Redington, Pensions, Defined Benefit

1. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
Understanding, Modelling and
Managing Defined Benefit
Pension Risk
Oxford-Man Institute of Quantitative Finance
Wednesday 21st May 2014
1

2. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
Agenda
What is a Defined Benefit Pension Fund? 4
How do we Measure the Health of a Pension Fund? 5
What are the Different Stages of a Defined Benefit Pension Fund? 6
What are the Key Risks to a Pension Fund? 7
What are the Main Challenges to the Pension Industry? 8
How do we Measure the Risks to a Pension Fund? 10
How can a Pension Fund Measure and Hedge Risk? 11
What if? Stress Testing 13
How do you Combine Contributions, Investment Return and Funding
Date to fund a Pension Fund?
15
How can a Pension Fund Manage and Monitor its Risks in a single
Framework?
16
How does this Framework work in practice to determine Dynamic
Risk Management Actions?
17
Any Questions 18
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3. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014 3

4. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
What is a Defined Benefit Pension Fund?
4
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
CashFlow£
Years
Fixed Cash Flows Real Cash Flows

5. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How do we Measure the Health of a Pension Fund?
5

6. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
What are the Different Stages of a Defined Benefit Pension Fund?
6
1,000
1,200
1,400
1,600
1,800
2,000
2,200
2,400
GBP Millions
Liabilities (Gilts Flat) Liabilities (TP Basis) Assets
Expected Return: Gilts +2.25%
Risk: 11.2%
Hedge Ratio: 35%
Expected Return: Gilts +1.62%
Risk: 6.5%
Hedge Ratio = Funding Ratio
Expected Return: Gilts +0.25%
Risk: 2.2%
Hedge Ratio = 100%
1. Managing the
Deficit
2. Preparing for
the End Game
3. Running Off the
Pension Fund

7. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
What are the Key Risks to a Pension Fund?
7
Liabilities
CovenantAssets
Equity
Credit
Manager Skill
Contributions (£):
Willingness to Pay
Ability to Pay
Longevity
Interest Rate
Inflation
Modelling

8. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014 8
What are the Main Challenges to the Pension Industry?

9. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014 9

10. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How do we Measure the Risks to a Pension Fund?
Using Value at Risk
10
Funding Ratio at Risk

11. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How can a Pension Fund Measure and Hedge Risk?
Using Sensitivity Analysis
11
Interest Rate Sensitivity (PV01)

12. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How can a Pension Fund Measure and Hedge Risk?
Using Sensitivity Analysis
12
Inflation Sensitivity (IE01)

13. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
What if? Stress Testing
13
Impact on Deficit of Stress Test by Assets and Liabilities

14. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014 14

15. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How do you combine Contributions, Investment Return and Funding Date to
fund a Pension Fund?
15

16. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
How can a Pension Fund Manage and Monitor its Risks in a single Framework?
16
Objective Measurement Performance Indicators Performance RAG
Primary Funding
Objective
To reach 100% funded on a swaps flat
basis by 2026
Expected Returns (ER) > Required Returns
(RR)
RR: Libor + 300bps
ER: Libor + 200bps
Difference: -100bps
Investment Strategy
Actual Returns should exceed Expected
Returns
Actual Returns (AR) > Expected Returns (ER)
AR: Libor + 210bps
ER: Libor + 200bps
Difference: +10bps
Risk Budget
The investment strategy should not risk
the deficit worsening by £600mm over
a 1 year period
VaR95 < £600mm VaR95: £700mm
Hedging Strategy
Nominal and inflation hedge ratio
should be maintained within +/- 5% of
the funding ratio
Funding Ratio (swaps flat) 70% n/a
Nominal Hedge Ratio (swaps flat) 50%
Inflation Hedge Ratio (swaps flat) 85%
Collateral
Sufficient liquidity to make pension
payments and to cover margin calls
that may arise from derivative
positions.
Total available eligible collateral £900mm
Remaining collateral after VaR95 event £600mm
RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away

17. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014 17
How does this Framework work in practice to determine Dynamic Risk
Management Actions?

18. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
Any Questions?
18

19. Oxford-Man Institute Understanding Modelling and Defined Benefit Pension Risk May 2014
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19
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