred to herein were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities referred to in this presentation.

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This presentation does not constitute an offer to sell or a solicitation to offer to buy any securities and nothing in this presentation shall limit or restrict the particular terms of any specific offering. Offers will be made only to qualified investors by means of a prospectus or confidential private placement memorandum providing information as to the specifics of the offering. No offer of any interest in any product will be made in any jurisdiction in which the offer, solicitation or sale is not permitted, or to any person to whom it is unlawful to make such offer, solicitation or sale.

Any statements made regarding investment performance expectations, risk and/or return targets shall not constitute a representation or warranty that such investment objectives or expectations will be achieved. The achievement of a targeted ex-ante tracking error does not imply the achievement of an equal ex-post tracking error or actual specified return. According to independent studies, ex-ante tracking error can underestimate realized risk (ex-post tracking error), particularly in times of above-average market volatility and increased momentum. Different models for the calculation of ex-ante tracking error may lead to different results. There is no guarantee that the models used provide the same results as other available models.

Copyright © 2006 UBS Global Asset Management (Americas) Inc.

managing funding ratio risk and return aaron h. meder, fsa, ea senior asset-liability analyst, ubs...

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