Post on 22-Nov-2014
description
LDI for Public Funds?
Drew Carrington, CFASenior US Fixed Income Portfolio Manager
December 4, 2006
US-INot intended for public distribution. For important additional information, please see the Additional Disclosures at the end of the presentation.
2
What I’m NOT going to do
Argue in favor of Defined Contribution over Defined Benefit plans
Argue in favor of freezing or closing existing DB plans
Sensationalize the risks associated with underfunded public DB plans
Tell you to invest your entire plan in long duration bonds
3
What I am going to cover
What is LDI?
Why is Corporate America focused on this?
Does LDI apply to public funds?
If not, can public funds apply lessons learned from LDI?
4
What is LDI?
Liability Driven Investing (LDI), simply put, means designing asset allocation with liabilities in mind
LDI is also commonly referred to as Asset Liability Management (ALM) and has applications in not only pension investing but also in banking, insurance, lottery, trust funds – any obligation whose cash flows can be forecasted
Phenomenon not just limited to US; has global roots
LDI benchmarks must incorporate liability characteristics including cash flow profile, duration, embedded credit spreads, etc.
Extreme proponents of LDI prescribe investing in a portfolio that precisely matches liability cash flows
5
Measuring risk and return vs. the liability
Source: UBS Global Asset ManagementFor illustrative purposes only.
Funding ratio risk/return characteristics
Source: UBS Global Asset ManagementFor illustrative purposes only.
-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
Fund
ing
ratio
retu
rn
Long Gov’t/Credit
Equities
Traditional 65/35 policy
Asset-o
nly fron
tier
Aggregate Bonds
Cash
Funding ratio frontier
Liability matching strategy
US-I
6
The case for liability-driven investing
Funding levels reduced during the “perfect storm” of 2000-2002
Drop in equity markets lowered plan asset levels
Falling interest rates increased plan liabilities Large drop in funding ratios
Pension reform increases attention to funding ratio volatility
Increased short-term volatility Greater incentive for sponsors to
reduce pension funding volatility
Increased focus on funding ratio Growing interest in the relationship
between liability structure and market value of plan assets
US-I
Why is Corporate America so focused on this?
7
The 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
Funding ratio returns
Asset-liability mismatch risk causes funding ratio volatility
US-I
8
Anticipating effects of pension reformPension reform may unsmooth the impact of A-L mismatch risk
Funding reform Accounting reform
August 17, 2006 Phase 1: End of 2006 Phase 2: 2008-2009
Reduce smoothing of assets and liabilities
Severe penalties for falling below funding ratio thresholds (80% and 60%)
PBGC premiums required for all underfunded plans
Mark-to-market balance sheet
Immediate recognition of gains/losses
US-I
9
Why doesn’t LDI apply to public funds?
Driver
PPA 2006
FASB accounting changes
PBGC (Pension Benefit Guaranty Corp.)
Voluntary plan terminations / purchase of annuities
Equity analyst focus
Expanded derivative availability allows for liability hedging
Mismatch
Public funds not governed by ERISA, DOL, IRS funding rules
Public fund accounting governed by GASB
No federal pension insurance
Pension benefits irrevocable; no reasonable termination option
No stock to evaluate
Not required to mark liabilities to market
10
Yes, but…
Driver
PPA 2006
FASB accounting changes
PBGC (Pension Benefit Guaranty Corp.)
Voluntary plan terminations / purchase of annuities
Equity analyst focus
Expanded derivative availability allows for liability hedging
Relevance
Congress holding hearings on public plan funding
GASB reviewing potential changes to pension accounting
Concern by tax payers regarding “funder of last resort” for DB plans
COLA’s add liability complexity
Rating agencies incorporating pension funding in debt rating analysis
Economics vs. accounting; hedging unacceptable investment outcomes
11
Can public plans learn anything from LDI?
Focus first on the liability
Equities are not the only way to increase return
Learn to love derivatives
Key take-aways
12
Constructing a plan-specific liability based benchmark1. Develop the “typical” liability cash flow
profile
Typical active member liability profile
0 10 20 30 40 50 60 70Year
Expe
cted c
ash fl
ow
Typical retired member liability profile
0 10 20 30 40 50 60 70Year
Expe
cted c
ash fl
ow
Typical aggregate liability profile
0 10 20 30 40 50 60 70Year
Expe
cted c
ash fl
ow
+
=
2. Select the discount curve to calculate the present value of the cash flow profile
Typical aggregate liability profile
0 10 20 30 40 50 60 70Year
Expe
cted
cash
flow
Source: Lehman, Hewitt Associates
US-I
13
Selecting the risk budget
Key question: How much investment return is required to meet the liability?
— a function of funding ratio, liability growth, and expected contributions
Higher the funding ratio, the lower the required return
Minimize funding ratio risk for the given required return
Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation
Alternative investment policies
Funding ratio risk budget
Fund
ing
ratio
retu
rnRequired return A
B
C
US-I
14
Investing implications of COLA’s
Many public plans contain cost of living provisions which are directly linked to published inflation indices
Nominal bonds are an exceptionally poor hedge for inflation
Using TIPs (Treasury Inflation Protected Securities) to hedge inflation risk embedded in COLA’s is LDI in its purest form
Consider adding TIPs as a stand-alone asset class in your plan to hedge COLA risk
15
Equities aren’t the only way to generate returns
Traditional view: linear relationship between equity allocation and increasing return
Modern investment tools allow for separation of alpha and beta
Proliferation of alternative asset classes
Endowments & Foundations manage state-of-the-art portfolios
Source: UBS Global Asset ManagementFor illustrative purposes only.
US-I
-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
Fund
ing
ratio
retu
rn
Equities
16US-I
Return generation: Absolute return strategies
Focus on improving risk/return trade off by— less reliance on equity market return— better balance between alpha and
beta
Driver of absolute return based strategies is to improve consistency
Typically this means— less equity market risk— more diversified sources of return— more active management of risks and
returns
UBS Global Asset Management Capabilities— Dynamic Alpha Strategy (DAS)— Absolute Return Bond (ARB)
Desired distribution
Probability
Real return (% p.a.)
0%
Absolute return strategies seek to improve on risk/return tradeoff
For illustrative purposes only.
17
Derivatives: Learn to love them
Many alternative asset categories make extensive use of derivative strategies
Derivative markets are better regulated, more liquid and more complete than ever before
Widespread use has increased general public comfort with derivatives
Derivatives not inherently dangerous: can be used to reduce risk
Direct use of derivatives allow investors to custom design range of portfolio risk/return outcomes
18
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
AssetsLiabilities
DeficitValu
e
AssetsLiabilities
SurplusValu
e
Currently, interest rate changes cause funding ratio changes
For illustrative purposes only.
US-I
19US-I
Impact 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
Swap
Valu
e
AssetsLiabilities
SwapValu
e 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
For illustrative purposes only.
20
Managing derivative transaction risks
US-I
Liquidity risk Counterparty risk
“Headline” risk Collateral risk
Low degree of control
High degree
of control
21
Summary
LDI is here to stay
Direct application of Corporate LDI approaches may not fit for public plans but …… relevance of LDI to public plans is increasing
Three key take-aways— consider TIPS for fixed income allocation— look beyond equities for return generation— learn to love derivatives
Appendix
23US-I
Benefiting from a heritage of innovation
UBS predecessor First Chicagomanages assets
Equity
Real Estate
Dynamic Alpha Strategy
Asset Liability Investments Solutions Private REITGlobal & regional 130/30 strategiesUnconstrained global tactical asset allocation strategies: currency/marketJapan opportunitiesAgriVest Farmland
Core Plus Property
US Equity 130/30
Long/Short equity opportunities
Mid Cap Growth
1970s:Total return
1990s:Specialization
2000s & beyond: Alpha & beta integration
Growth Investors prede-cessor joins UBS
Third-party Manager Program
Short Duration
Emerging Markets Equity and Debt
Single- andMulti-Manager Hedge Funds
SBC merges with UBSDSI joins; enhanced indexing
1991 1995 1998
Swiss Bank Corporation (SBC) acquires O’Connor
SBC acquires Brinson Partners
Hedge Fund ManagerO'Connor launched
1992Systematic AlphaAbsolute Return Bond
1974 1978
1980s:Globalization & asset allocation
Global Multi-Asset Portfolio –
Integrated SolutionsAsset class specialists Global and Core EquityRegional portfolios
19812003 2004 2005 2006 Forward2000
Integrated alternative solutionsPension risk managementRetirement income solutions
24
Liability Hedging: One UBS Global Asset Management solution
Long duration commingled vehicles
Interest rate derivative overlay
(single manager)
Interest rate risk coordinator(multi-managers)
Passively managed to a duration target Actively managed versus duration
target
Manages duration position of overall plan across several managers
Can be passive or active
Active Member with 18 year duration1
Retired Member with 8 year duration1
1 As of October 2006
US-I
25
Our solution fills in gaps: Customized indicesModular, allowing blended construction of a customized liability index
iBoxx US Pension Liability Index – Retired Member, which will mimic the performance of a retired member liability profile for a model traditional defined benefit plan in the US, taking into consideration a plan’s estimated future liability cash flows for retired members, the passage of time and changes in the term structure of interest rates.
iBoxx US Pension Liability Index – Active Member, which mimics the performance of an active (i.e., non-retired) member liability profile for a model traditional defined benefit plan in the US taking into consideration a plan’s estimated future liability cash flows for active members, the passage of time and changes in the term structure of interest rates.
iBoxx US Pension Liability Index – Aggregate, which mimics the performance of a model (or typical) traditional defined benefit plan in the US, taking into consideration such a plan’s estimated future liability cash flows, the passage of time and changes in the term structure of interest rates.
US-I
26US-I
iBoxx US Pension Liability indices incorporate two important features:
Other currently published indices lack one or both of these important criteria
Pooled funds: Appropriate benchmarks
Mimic the sensitivity of the liabilities to changes in interest rates, as well as the slope and shape of the yield curve
Provide an extremely liquid, long-dated and high-quality yield curve representative of a pension plan’s interest rate exposure to the corporate bond yield curve
Reflect the actual liability profile of a plan
Are investable via LIBOR interest rate swaps
1 2
27
Drew Carrington, CFA
Drew Carrington is a member of the US Core/Core Plus and Emerging Market Debt strategy teams, focusing on fixed income strategy and development of the portfolios. Drew is also responsible for communicating the firm's full range of fixed income strategies to clients and consultants.
Additionally, Drew works with the firm's GIS (Global Investment Strategy) team on the development of asset/liability solutions for clients.
Prior to joining the firm in early 2005, Drew was a principal at Mercer Investment Consulting, serving an array of institutional clients. Drew was also a member of Mercer's manager review committee and the strategic research committee. Prior to joining UBS, Drew's entire 16 years of professional experience was in the institutional investment consulting field.
Drew is a long-time member of the Atlanta Society of Financial Analysts.
Senior US Fixed Income Portfolio ManagerExecutive DirectorYears of investment industry experience: 16Education: Harvard University (US), BA
28
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.A client's returns will be reduced by advisory fees and other expenses incurred by the client. Advisory fees are described in Part II of Form ADV for UBS Global Asset Management (Americas) Inc.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.
US-I