Download Canadian Institute of Actuaries L`Institut canadien des actuaires

Canadian
Institute
of
Actuaries
L’Institut
canadien
des
actuaires
2009 Annual Meeting ● Assemblée annuelle 2009
Halifax, Nova Scotia ● Halifax (Nouvelle-Écosse)
Liability Interest Rate Risk
Value of the Funding Objective is Very Volatile!
Annualized 3-Year Returns
Market Value of Liabilities
Returns
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
1
Dec-08
Dec-60
Dec-62
Dec-64
Dec-66
Dec-68
Dec-70
Dec-72
Dec-74
Dec-76
Dec-78
Dec-80
Dec-82
Dec-84
Dec-86
Dec-88
Dec-90
Dec-92
Dec-94
Dec-96
Dec-98
Dec-00
Dec-02
Dec-04
Dec-06
MV of Liabilities
Defining the Investment Objective
Risk Budgeting Framework
Risk Budget
Risk Capital
Return on
Risk Budget
Liability
Interest Rate
Risk
PV Maximum
Contribution
Increases
Plus
PV Maximum
Benefit
Reductions
PV Expected
Risk
Premiums
>
=
Other
Investment
Risks
2
Liability Interest Rate Risk
A Risk Worth Accepting?
•
•
•
Policy (Strategic) Decisions
–
Committee level decision
–
Secular direction of interest rates
–
Changed infrequently (long-term horizon)
Active Interest Rate Strategies
–
Manager level decisions
–
Tactical in nature (shorter-term horizon)
Considerations
–
Ability to forecast direction of interest rates
–
Expends risk budget (bets are often huge)
–
Evaluate relative to other available strategies
3
Asset / Liability Hedge Ratio
Options to Increase Asset / Liability Hedge Ratio
•
Increase fixed income allocation
– reduces expected return on assets
– limited impact given funded status
•
Duration extension
– introduces yield curve risk
– plan already has a long duration
•
Overlay program
– Use of swaps and forwards
4
Fixed Income Overlay Programs
Primary Implementation Instruments
•
•
•
•
Interest Rate Swaps
Total Return Swaps
Bond forwards
Government of Canada bond futures
Use of leverage is key to overlay strategies
– While mechanics vary by instrument, full market exposure can be
obtained without requiring the full amount of capital
– “Freed-up” capital can be redeployed in other areas while
maintaining desired asset/liability hedging ratio
• (e.g. equities, alternative asset classes, etc.)
5
Determining Appropriate Mix of Instruments
Relative Factors to Consider
•
Market exposures
– duration and term structure contributions
– sector/credit exposures
– credit risk look-through – notional versus net
•
Market/liquidity conditions
– supply/demand valuation impact
– financing/counterparty spread cost impact
•
Operational Risks
– potential m-t-m cash flow differences
– relative flexibility
Thorough assessment of various factors will determine suitable mix
6
Fixed Income Overlay Program
Aligning the Investment Problem to Today’s Reality
•
Today’s investment reality
– Short-term mark-to-market measures (e.g. solvency and accounting)
turn the investment problem from a long-term to a short-term problem
•
The revised investment problem
– Overlay offsets the market value volatility in liabilities
• Largely eliminates potentially huge capital gains and losses
– Overlay costs short-term interest rate on notional value
– Non-fixed income assets now need to beat cash
•
Economic characteristics of a cash benchmark
– Very little / no market value volatility
– Increased volatility in annual financing cost
• Trade-off for eliminating amortization costs of large capital gains and losses
7
Beyond Immunization
Two LDI Examples
•
•
Duration extension using fixed income overlay
–
Used to increase Asset/Liability hedge ratio
–
Existing structure (e.g. equity allocation) maintained
Portable alpha
–
Liability “beta” is hedged
–
Alpha sources added to meet return target
8
Duration Extension
Traditional Portfolio
Assets
10.0
Expected Rate of Return
(%)
8.0
Liabilities
60 / 40
Equity / Bond
Equity
Portfolio
6.0
4.0
2.0
0.0
Equity
Portfolio
Bond
Portfolio
+
Interest
Rate
Swap
Interest
Rate
Swap
Sell
Bonds
Bond
Portfolio
-2.0
-4.0
-6.0
Note: Financing and other costs are ignored
9
Liabilities
Portable Alpha
Definition
Example
Alpha Source
(e.g. Hedge Fund)
Portable alpha is the process
of separating market returns
from skill-based returns and
then pairing alpha generated
in one asset class with the
beta from another asset class
+
Beta Source
(e.g. Bond
portfolio)
10
An Inconvenient Truth
Alpha Does Not Grow on Trees!
•
Portable alpha does not create alpha – you still have to identify
a manager that can consistently add value over time through
their investment skill
•
Required attributes of the alpha source:
–
Stable
–
Uncorrelated with market
–
Uncorrelated with other alpha sources
–
Sufficiently large to exceed fees and other transaction costs
11
Portable Alpha Strategy for LDI Portfolio
Example
Assets
10.0
Liabilities
Expected Rate of Return
(%)
8.0
Hedge
Fund
Return
6.0
4.0
2.0
0.0
Bond
Portfolio
+
Interest
Rate
Swap
Sell
Bonds
-2.0
-4.0
-6.0
Note: Financing and other costs are ignored
12
+
Hedge
Fund
Return
Interest
Rate
Swap
Bond
Portfolio
Liabilities
LDI Examples
Key Takeaways
•
Available tools allow A/L hedge ratio to be set at any desired level
•
LDI framework does not require reducing expected return
•
Approach helps optimize investment efficiency relative to liabilities
–
–
–
•
Explicitly identify risk/return profile of key components of investment strategy
Take risk where rewarded
Minimize unintended or undesired bets
Caveats:
–
LDI does not manage underwriting risk:
•
–
e.g. longevity
While solvency and accounting help bring transparency to the economic risk of
the pension plan, investment strategies can be directed toward but cannot fully
hedge these liability measures
13
Implementation Considerations
Fees and Other Expenses - Portable Alpha Example
•
Structure
–
•
•
•
Overlaying a hedge fund manager on a long bond portfolio
Assumptions
–
–
–
–
Hedge Fund generates gross return of 10.0%
Hedge fund fees: 2% + 20% above T-Bills
T-Bills yield 4.0%
Transaction costs of 0.5%
–
–
–
–
2.0% investment management fee (flat portion)
0.8% performance fee [20% of (8% - 4%)]
4.0% financing cost
0.5% transaction costs
Costs
After-fee alpha of 2.7%
14
Implementation Considerations
Other
 Leverage
 Counterparty risk
 Beta replication comes with tracking error
 Margin maintenance
 Exposure maintenance and rebalancing
 Restrictive SIPPs
 ISDA agreements and futures trading
accounts
 Trustee knowledge and comfort level
15
Options for Smaller Plans
Pooled Fund Approach
•
Liability is limited to the amount invested in the pooled fund
•
Modest oversight requirements and fewer demands on internal
resources
•
Lower minimum asset size
•
ISDA agreements and futures trading accounts are not required
(these are done within the pool)
•
However:
–
Customization is reduced
16
Final Comments
•
LDI is about managing risk relative to liabilities
–
–
Absolute level of risk relative to liabilities
Managing where risks are taken
•
Interest rate risk generally not considered a high quality source
of alpha
•
Overlay programs
–
–
•
Brings investment problem back to beating cash
Positions the plan for introducing alternative sources of return
Implementing LDI correctly requires increased co-ordination
between actuaries, investment consultants and investment
managers
17