understanding modelling and defined benefit pension risk

Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014

Understanding, Modelling and

Managing Defined Benefit

Pension RiskOxford-Man Institute of Quantitative Finance

Wednesday 21st May 2014

1


Agenda

What is a Defined Benefit Pension Fund? 4

How do we Measure the Health of a Pension Fund? 5

What are the Different Stages of a Defined Benefit Pension Fund? 6

What are the Key Risks to a Pension Fund? 7

What are the Main Challenges to the Pension Industry? 8

How do we Measure the Risks to a Pension Fund? 10

How can a Pension Fund Measure and Hedge Risk? 11

What if? Stress Testing 13

How do you Combine Contributions, Investment Return and Funding

Date to fund a Pension Fund?15

How can a Pension Fund Manage and Monitor its Risks in a single

Framework?16

How does this Framework work in practice to determine Dynamic

Risk Management Actions?17

Any Questions 18

2

Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014 3


What is a Defined Benefit Pension Fund?

4

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49

Cas

h F

low

£

Years

Fixed Cash Flows Real Cash Flows


How do we Measure the Health of a Pension Fund?

5


What are the Different Stages of a Defined Benefit Pension Fund?

6

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400GBP Millions

Liabilities (Gilts Flat) Liabilities (TP Basis) Assets

Expected Return: Gilts +2.25%

Risk: 11.2%

Hedge Ratio: 35%


Risk: 6.5%

Hedge Ratio = Funding Ratio


Risk: 2.2%

Hedge Ratio = 100%

1. Managing the

Deficit

2. Preparing for

the End Game

3. Running Off the

Pension Fund


What are the Key Risks to a Pension Fund?

7

Liabilities

CovenantAssets

Equity

Credit

Manager Skill

Contributions (£):

Willingness to Pay

Ability to Pay

Longevity

Interest Rate

Inflation

Modelling


What are the Main Challenges to the Pension Industry?


How do we Measure the Risks to a Pension Fund?

Using Value at Risk

10

Funding Ratio at Risk


How can a Pension Fund Measure and Hedge Risk?

Using Sensitivity Analysis

11

Interest Rate Sensitivity (PV01)


How can a Pension Fund Measure and Hedge Risk?

Using Sensitivity Analysis

12

Inflation Sensitivity (IE01)


What if? Stress Testing

13

Impact on Deficit of Stress Test by Assets and Liabilities


How do you combine Contributions, Investment Return and Funding Date to

fund a Pension Fund?

15


How can a Pension Fund Manage and Monitor its Risks in a single Framework?

16

Objective Measurement Performance Indicators Performance RAG

Primary Funding

Objective

To reach 100% funded on a swaps flat

basis by 2026

Expected Returns (ER) > Required Returns

(RR)

RR: Libor + 300bps

ER: Libor + 200bps

Difference: -100bps

Investment StrategyActual Returns should exceed Expected

Returns Actual Returns (AR) > Expected Returns (ER)

AR: Libor + 210bps

ER: Libor + 200bps

Difference: +10bps

Risk Budget

The investment strategy should not risk

the deficit worsening by £600mm over

a 1 year period

VaR95 < £600mm VaR95: £700mm

Hedging Strategy

Nominal and inflation hedge ratio

should be maintained within +/- 5% of

the funding ratio

Funding Ratio (swaps flat) 70% n/a

Nominal Hedge Ratio (swaps flat) 50%

Inflation Hedge Ratio (swaps flat) 85%

Collateral

Sufficient liquidity to make pension

payments and to cover margin calls

that may arise from derivative

positions.

Total available eligible collateral £900mm

Remaining collateral after VaR95 event £600mm

RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away


How does this Framework work in practice to determine Dynamic Risk

Management Actions?


Any Questions?

18


13-15 Mallow Street London EC1Y 8RD

Telephone : +44 (0) 20 7250 3331

www.redington.co.ukPlease get in touch

19

Disclaimer

For professional investors only. Not suitable for privatecustomers.

The information herein was obtained from various sources.We do not guarantee every aspect of its accuracy. Theinformation is for your private information and is fordiscussion purposes only. A variety of market factors andassumptions may affect this analysis, and this analysis doesnot reflect all possible loss scenarios. There is no certaintythat the parameters and assumptions used in this analysiscan be duplicated with actual trades. Any historical exchangerates, interest rates or other reference rates or prices whichappear above are not necessarily indicative of futureexchange rates, interest rates, or other reference rates or

prices. Neither the information, recommendations oropinions expressed herein constitutes an offer to buy or sellany securities, futures, options, or investment products onyour behalf. Unless otherwise stated, any pricing informationin this message is indicative only, is subject to change and isnot an offer to transact. Where relevant, the price quoted isexclusive of tax and delivery costs. Any reference to theterms of executed transactions should be treated aspreliminary and subject to further due diligence .

Please note, the accurate calculation of the liability profileused as the basis for implementing any capital marketstransactions is the sole responsibility of the Trustees'actuarial advisors. Redington Ltd will estimate the liabilities if

required but will not be held responsible for any loss ordamage howsoever sustained as a result of inaccuracies inthat estimation. Additionally, the client recognizes thatRedington Ltd does not owe any party a duty of care in thisrespect.

Redington Ltd are investment consultants regulated by theFinancial Services Authority. We do not advise on allimplications of the transactions described herein. Thisinformation is for discussion purposes and prior toundertaking any trade, you should also discuss with yourprofessional tax, accounting and / or other relevant advisershow such particular trade(s) affect you. All analysis (whetherin respect of tax, accounting, law or of any other nature),

should be treated as illustrative only and not relied upon asaccurate.

©Redington Limited 2013. All rights reserved. Noreproduction, copy, transmission or translation in whole orin part of this presentation may be made withoutpermission. Application for permission should be made toRedington Limited at the address below.

Redington Limited (6660006) is registered in England andWales. Registered office: Austin Friars House, 2 – 6 AustinFriars, London, EC2N 2HD

2 - 6 Austin Friars, EC2N 2HD

Robert GardnerFounder & Co-CEODirect Line: +44 0 207 250 [email protected]@robertjgardnerhttp://uk.linkedin.com/in/robertjgardner

understanding modelling and defined benefit pension risk

Economy & Finance