Download Report

Redington
13-15 Mallow Street
London EC1Y 8RD
T. 020 7250 3331
www.redington.co.uk
Matching Assets – How to Beat Inflation
Flight Plan Consistent Assets – Why and How?
September 2011
Introduction
Flight Plan Consistent Assets – Why and How?
The situation pension funds are in
Pension Funds have faced a challenging environment since the financial crisis began in 2007/2008. Falling yields and disappointing asset
returns have led to increasing deficits and falling funding levels. The recent turmoil in the markets and yields which keep on declining
relentlessly have only made it clearer that a new approach to pension fund investment is needed.
The challenge
We are convinced that pension funds will only be successful if they:
• Recognise
the
difficult
situation they are in
• Are clear about their goals
and constraints
• Draw up a comprehensive and
effective game plan to make
focussed
investment
strategy
decisions
• Access the right kind of
investment that will enable
them to return to full
funding
Meeting the challenge
This presentation discusses our approach to meeting these challenges:
1
The Pension Risk Management Framework
for formulating your goals clearly
2
The Flight Plan
for making effective investment strategy decisions and choosing the right investments
3
Flight Plan Consistent Assets (FPCA)
for accessing the long-term, secure, inflation-linked cashflows and attractive real returns
that you need to achieve full funding
2
Flight Plan Consistent Assets – Why?
The markets we are in...
1
5.5
Long-term yields have fallen, pushing up the
value of pension funds’ liabilities...
30-year swap rate
5
30-year gilt yield
%
4.5
4
3.5
3
Jan 07
Jul 07
Jan 08
Jul 08
Jan 09
Jul 09
Jan 10
Jul 10
Jan 11
Jul 11
Source: Bloomberg, Redington
3
Flight Plan Consistent Assets – Why?
The markets we are in...
2
The financial crisis has set equities on a rollercoaster ride
with low and volatile medium and long-term returns. Risky
assets have increasingly failed to deliver adequate
outperformance.
160
Rebased at 1 Jan 07 = 100
140
120
100
80
FTSE 100
Emerging market equity*
Developed world equity**
60
40
Jan 07
Jul 07
Jan 08
Jul 08
Jan 09
*Emerging market equity = MSCI Emerging Markets Index
**Developed world equity = MSCI Developed World ex. UK
Jul 09
Jan 10
Jul 10
Jan 11
Jul 11
Source: Bloomberg, Redington
4
Flight Plan Consistent Assets – Why?
The markets we are in...
3
2.25
Real yields have declined, making it more difficult for
pension funds to access attractive and secure longterm returns that will allow them to reach full funding.
1.75
Yield on 30-year inflation-linked gilt
30-year real swap rate
%
1.25
0.75
0.25
-0.25
Jan 07
Jul 07
Jan 08
Jul 08
Jan 09
Jul 09
Jan 10
Jul 10
Jan 11
Jul 11
Source: Bloomberg, Redington
5
Flight Plan Consistent Assets – Why?
... and the effect on pension schemes
3. Declining real rates
2. Risky assets underperforming
1. Falling long-term yields
As asset performance failed to keep pace with rising liabilities, funding levels declined.
Pension funds must therefore focus on making the right decisions to achieve full funding in a difficult environment.
450
115%
£ bn
400
Assets
Funding Level (Assets/Liabilities)
Funding level
Liabilities
350
300
250
Full funding
105%
95%
85%
75%
Jan 07
Jul 07
Jan 08
Jul 08
Jan 09
Jul 09
Jan 10
Jul 10
Jan 11
FTSE 100 companies’ aggregate pension assets and liabilities
Source: Aon Hewitt Pension Risk Tracker, Redington
Jul 11
Jan 07
Jul 07
Jan 08
Jul 08
Jan 09
Jul 09
Jan 10
Jul 10
Jan 11
Jul 11
Aggregate funding level of FTSE 100 pension schemes
Source: Aon Hewitt Pension Risk Tracker, Redington
6
Flight Plan Consistent Assets – Why?
Making Smart Decisions
Pension funds must find ways to:
• Earn secure long-term returns
sufficient to achieve full funding;
Manage the risks that can prevent you from
reaching your goal
Be clear about where you
want to go
• Understand where risks are coming from
• Monitor risks closely
• Manage risks effectively
• To manage risks stemming from
deficits and the current market
environment effectively
Choose investments that will allow you to
get fully funded with little additional risk
This requires:
• A
comprehensive
framework
•
strategic
• Clearly articulated goals
Access long-term, safe and inflationlinked cashflows offering attractive real
rates of return
Understand where you are
• Well-defined risk budget
These should be market consistent
so that effective action can be taken
quickly.
A rigorous approach to pension investment builds upon
• The Pension Risk Management Framework, which clearly articulates a scheme’s objectives and
constraints
• The Flight Plan, which plots the journey towards full funding and allows a scheme to identify
the best investment opportunities
7
Flight Plan Consistent Assets – Why?
The Pension Risk Management Framework (PRMF)
• Having a clear game plan is essential for long-term success in a difficult environment: only when you know exactly what you want (and what you
don’t want), can you make the decisions that enable you to reach your objectives.
• We call this the Pension Risk Management Framework: a clear, concise and effective tool for making focussed investment decision. It allows pension
funds to evaluate each opportunity according to how it supports their progress towards full funding.
• It can therefore be used to identify the investments which fit a scheme’s individual requirements.
Objective
Triggers
Performance Indicators
Actual Performance
What is the overall objective?
Full funding on self-sufficiency basis
By 2020 on a swaps + [50]bps basis with
contributions of £[25]m p.a.
How will we measure the objective?
Required return on the scheme’s assets
Required return of assets is swaps +
[160]bps
What are the primary risk targets?
Required return at risk (RRaR)
Contributions at Risk (CaR)
RRaR < [200]bps
CaR should be kept below £[50]m
What is the secondary risk target?
Value at Risk (VaR)
VaR should not exceed [20]% of the
liabilities
What are the primary aspirational
targets?
To be fully inflation and interest rate
hedged
Hedge ratios should be equal to [100%]
What are the secondary aspirational
targets?
Increase efficiency of hedges by earning
more return for same risk
Regular monitoring of relative value of
swaps vs. gilts
What is the primary scheme
constraint?
Liquidity
Sufficient liquidity to make pension
payments
What is the secondary scheme
constraint?
Collateral requirements
Enough available collateral to cover the 1year derivative [VaR95]
Metric is at or
above target
Metric is within
10%of target
Metric is more
than 10% away
from target
Flight Plan Consistent Assets – Why?
The PRMF Dashboard
The Dashboard summarises provides a comprehensive, easyto-understand overview of how well a scheme is performing
against objectives.
1
1
Dashboard – Key Features
2
2
1
Risk Radar – What are your biggest risk
factors? What risks should you be focussing
on?
2
Scheme Gauge – What condition is your
scheme in judged on four fundamental
variables?
3
Risk Monitor – Putting numbers to your
exposure: How much risk is the scheme
taking at the moment? (as measured by four
elemental risk metrics)
4
3
4
5
6
Performance Monitor – Shows how the most
important markets have performed.
Traffic light system – Where your scheme is
meeting targets (green), falling short by a
small margin (yellow) or underperforming
significantly (red). Ideal for identifying areas
where effective action is needed.
PRMF checker – A summary of your scheme’s
objectives and whether they are being met
5
6
9
Flight Plan Consistent Assets – Why?
Flight Plan
•
The Flight Plan maps out the path of a
scheme’s assets and liabilities from their
current position to the funding goal under a
given investment strategy.
The Flight Plan is an effective tool for making focussed asset allocation decisions and identifying
the best opportunities.
•
It allows us to understand how different
factors (e.g. time until full funding, future
inflation, changes in the interest rate) affect a
scheme’s progress towards full funding.
•
Together with the parameters set out in the
PRMF the Flight Plan produces ‘calls to
action’ whenever the Scheme diverges too
far from the scheme’s goals.
GBP Millions
Liability Basis
Time Horizon
Contributions & Asset Returns
2010
•
The Flight Plan also helps highlight the
opportunity costs of investment strategy
decisions.
2011
2012
Liabilities Path
2013
2014
2015
Actual Liabilities
2016
2017
Assets Path
2018
2019
2020
Actual Assets
It allows schemes to identify the assets which contribute most towards their progress to full
funding – we call them Flight Plan Consistent Assets.
10
Flight Plan Consistent Assets – How?
Flight Plan Consistent Assets
• Flight Plan Consistent Assets (FPCA) offer an
excellent opportunity for increasing fuel
efficiency because they provide liabilitymatching cashflows and attractive real
returns with a high level of security.
8
Flight Plan Consistent Asset – Example Cashflow Profile
6
GBP Millions
Inflows
Inflation-linked cashflows
4
• The attractive real returns are the result of a
significant illiquidity premium which has
emerged after the financial crisis as
traditional sources of finance for these
assets, such as bank lending, dried up.
2
Attractive real returns
0
-2
Providing a match for liabilities
Initial investment
Outflows
-4
-6
0
5
Source: Redington
10
15
Years
20
25
30
Typical characteristics of Flight Plan Consistent Assets
Attractive real returns and inflation-linked cashflows
High-quality, often secured cashflows
Illiquid & illiquidity premium
Varying degrees of complexity/might be difficult to access
11
Flight Plan Consistent Assets – How?
Flight Plan Consistent Assets – Examples
Secured Leases
•
Take advantage of attractive yields on long-term secured property
leases
•
•
Infrastructure
•
Yields may be in excess of yields on corporate bonds issued by
same borrower
Investing in public sector projects through, for example, Private
Finance Initiatives (PFIs), bespoke investments structures or by
purchasing a suitable infrastructure asset
•
Wide range of possible assets, from roads to power generation
Long-dated index-linked cashflows
•
Long-term, potentially inflation-linked revenue streams
Social Housing
Ground Rents
•
Low-cost rental housing provided for disadvantaged people in
need of housing
•
Ground rent created when freehold land or building is sold on long
lease
•
Generally provided by local councils and housing associations
•
Typically “pepper-corn” rent for land only (not buildings)
•
Offers long-dated, inflation-linked cashflows from secured
borrowers (i.e. housing associations) with quasi-government
guarantee
•
Offers attractive returns, limited credit risk and high level of
security
Flight Plan Consistent Assets – How?
Investing in Flight Plan Consistent Assets
Investing in Flight Plan Consistent Assets is usually very
complex.
It is essential to focus on getting the details right to ensure
that a pension fund investor actually receives the required
returns and cashflows .
Specific Risk/Return
Profile
of the individual asset
Investment Structure
used to access the returns and
cashflows
We focus on Social Housing and Infrastructure to illustrate the different factors that need to be taken into account.
Social Housing
Infrastructure
• Redington has been a pioneering force for turning
Social Housing into an investable asset class for
pension funds.
• Redington is cooperating closely with a market
actor with strong infrastructure expertise to provide
attractive investment solutions for pension funds.
13
Flight Plan Consistent Assets – How?
Investment Structure
Debt or Equity?
• An equity investment promises higher returns but also holds
additional risks
Pension funds must be clear about the way in which they want
to access Flight Plan Consistent Assets.
• Debt investments are more secure, but are also likely to yield
lower returns
Example Bespoke Investment Structure
Bespoke Investment Vehicle?
• An investment structure tailored towards the
requirements of a pension fund will be the
most effective way to access Flight Plan
Consistent Asset returns
Investment Consultant
•
•
Support for evaluating and structuring investments
Ensure investments’ risk/return profile and
investment structure are in line with Fund
requirements
Pension Fund
Housing Association
Equity/Debt Investment
• This will involve work and incur costs before
the investment can be made
Equity Investment
Investment Manager
•
• Responsibilities between different parties
must be clearly defined, e.g. asset (day-today) management vs investment management
(high level supervision of investment)
Provide financial analysis and investment,
origination and structuring expertise
Tailored Investment Structure
(e.g. Fund/Special Purpose Vehicle)
Portfolio
Development 1
• How will the bespoke investment vehicle be
structured? Will the pension fund partner with
a housing association/asset manager?
Development 2
Development 3
Asset Manager
•
Source: Evolution
Securities, Redington
Manage day-to-day operations and supervise financial
investment/provide operational fund management services
performance
of
each
14
Flight Plan Consistent Assets – How?
Infrastructure: Risk profile
Infrastructure Sector
The risk that an infrastructure investment fails to provide
liability-matching returns depends on several factors.
• “Infrastructure” covers a wide range of different assets
which can be exposed to a wide range of risks such as
-
Pricing Mechanism
Development Stage
• An asset that earns a
return simply because it is
available for use will be
less risky than an asset
where the return depends
on actual demand
• Investors will be exposed to
more risk if they invest at an
early stage of development,
but can also expect a higher
return
-
availability risk
construction & performance risk
political & regulatory risk (e.g. changing
regulatory regimes)
environmental risk (e.g. pollution)
technological risk (e.g. obsolescence,
technical challenges).
• Pension fund investors must therefore thoroughly assess
the risk profile of the asset they want to invest in
Pricing mechanism
Most Risk
Least Risk
Availability
Regulatory
Demand
Economic Price
Sector
Least Risk
Most Risk
Source: Evolution
Securities, Redington
15
Flight Plan Consistent Assets – How?
Social Housing: Risk profile
Social Housing is typically a low-risk asset class but the returns
and the risk on a portfolio can be tailored (to some extent) to
meet pension funds’ requirements.
• The diagram shows a typical
social housing portfolio for a
pension fund investor with a
blended real return of ca. 3-4%
p.a.
• The portfolio consists of different
housing types with specific
risk/return profiles.
• By adapting the share of the
different housing types in the
portfolio, an investor can tailor
the portfolio’s return and the risk
characteristics so that they fit
requirements.
Source: Evolution Securities, Redington
16
Flight Plan Consistent Assets – How?
Example: Tapping the illiquidity premium in water
The UK water sector is an excellent example of a Flight Plan
Consistent Asset, providing the security, returns and cashflows
that pension funds need.
Water sector: key characteristics
• Economic environment has small impact on returns:
water is a necessity and will therefore be demanded
irrespective of economic growth.
Case study: Cambridge Water
• Currently up for sale
• Bought by HSBC in August 2011 (for warehousing) for £74m
• Provides water for 300,000 people in Cambridgeshire
• 2010/2011: Revenue of £20m with profits of £7m before tax with
no external debt except for a revolving credit facility to cover
working capital
• Inflation-linked cashflows and returns: water companies
can increase prices in line with the agreed price review
which in turn is based on a formula related to RPI.
• Low regulatory risk: The regulator’s desire to increase
competition in the area could have a negative impact on
returns but the Government is likely to block any such
move.
• Attractive purchase opportunity for a large pension fund or a
consortium of funds.
17
Contacts
Disclaimer
Contacts
Redington
13-15 Mallow Street
London EC1Y 8RD
Direct Line: +44 (0) 20 7250 3416
Telephone: +44 (0) 20 7250 3331
Scan in the QR code with your
smartphone to get straight to our
website.
Robert Gardner
Founder &Co-CEO
[email protected]
www.redington.co.uk
THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT
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 .
Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions 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 or damage howsoever sustained as a result of inaccuracies in that estimation. Additionally, the client recognizes that Redington
Ltd does not owe any party a duty of care in this respect.
Redington Ltd are investment consultants regulated by the Financial Services 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), should be treated as illustrative only and not relied upon as accurate.
Redington Limited (reg no 6660006) is a company authorised and regulated by the Financial Services Authority and registered in England and Wales. Registered office: 13-15 Mallow Street London EC1Y 8RD
18