Balancing Risk, Return and Contributions Redington teach-in - 6 may 2014

Teach-in Balancing Risk, Return and Contributions 6 May 2014

Balancing Risk, Return and Contributions

1

Balancing Risk, Return and Contributions

© Sacker & Partners LLP 2014 www.sackers.com

Ian Cormican

Sacker & Partners LLP

6 May 2014

Draft Code – Funding Defined Benefits

Principal

Driver for

consultation

…to minimise

any adverse

impact on the

sustainable

growth of an

employer

New statutory

objective –

Pensions Bill

© Sacker & Partners LLP 2014 3

www.sackers.com

© Sacker & Partners LLP 2014

Consultation Document

Defined Benefit Regulatory

Strategy

Defined Benefit Funding Policy

Draft Code of Practice

Consultation closed on 7 February

4

www.sackers.com

Text

DB

Funding


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Principles

based

Scheme -

specific

Flexible

Moving away

from fixed

triggers


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Is it same old,

same old?

No. Possibly a

profound sea-change

Balanced

Funding

Outcome

(BFO)

Risk - bar New

approach to

covenant -

Segmentation

Focus on

investment


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Risk Management is at heart of it

Financial Management Plan? Contingency

planning

Covenant

risk

Funding

risk

Investment

risk Governance

Covenant

Regulator’s key factors

Outlook / plans for

sustainable growth

Sector outlook

/ position of

employerr

Profitability / trends

Generation cash

/ application

Debt level /

servicing

Balance sheet vs

deficit

Reinvestment

Balance sheet

strength

Dividend

policy


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Covenant Gradings

Gradings

1.Strong

Very strong trading,

cash generation and

asset position relative

to size of scheme / deficit.

Low risk.

4. Weak

Concerns over potential

insolvency or where scheme

is so large that without

fundamental change to the

strength of the employer it is

unlikely ever to be able to

adequately support the

scheme

2. Tending to strong

Good trading, cash

generation and asset

position relative to size

of scheme / deficit.

Medium risk.

3. Tending to weak

Concerns over employer

strength relative to the size /

deficit and/or signs of significant

decline, weak profitability or

balance sheet concerns /

vulnerable for economic cycle.

No immediate insolvency

but longer terms concerns.


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Key

change

How realistic is that?

Trustees are now expected

to understand and assess

employer’s business plans

Not just backward

looking / performance

but prospects

as well


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Balanced Funding Outcome?

Expresses a level

of contributions

they think should

be payable by a

company within

that segment

Reviewed

annually But say it is

not a

minimum

level of

funding

11

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Notional value of

assets such that no

further deficit

reduction

contributions

required

Compare with actual

contributions to see

if it meets

expectations

BFO – How do

they go about

assessing it?

Calculated on an

“objective liability”

basis (not scheme

specific)

Compare to actual

assets / determine

the notional annual

rate to repair deficit


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RISK BAR - INDICATORS

How much scheme falls short of BFO Reliance on

investment

outperformance

in Recovery Plan

Quality of

Governance

Weakening of

covenant eg

dividends PPF

deficit

Avoidance

issues

Reductions in

deficit

contributions

Issues raised

by tPR in

previous

valuations /

previous

interaction

Back-end

loadings

Mortality

Investment

strategy

risk


Risk

Bar for

Intervention

Shortfall compared to the BFO

indicator

Size of the scheme’s liabilities

Impact of the interventions / value

tPR can add

Overall tPR resources

14

www.sackers.com


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Spring 2014

Annual

Funding

Statement

Completing

valuations

now – bear

in mind

Pro-active

investigations

with 25 schemes

applying

these

principles

Transitional

BFO Indicator for September

2013 – 2014 valuations Risk Bar for September

2012 - 2013 valuations


Balancing Risk, Return and Contributions John Towner, Redington

16


600

650

700

750

800

850

900

950

1,000

in £

Millio

ns

Liabilities Assets

Stable Funding?

17

What is your funding objective?

Full funding and Scheme can transition

into terminal portfolio Self Sufficiency?

Gilts/Swaps?

Buy-out?

…….. And how long will it take to get there?

Technical Provisions?


600

650

700

750

800

850

900

950

1,000

in £

Millio

ns

Liabilities Assets

18

What levers can you pull to reach your goal?

One Lever is Time

Time 2029

Contributions £10.0m p.a.

Required Rate of Return Gilts + 1.20%

Time 2024



10-Year Recovery Plan

600

650

700

750

800

850

900

950

1,000

in £

Millio

ns

Liabilities Assets

15-Year Recovery Plan


600

650

700

750

800

850

900

950

1,000

in £

Millio

ns

Liabilities Assets

600

650

700

750

800

850

900

950

1,000

in £

Millio

ns

Liabilities Assets

19


Another Level is Contributions from the Sponsor

Time 2024



Base Model

Time 2024



Higher Contributions


600

650

700

750

800

850

900

950

1,000

in £

Millio

ns

Liabilities Assets

20


The Final Lever is Investment Return

Time 2024



Base Model

600

650

700

750

800

850

900

950

1,000

in £

Millio

ns

Liabilities Assets

Time 2024



Higher Investment Returns

Teach-in Balancing Risk, Return and Contributions 6 May 2014 21

How much should you pull each lever?

An Integrated Framework to Assess Impact on

Total Covenant Load

Scenario A: Highly dependent on asset returns

Scenario B: Increased sponsor costs

Scenario C: Win-win impact of de-risking

Contributions

Investment Risk /

Returns

Current

Funding and

Target Date

The Trade-Offs of Different Policy Levers

A B C


How do you agree on the right journey plan?

Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

Liability valuation

Full funding Date

Contributions

Hedge Ratio

Required rate of return 2.40% 2.04% 2.04% 1.50% 1.07%

Return Seeking assets 81% 66% 66% 45% 28%

UK Credit 6% 10% 10% 16% 21%

Liability Matching 14% 24% 24% 39% 52%

Cash 0% 0% 0% 0% 0%

Total VaR 29.54% 24.51% 19.51% 26.89% 16.90%

1 Yr Assets Cash Generation £45 £39 £39 £30 £22

1 Year Cash Contributions £12 £20 £20 £20 £28

1 YR Contributions at Risk £83 £49 £41 £43 £27

£140.3 £108.3 £99.5 £92.8 £77.1Total Potential Cash Requirement

0

20

40

60

80

100

120

140

160

180

1 2 3 4 5

CO

VE

NA

NT L

OA

D,

£ m

illio

ns

1 YR Contributions at Risk 1 YR Cash Contributions 1 YR Assets Cash Generation

22

An interactive tool for Trustee and Sponsor collaboration:

Adjust

variable to

find

optimal

solution


Case study – how does it all work in practice?

23

Case Study

Situation The Trustee board of a multi-billion pound UK defined benefit pension scheme wanted

to increase the level of interest rate and inflation hedging within its scheme.

Problem

Every time the Trustees discussed their plans with the corporate sponsor, all the

sponsor heard was "unaffordable, low rates, expensive, locking in deficit" and pushed

back.

Implication A dysfunctional stalemate in which nothing got done and governance budget was

spent with no result.

Need

An integrated investment and funding framework with a resulting dynamic de-risking

plan that provides the clarity needed to discuss and agree de-risking, as well as

weighs Trustee risk management objectives against sponsor affordability concerns.


Integrated funding and investment in action

24

Sponsor Advisor

Trustee Sponsor

Clear consensus on long-term funding

objective

Collaboration

Trustee Sponsor

Sponsor Advisor Trustee Advisor

Working in Isolation

Trustee Advisor

Stakeholder Preferred Approach Consequence

Trustees Lower Risk Higher costs

Sponsor Lower Contributions

Higher returns

required leading to

higher risk and

potentially higher

contributions


Austin Friars House, 2-6 Austin Friars,

London EC2N 2HD

Telephone : +44 (0) 20 7250 3331

www.redington.co.uk

Contacts & Disclaimer

John Towner Director│Investment Consulting

Tel: 0203 326 7143

Email: [email protected]

25

Disclaimer

For professional investors only. Not suitable for private customers.

The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or

prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence .

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Redington Ltd are investment consultants regulated by the Financial Conduct Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature),

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Economy & Finance

Balancing Risk, Return and Contributions Redington teach-in - 6 may 2014