Background
A Pension Scheme faces risk from changes in its funding level. This risk causes the following problems:
-
Instability in the reported funding position to members – reducing confidence in scheme
-
Instability will affect Pension Regulator's view
-
Instability in funding affects sponsor’s contributions and balance sheet
The risk in the funding position is caused fundamentally by two constituent risks:
-
Asset Risk
-
Liability Risk
The Scheme has in place a well diversified, dynamically managed asset allocation through the P-Solve Total Investment Governance Solution and so the residual risk management left is that of Liability Risk – Risk Management Solutions were appointed to manage this risk using a derivatives portfolio.
Stage 1: Strategy and Objectives
The design of the suitable derivatives portfolio was wholly dependent on the risk objectives of Scheme. We engaged initially with the Trustees and Sponsor to:
-
Quantify the risk measures that were important
-
Quantify the size of this risk
-
Quantify the “shape” of this risk
The liabilities associated with pension schemes are by nature long-term. This means that the various methods of reporting the size of liabilities play an important role in the definition of risk. The Trustees were worried about the ongoing basis assumed by their Actuary as this is the primary measure that they are judged upon. The underlying corporate sponsor was more focussed on the accounting numbers that are determined by the IAS19 standard as it is this number that is ultimately reported in the company accounts. Each of these liability valuation bases had different sets of assumptions and so different sizes and shapes of risk.
We advised the scheme that in liability risk management is that there is no “right answer” and that through communication with the sponsor a strategy could be devised that addressed concerns from both parties to a large degree. The nature of pension scheme liabilities is that there are assumptions and uncertainties embedded within them, so a precise solution would provide spurious accuracy. The biggest reduction in liability risk is brought about by simply having a derivative portfolio that addresses the majority of the risk. The shape of the portfolio is a secondary improvement in risk on top of this.
In addition, this scheme was relatively immature and open to new entrants and therefore had significant levels of new accrual. It was important that the derivatives design, implementation and management process took this into account.
We, in conjunction with the parties involved, designed a solution that was accurate yet pragmatic in its approach and was cost effective.
Stage 2: Implementation and Management
The next stage of the process was the implementation and management of the designed derivatives portfolio. The implementation process involved refinements to the design to reflect market developments and views. We modified the strategy to take into account the value across the yield curve, this intelligent implementation resulted in a more cost effective hedge without sacrificing risk reduction benefits.
We also leveraged off our trading experience to try and optimise the timing of the trade given the underlying market liquidity and volatility.
The implementation of the swap profile and subsequent adjustments was delegated to P-Solve by the Trustees as we were best placed to monitor and manage the relationship between:
Because of the Scheme’s immaturity, the overall strategy for the Scheme required a high allocation to return-seeking assets. This meant that the RMS team needed to liaise with the management of the TIGS portfolio on a regular basis to ensure efficiency between collateral requirements and return generation.
Stage 3: Governance
The ongoing governance of any strategy not only involves monitoring the performance of the strategy but also an ongoing assessment of the appropriateness of the investment strategy and objectives.
After 3 years of the strategy being in place, the underlying markets moved such that the derivatives values formed a significant part of the asset allocation. Because the derivative portfolio was designed effectively as a low-returning asset, this high allocation was effectively beginning to drag down the return generation at a total portfolio level.
The RMS team worked with the Trustees on a re-assessment of their objectives and return requirements in light of this. The important considerations were that any rework of the strategy needed to focus on a return in excess of cash, the portfolio had to have assets that were eligible to be posted as collateral and any change in the portfolio had to continue to maintain a focus on risk reduction.
Through the discussions with the Trustees it became clear that the existing portfolio of assets provided the following characteristics
Therefore, an obvious gap in the return profile of the assets of the Scheme was for static equity markets. RMS therefore designed an equity derivative overlay strategy that would provide downside protection plus performance in excess of cash for zero to low equity returns over a three year period. The strategy utilised existing legal documentation to purchase equity options to provide the required risk-return profile whilst a Libor generating asset was funded by releasing value from the current derivatives portfolio. The Libor generating asset was then used to provide the downside protection whilst still being available to meet collateral requirements.
We believe that we added value to the process in a number of ways; we provided a clear and concise appreciation of the risks from the perspective of all stakeholders. We designed a cost effective pragmatic derivatives strategy to reduce the risks whilst bearing in mind the objectives of the Scheme. We used our delegated authority to ensure effective value added implementation and ongoing management. We continue to provide valuable advice that looks to refine the strategy to take into account the conditions in underlying markets.