1. What Lies Beneath: The Hidden Cost of
Pension Equity Risk
March 2014
For Institutional Investors

2. 2 For Institutional Investors March 2014
Contents
Situation
A recent change to banking regulation brings pension risk to the fore
3
Problem
Allowing for equity risk at a 99.5% 1-year risk level means reserving against quite extreme
shocks
4
Implication
Additional capital requirement can be lessened by capital protected equity strategies
5
Need
Using a volatility controlled benchmark greatly reduces the cost of protecting an equity
portfolio against large losses, while maintaining return expectations similar to a
conventional equity portfolio
6
Source Data 12
About the Author 13
What Lies Beneath: The Hidden Cost of Pension Equity Risk

3. March 2014 For Institutional Investors 3
Situation
A recent change to the banking regulatory landscape brought pension risk
to the fore…
On 29th November 2013, following a consultation, the Prudential Regulation Authority, responsible for
the prudential regulation and supervision of banks, building societies, credit unions, insurers and major
investment firms, announced1 changes to the capital framework applying to UK banks and building
societies, specifically with respect to defined benefit pensions risk.
“The PRA has decided that firms should meet all Pillar 2A risks (5), including pension risk, with
at least 56% CET1 capital from 1 January 2015 onwards. This matches the proportion of CET1
capital required for Pillar 1. In its consultation the PRA asked for views on whether Pillar 2A
should be met in full with CET1 capital from 1 January 2016. In light of consultation responses,
the PRA has decided that it will not require firms to meet Pillar 2A in full with CET1.”
Source: The Bank of England1
Here, “pension risk” means the 1-year 99.5% Value-At-Risk (“VaR”) of the scheme assets relative to the
liabilities. This is quite an onerous shock, for example for equities the 99.5% VaR would be around 2.5x
the annual volatility of equities. The historic annual volatility of equities varies depending on the time
period but is generally 16-20% per annum. The 99.5% VaR would also be nearly twice the 95% VaR which
many pension schemes use for risk modelling.
Pensions were already in the spotlight when it comes to banks’ accounting (see table 1) but the previous
regulations required only a figure relating to the accounting deficit and agreed contributions be covered
by tier 1 capital. Thus the risk of the scheme was not so important, this has now changed as a large
proportion (56%) of the risk in the pension fund must be covered by high quality (“CET1”) capital.
Table 1 : Number of times the word "pension" appeared in each bank's 2012 Annual report & Accounts
Barclays HSBC Lloyds RBS Santander
UK
Word count for
“pension” in 2012
report & accounts
59 107 183 163 199
This change signifies the latest in a series of efforts by regulators to tighten up banking capital regulations
in the wake of the financial crisis of 2008 onwards. This seemingly small change can have deep and
lasting effects on the way risk is measured and managed, and the capital banks must hold as a result.
In this paper we analyse the most recent2 publicly available data on five UK banks (Barclays, HSBC,
Lloyds, RBS and Santander UK).
1 http://www.bankofengland.co.uk/publications/Pages/news/2013/181.aspx
2 For all the banks analysed, the most recent report & accounts available were for 2012. The pension position may have changed
since this date
Source: Individual Company 2012 Report & Accounts (see “Source data” section). Calculations: Redington

4. 4 For Institutional Investors March 2014
Problem
Equity portfolios across the UK banks are considerable, and the 99.5% VaR
used to determine the capital requirement is a large shock…
Figure 1: Summary of Asset & Liability positions
The Capital Requirement for Equities
The capital charge is based on a 1-year 99.5% VaR estimate. There is no prescribed method for
calculating this by the regulator, with each banking using their own modelling approach and calibration
which are not publicised. The exact modelling approach and calibration used will affect the result of this
calculation but one independent and public guide is the Solvency II standard formula, which gives an
equity shock (base level) to determine the capital requirement of 39% for developed, quoted equities.
For comparison, this is roughly equivalent to an annualized volatility of 16%. Redington’s own modelling
produces a very similar result of a 38% equity shock.
While each of the banks’ pension schemes will have other diversifying risks which makes the overall
ALM VaR analysis more complicated, we can look at the new capital requirement arising solely from the
equity portfolio simply by multiplying the capital charge of 39% by the £ size of the equity portfolio and
then multiplying by 56%, that being the proportion of pension risk that is met with CET1 capital under
the new regulation.
Barclays HSBC Lloyds RBS Santander UK
% Equity 26% 13% 41% 41% 27%
Equity (£m) 6,265 2,129 12,450 10,812 2,026
Total Assets (£m) 24,096 16,380 30,367 26,370 7,503
Liabilities (£m) 25,407 17,999 31,324 30,110 7,554
-
5,000
10,000
15,000
20,000
25,000
30,000
35,000
£m
Source: Individual Company 2012 Report & Accounts (see “Source data” section”)

5. March 2014 For Institutional Investors 5
Implication
The high additional CET1 capital required to cover pension risk once equity
risk is allowed for can be lessened by capital protected equity strategies …
but these can often seem prohibitively expensive when applied to
conventional equity portfolios
Figure 2: Bank pension scheme equity holdings, VaR, current capital and pension adjustment
• The increased CET1 requirements for equity risk (item 3 above) are large compared to the previous
pensions adjustments to CET1 capital (for example those in the 2012 report & accounts).
3 Calculated as 39% of the amount held in equity
4 Calculated as 56% of the 1-year 99.5% VaR
5 Sourced from individual 2012 annual report and accounts – see source data section
Barclays HSBC Lloyds RBS Santander UK
1. Equity
holdings (£m)
6,300 2,100 12,500 10,800 2,000
2. Estimated
1-year 99.5%
VaR (£m)3
2,400 830 4,900 4,200 790
3. Estimated
CET1 Capital
requirement
equity-only
(£)4
1,400 500 2,700 2,400 440
4. 2012 total
CET 1 capital5
42,121 22,088 37,913 47,320 8,861
5. 2012
Pensions
Adjustment to
CET1 Capital
(£m)4
2,445 1,218 1,438 913 52
Source: Individual Company 2012 Report & Accounts (see “Source data” section). Calculations: Redington

6. 6 For Institutional Investors March 2014
Need
Using a volatility controlled benchmark greatly reduces the cost of
protecting an equity portfolio against large losses using put options, while
maintaining return expectations similar to a conventional equity portfolio
Enter Volatility Control
In previous papers we have introduced the idea of using a volatility controlled index to manage the
equity portfolio6.
This is an index that systematically adjusts its exposure to equity markets dynamically, in response to
changes in the realised volatility of equities. This means that the index has a lower, and more constant
level of volatility.
Both our own work, and external studies7 find that a volatility controlled equity benchmark has delivered
greater risk-adjusted returns than a static benchmark, over a wide variety of long-term time periods and
equity indices. This means we can reasonably expect a similar level of return as a static allocation for
a lower level of risk.
Another consequence of reducing and controlling the level of volatility in an equity investment is the
fact that put options on the value of the portfolio become much cheaper than on a static portfolio, which
means that credible investment strategies can be adopted which embed this “hard floor” protection of
the portfolio value on a rolling basis (see figure 3).
Figure 3: Comparison of protection costs
1-Year protection
level
Current cost of
protection on Global
Equity Index (%)
February 2014
Stressed market
conditions cost of
protection on Global
Equity Index (%)
Cost to Protect 10%
Volatility Control
portfolio (%)
90% 3.5% 6.5% 1.0%
85% 1.6% 4.8% 0.4%
80% 1.3% 3.5% 0.2%
6 Volatility Control : An Introduction http://blog.redington.co.uk/Articles/Dan-Mikulskis/September-2012/VOLATILITY-
CONTROL.aspx
Volatility Control Taming the Beast: A Tale of Two Crashes http://www.redington.co.uk/getattachment/172c962e-bd64-4adc-
8243-9bcfdcc62d5b/Taming%20The%20Beast%20-%20A%20Tale%20of%20Two%20Crashes.aspx
Volatility Control: The Hedgehog and the Fox http://redington.co.uk/getattachment/eea3dd74-37c8-446e-afa9-
fd8d1973f295/Taming%20The%20Beast.aspx
7 Guide Giese: The Optimal Design of Risk Control Strategy Indices (Journal of Indexes)
http://www.etf.com/publications/journalofindexes/joi-articles/12932-optimal-design-of-risk-control-strategy-indexes.html
Source: Redington, Investment Banks

7. March 2014 For Institutional Investors 7
While the capital reduction of implementing a volatility controlled benchmark (without capital
protection) is model dependent (it does substantially reduce the 1-year VaR in our model as shown in
figure 4, but this depends on how it is modelled), the capital reduction associated with a benchmark
involving explicit downside protection should be much easier to demonstrate. Given the portfolio has
protection in place at a certain level (90% say), and as long as this protection is maintained throughout
the year and on a rolling basis, this level of protection should be reflected in a reduced capital
requirement (see figure 4).
Figure 4: Reducing Equity VaR using volatility control and put options
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
0% 10% 20% 30% 40% 50%
ExpectedReturnoverswaps(bps)
1-year VaR 99.5% (% of notional exposure)
Stage 1: Developed
Market Equity
Source & Calculations: Redington
Stage 2: Developed
Market Equity with
Volatility Control
Stage 3: Volatility
Control with rolling
90% put option

8. 8 For Institutional Investors March 2014
Figure 5: Illustration of CET1 capital requirement reduction with volatility control + put option
Barclays Lloyds HSBC RBS Santander
UK
Equity holdings (£m) 6,300 12,500 2,100 10,800 2,000
Estimated New CET1
capital requirement,
equity risk only (£)
1,400 2,700 500 2,400 440
Estimated New CET1
capital requirement,
replacing equity with
volatility control + put
option (£m)8
350 700 120 600 200
Change in Equity Only
capital requirement
from implementing
volatility control (£m)
-1,050 -2,000 -380 -1,800 -240
8 Volatility controlled equity includes annual put option with a strike of 90%. Capital charge calculated as 10% of the value of
volatility controlled equity holding
• This example focuses on equity risk in isolation, and so approximates a situation where other
risks are either minimal or closely matched. In practice this will not be the case and the
interplay between the other risks in the scheme will be a significant factor in determining the
overall change in VaR, and hence capital requirement – this is discussed further below
• The reductions in equity-only CET1 capital requirement from adopting a protected volatility
controlled benchmark are substantial (the reduction is around 75%).
• Figures above may not sum due to rounding
Source: Individual Company 2012 Report & Accounts (see “Source data” section”). Calculations: Redington

9. March 2014 For Institutional Investors 9
Accounting for diversifying risks
• So far, we have looked at the equity component of the capital requirement in isolation. In reality,
the diversifying effects of other risks in the pension scheme, particularly unhedged interest rate risk
will change the picture when viewed at the aggregate level
• The extent of this will be depend on the individual assumptions and models that the banks use,
which are not public. Further, it is not possible to tell exactly from the publicly available information
the level of interest rate hedging that each bank has implemented within the pension fund
• We can, however, make some approximate conclusions based on various assumptions. The most
important modelling assumptions are the level of the interest rate shock, and the level of interest
rate/equity correlation
• The chart below shows the approximate percentage reduction in the overall capital requirement,
for varying levels of liability hedge ratio. Each line depicts a different allocation to equities. The
change in capital requirement reflects moving the entire equity portfolio from conventional equity
to volatility controlled equity with put option

10. 10 For Institutional Investors March 2014
Figure 6: Reduction in capital requirement taking into account diversifying risks
-80.0%
-70.0%
-60.0%
-50.0%
-40.0%
-30.0%
-20.0%
-10.0%
0.0%
ChangeinoverallCapitalrequirement
Liability Hedge ratio
Approx. Overall Capital reduction from applying protected
volatility controlled equity
15% Equity 25% Equity 40% Equity
How to read this chart:
Each line represents a different level of equity allocation. The vertical axis tells us the approximate reduction in the overall
capital requirement from implementing a capital protected volatility controlled allocation to equity (allowing for the diversifying
effect of interest rate risk) at different levels of liability hedge ratio (along the horizontal axis).
For example, for the 40% equity allocation, if the liability hedge ratio was 0% the overall capital requirement would be reduced
by roughly 20% if the equity portfolio was changed to a volatility controlled benchmark with put option (grey line, left hand end).
If the liability hedge ratio was then increased to 50%, for example by employing an increased interest rate matching overlay
(moving to the right on the grey line) the reduction in overall capital requirement – from moving to volatility controlled equity
plus put option - increases to around 35-40% (although the overall size of the capital requirement would also reduce).
Notes: analysis takes into account equity and interest rate risk only. Correlation between bonds and equity assumed -0.2.
Interest rate shock assumed to be a 1.2% fall in real yields. Assumed liability duration 20 years.

11. March 2014 For Institutional Investors 11
Conclusions
• The latest change in regulatory landscape for banks and building societies brings pensions risk to
the fore, requiring a more significant CET1 capital requirement for risks being run in the pension
fund, including equity risk
• The five schemes analysed represent more than £100bn of liabilities. The level of risk in each
scheme is dependent on a number of factors, the most important being:
– The proportion of assets invested in equities or other growth assets;
– The level of liability hedging/matching undertaken
• Looking at the capital requirement from the equity portfolios only, the new regulation points to a
substantial increase in capital required, as the equity shock used to determine capital
requirement is likely to be relatively high (although each bank’s methodology is not public)
• In practice the interplay of the other risks in the scheme, particularly the unhedged liability interest
rate risk will play a role in determining the reduction in capital requirement from employing volatility
controlled equity
• This effect is hard to quantify exactly as the specific assumptions and calibrations used by each
banks modelling team will affect the result. We have however made an attempt to look at this
affect approximately for a range of equity allocations and liability hedge ratios
• We can draw two broad conclusions from this part of the analysis:
– The capital reduction from employing volatility controlled equity with put option is more
significant the greater the level of liability hedging already in place
– However for equity allocation greater than 40%, a significant reduction in overall capital
requirement can be obtained even at low liability hedge ratios
– For low equity allocations of 15% or less, the benefits of adopting a capital protected equity
strategy are likely to be small below liability hedge levels of 70%. Above this level the benefits
begin to increase quite rapidly

12. 12 For Institutional Investors March 2014
Source Data
Bank Source
Barclays Barclay Bank PLC Annual Report 2012 pages 66, 212
http://group.barclays.com/Satellite?blobcol=urldata&blobheader=application/pdf&
blobheadername1=Content-Disposition&blobheadername2=MDT-
Type&blobheadervalue1=inline;+filename%3D2012-Barclays-Bank-PLC-Annual-
Report-PDF.pdf&blobheadervalue2=abinary;+charset%3DUTF-
8&blobkey=id&blobtable=MungoBlobs&blobwhere=1330696635849&ssbinary=tr
ue
Lloyds Annual Report and Accounts 2012 pages 49, 189, 272-4
http://www.lloydsbankinggroup.com/media/pdfs/investors/2012/2012_LBG_Ran
dA_Interactive.pdf
HSBC HSBC Group 2012 Annual Report & Accounts pages 82, 120, 133
http://www.hsbc.co.uk/1/PA_esf-ca-app-
content/content/pws/content/personal/pdfs/hbeu-2012-ara-final-online.pdf
RBS RBS Group Annual Report and Accounts 2012 pages 381 - 383
http://www.investors.rbs.com/~/media/Files/R/RBS-IR/documents/annual-report-
2012.pdf
Santander
UK
Annual Report and Accounts 2012 pages 84, 270
http://www.aboutsantander.co.uk/media/59517/santander%20uk%202012%20a
nnual%20report.pdf

13. March 2014 For Institutional Investors 13
About Redington
Redington is committed to improving financial futures. We design, develop and deliver
investment strategies for pension funds and insurance companies to help them to define and
reach their goals, we work to help create a new pensions system for those currently saving
and planning for retirement, and we run a financial education programme for young people.
Our investment advice is more action-focused than many other consultancies, and we are not
afraid to be innovative in the types of strategies we deliver. We take our clients through a
rigorous 7 Steps to Full Funding™, and our three flagship clients are measurably better
funded with less downside risk as a result of working through this. We were named
Investment Consultancy of the Year by four separate award-giving bodies in 2013.
We advise 50+ clients, eleven of the top 30 pension funds in the UK, and have over £300bn
in assets under consulting.
About the Author
We would welcome the opportunity to discuss further. Please do get in touch to find out more.
Dan Mikulskis
Director, ALM & Investment Strategy
• Dan joined Redington in
June 2012 and is Co-Head
of ALM.
• Prior to this, Dan worked at
Deutsche Bank in their
Cross Asset Trading Group,
where he focused on
volatility trading and in-
house systems
development.
• Earlier, he developed and
tested quantitative tools to
support portfolio
management at Macquarie
Funds Group.
• Dan started his career as
an Investment Consultant
at Mercer.
• He is a fellow of the
Institute of Actuaries.
Contact:
+44 (0) 20 3326 7129
dan.miksulkis@redington.co.uk

14. 14 For Institutional Investors March 2014