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abcd. The 2nd Younger Members Convention. Use of Swaps in Matching Pension Fund Liabilities Huw Williams 1-2 December 2003 The Glasgow Moat House. Pension scheme asset allocation – a trend towards greater bond investment Recent bond market performance – the impact on credit spreads

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The 2nd younger members convention

abcd

The 2nd Younger Members Convention

Use of Swaps in Matching Pension Fund Liabilities

Huw Williams

1-2 December 2003

The Glasgow Moat House


Using swaps to match pension scheme liabilities agenda

Pension scheme asset allocation – a trend towards greater bond investment

Recent bond market performance – the impact on credit spreads

Structure and capacity of the bond markets

Sterling

Euro

How will pension scheme demand be met going forward?

Introduction to swaps

Applications for pension funds

Enhancing investment returns

Using swaps to meet liabilities

Examples in practice

Risks and other features of the swap market

Summary

Using Swaps to Match Pension Scheme Liabilities Agenda


Pension scheme asset allocation strategic issues facing pension funds

Reduced scope for risk taking bond investment

Funding levels have reduced

Sponsoring companies downsizing

Increased attention from Government, analysts, rating agencies

Increasing focus on “insurance company buy-out solvency”

Changes in the accounting environment – FRS17, IAS19

Government Action Plan – 11th June 2003

Reduction possible to LPI for future service benefits

On voluntary wind up full accrued benefits (on insurance company buy out) to be met

Insurance scheme to apply where companies are insolvent. Premiums to be based partly (or fully?) on risk – funding level to determine “riskiness”.

Trustees to be given the right to wind up a scheme where they judge this to be in members’ interests.

Pension Scheme Asset Allocation Strategic issues facing pension funds


Pension scheme asset allocation pensions protection fund

Likely mechanics on formal insolvency of sponsoring employer:

Buy-out from an insurer for PPF level of benefits or better

OR if not possible

Receive scheme assets and accept liability for PPF level of benefits

Buy-out basis - How much you would have to pay an insurer to take on liabilities?

Implied yield: gilts – 0.5% (reinforced by emerging actuarial guidance)

Risk-based premium expected - main risk factors are:

Current deficit

Asset allocation relative to liabilities

Probability of default of company

But expect a proxy – simplicity and political compromise

US PBGC premium = 0.9% of deficit + $19 per member

Pension Scheme Asset Allocation Pensions Protection Fund


Pension scheme asset allocation trend towards a higher bond allocation
Pension Scheme Asset Allocation employer:Trend towards a higher bond allocation


Pension scheme asset allocation trend towards a higher bond allocation1
Pension Scheme Asset Allocation employer:Trend towards a higher bond allocation


Factors influencing asset allocation an improvement in funding levels may have an impact
Factors Influencing Asset Allocation employer:An improvement in funding levels may have an impact?




Euro versus sterling market sterling offers longer maturities

The Sterling market is a long dated market, offering better long matching opportunities for UK pension funds

The maturity of new issues in the sterling market are consistently longer dated the the euro market

Euro versus Sterling MarketSterling offers longer maturities


Euro versus sterling market sterling offers greater access to credit risk

The euro market (£945bn. equiv.) is significantly larger than the sterling market (£258bn.); hence euro market is more liquid

The average credit rating of the sterling market is lower than the euro market; hence sterling offers higher spreads

Euro versus Sterling MarketSterling offers greater access to credit risk


Sterling index linked versus fixed market index linked a small utility sector dominated market
Sterling Index Linked versus Fixed market than the sterling market (£258bn.); hence euro market is more liquidIndex linked: a small, utility sector dominated market


How will demand be met going forward

From increased corporate bond issuance than the sterling market (£258bn.); hence euro market is more liquid

Government issuance also rising

Greater use of the Euro and Dollar markets

But inflation-linked assets likely to remain a problem

Greater use of the swaps markets is likely to help alleviate capacity constraints both in fixed income and inflation linked

How Will Demand Be Met Going Forward?


The sterling debt market bn
The Sterling Debt Market (£bn) than the sterling market (£258bn.); hence euro market is more liquid

  • Overall sterling debt supply has increased from £81bn in 2001 to £128bn in 2003, but will stabilise in 2004.


Interest rate swaps market growth
Interest Rate Swaps than the sterling market (£258bn.); hence euro market is more liquidMarket Growth


Interest rate swaps comparison with uk domestic debt
Interest Rate Swaps than the sterling market (£258bn.); hence euro market is more liquidComparison with UK domestic debt


Interest rate swaps tenors
Interest Rate Swaps than the sterling market (£258bn.); hence euro market is more liquidTenors

  • Quotes available out to 50 years

  • Reasonable liquidity out to 40 years

Source: Reuters


Introduction to swaps

What is a swap? than the sterling market (£258bn.); hence euro market is more liquid

Simply an agreement to exchange two sets of cash flows

Usually these are equal in value but different in nature

For example a “fixed for floating” swap

Consider a deposit of £10m paying a floating rate of interest

The floating cash flows can be exchanged for a specified fixed rate of cash flows applicable for a given period

This fixed rate is known as the “swap rate” for a given maturity

Introduction to swaps


Interest rate swap example
Interest Rate Swap Example than the sterling market (£258bn.); hence euro market is more liquid

6 month Libor earned on 5 year cash deposit of £10m

Fixed swap rate of 3.9% per annum on £10m, paid semi-annually for 5 years

Bank

Fund

6 month Libor from cash deposit for 5 years


Applications for pension schemes

Receiving a fixed return is a substitute for a corporate bond return

Achieved by placing funds on deposit and receiving floating cash flows, which are then swapped for fixed cash flows

And the end of the period the Scheme receives a return of principal (by taking the cash off deposit)

Returns are in line with a AA rated bond yield – swaps are effectively a measure of generic bank credit

Flexible instruments as the cash flow proceeds can be tailored to meet the specific circumstances of the fund

Applications for Pension Schemes


Different types of swap contract

Cash flows can be structured to meet an investor’s particular needs

For example the swap flows can be tailored to meet specific liability cash flows

An example is where a pension scheme has inflation-linked liabilities, but owns a portfolio of fixed rate bonds

Solution is to enter into an inflation swap:

Pension scheme pays fixed flows (as generated by the corporate bond portfolio)

Scheme receives inflation linked cash flows tailored to meet the projected liabilities of the scheme

Different Types of Swap Contract


Example of an inflation swap

Buy a diverse portfolio of bonds. This could be sterling fixed income or broader still, e.g. Euros or dollars

Swap the fixed cash flows generated from the bond portfolio for either RPI or LPI linked returns

Example of an Inflation Swap

RPI-linked cashflows to match pension payments

RPI-linked pension payments

Bank

Fund

Cashflows generated by bond portfolio.

Can be fixed/floating & in any currency


Example liability cash flow graphs
Example Liability Cash flow Graphs fixed income or broader still, e.g. Euros or dollars


Projected pension payments example liability profile pensioners
Projected Pension Payments fixed income or broader still, e.g. Euros or dollars Example Liability Profile (Pensioners)


Pension payments versus index linked cash flows
Pension Payments Versus Index-Linked Cash Flows fixed income or broader still, e.g. Euros or dollars


Resulting cash flow match after substituting the index linked gilts for the swap
Resulting Cash Flow Match fixed income or broader still, e.g. Euros or dollars After substituting the index linked gilts for the swap


Potential for enhanced returns

Use of swaps effectively separates the asset and liability management from the investment of the assets

The swap payments to the Scheme can be tailored to meet the liability cash flows which need to be paid

Assets can then be invested independently – Trustees would be free to chose the most appropriate investment strategy without constraint

Hence potential for higher expected returns through:

Investment in asset classes with higher expected returns (e.g. corporate bonds versus index-linked gilts)

Improved potential for investment manager out-performance

Potential for Enhanced Returns


Corporate bonds benefits risks table
Corporate Bonds: Benefits & Risks Table management from the investment of the assets

* Costs include swap transaction costs and purchase of corporate bonds


The 2nd younger members convention

Example Broad Investment Grade Portfolio management from the investment of the assets

Number of bonds

57

Portfolio Value

£900m

Credit Spread (duration w'td)

101

Average Mod. Dur

10.4

Average Default Probability

0.199%

Diversity Score

43

[1] Based on long-run average historic default loss rates from Moody’s and S&P annual reports published in February 2003.

[2] The diversity score is an idea used by Moody’s for rating portfolios. A lower number means less diversity so it is a useful statistic for comparing portfolios. A portfolio may contain many different bonds but these might be issued by the same company, companies with common parents or companies in closely related industry sectors. The diversity score reduces the number of bonds to a number of bonds that are independent (except for common reliance on the global macro-economic environment).


Summary of benefits of swaps

Risk reduction through the ability to tailor asset proceeds to meet liabilities

Only realistic way of obtaining LPI assets

Only realistic way to achieve a cash flow match to expected benefit payments

Separates asset and liability management allowing potential for more efficient management of asset portfolio

Potential for higher expected returns

Summary of Benefits of Swaps


Counter party risk

Swap contracts introduce counterparty risk to the pension scheme

This is the risk that the bank counterparty defaults while owing money to the pension scheme under the contract

Counterparty risk can be mitigated by collateralisation – I.e calculating the mark to market exposure and passing collateral between parties to hold in the event of default.

Reduces the counterparty risk effectively to nil

This process is similar to margin calls on exchanged traded futures and options – collateralisation can be done daily if required

Counter-Party Risk


Summary

Pension Scheme switches have put the corporate bond market under pressure recently

Continued issuance and return to government issuance will help alleviate capacity somewhat

Capacity constraints are most acute in inflation-linked assets

The Swaps market is far bigger than the corporate bond market and offers significant benefits for pension schemes

A particular area of benefit is in matching inflation-linked liabilities, particularly LPI

Summary