Aspects of Risk
Risk Management Within The Investment Portfolio
September 28, 2011
© 2011 Towers Watson. All rights reserved.
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Today’s Presenters

Jon Pliner, Investment Strategy Consultant

Mark Ruloff, Director of Asset Allocation
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Today’s Discussion

Opening Thoughts

Payout/Liability Hedging

Better Diversification

Risk Steering

Risk Pricing

Long-Termism Risk Return Concepts

Beyond Investment Policy

Closing Thoughts
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Opening Thoughts

Holistic

Many tools beyond diversification and liability hedging

Risk return management
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Standard Efficient Frontier
Illustrative Efficient
Frontier
9%
8%
Most
Desirable
7%
6%
70% 60%
5%
4%
90%
80%
Efficient Frontier
Point Labels represent % fixed income
100%
3%
12%
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13%
14%
50%
10% 0%
20%
40% 30%
15%
16%
17%
18%
19%
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Asset/Liability Efficient Frontier
XYZ Retirement Plan
Asset/Liability Frontier - Year 2020
($375)
PV Contributions + PBO Deficits/(Surplus) ($M)
50th Percentile
Most
Desirable
0% LGC
10% LGC
With Surplus
20% LGC
30% LGC
($225)
40% LGC
50% LGC
60% LGC
($75)
70% LGC
Without Surplus
80% LGC
90% LGC
$75
$225
$125
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$275
$425
$575
$725
PV Contributions + PBO Deficits/(Surplus) ($M)
95th Percentile
$875
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Liability Hedging
$175
Asset/Liability Frontier - Year 2019
Desirable
Cumulative PV of Plan Year Contributions ($M)
50th Percentile
$200
$225
$250
$275
$300
$325
$250
$275
$300
$325
$350
$375
$400
$425
$450
Cumulative PV of Plan Year Contributions ($M)
95th Percentile
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An Eventful Couple of Months
Consumer confidence indicators
120
0
US (LHS)
Eurozone (RHS)
-5
100
-10
Recent signs of slowing economic growth in the developed
world have led to falling bond yields and a sharp sell off in
equities
80
The USD has strengthened against many currencies,
reinforcing it’s “safe haven” status
40
-15
60
-20
-25
-30
20
-35
0
Jan-07
Dec-07
Nov-08
Oct-09
-40
Aug-11
Sep-10
Sources: Thomson, Towers Watson
Speed of global rebalancing
(EM policy choices)
Fast
(EM FX appreciation)
Slow
(EM inf lation, DM def lation)
High
(Fiscal stimulus,
high market liquidity)
This in turn has led to rising uncertainty and increased
market volatility, consistent with our “Bumpy Path with Slow
Recovery” central scenario
Public policy
and financial
conditions
EM Overheating
High DM
inflation
High
DM
growth
Bumpy path
with slow
recovery
DM
sovereign
debt
crisis
(DM policy choices)
DM Deflation
Low
(Fiscal austerity,
tight market liquidity)
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Global growth
slowdown
EM: Emerging Markets DM: Developed Markets
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Government Bonds
Bond Yield Curves (As of August 31, 2011)
4.5
US
4
UK
Despite low absolute yield levels, the long end of the curve
implies a normalization of cash rates in line with our outlook
for anaemic economic growth in the US and Europe
Percent (%)
3.5
Euro (Germany)
3
Japan
2.5
2
1.5
1
0.5
0
1
5
10
15
20
25
Source: Bank of England, Deutsche Bundesbank, Federal Reserve, Bank of Japan
Global Markets Overview
Global Investment Committee, September 2011
In this issue
Though moderately unattractive versus cash, yield curves
still support hedging long-term liabilities
2
The outlook for EM equities
4
Summary of market views
Asset allocation in volatile
times. What now?
•
Valuations of risky assets fell sharply in early August. In a “normal” business
cycle current market levels (especially global equity markets) would look
attractive, supported by a new global easing cycle in reaction to the current
broad-based economic slowdown.
•
However, the high debt levels and deleveraging needs in developed countries
that are constraining governments and households and weakening conditions
have important structural elements. This is not a “normal” cyclical/liquidity
environment and a sustainable solution for growth and jobs requires both
money printing on the monetary side and specific structural reforms (eg public
finance reform in Europe and housing reform in the US) on the fiscal side.
•
Recent mediocre growth rates in the developed world and a necessary
slowdown in over-capacity emerging economies have been an important driver
of falls in risky assets. However, economic and financial outcomes remain
highly dependent on policymakers and politicians, especially in the euro area.
This will continue in the short-term, keeping investor sentiment fragile and
market volatility high.
•
When thinking about asset allocation it is important to balance perceptions of
value against a forward-looking view of the macro risks. Our central outlook is
still for policymakers to adopt a gradualist approach to addressing the
headwinds undermining economic growth and jobs and avoiding the very bad
economic and market outcomes. Nevertheless, there are still significantly
more positive and more negative risk scenarios that are plausible based on
policymakers boldly addressing the structural problems or failing to address
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sovereign, bank or household solvency concerns. Moreover, these policy
actions are very difficult to predict accurately.
5
World markets statistics
6
Notes
10
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Figure 01. Our current views
Modest opportunities due to recent moves,
relative to cash
•
While risky asset valuations are moderately attractive, we do think them
Diversified Portfolio: Risk/Return Buckets
Source of returns as a percentage of total return
The typical portfolio
includes some
diversification….
Typical portfolio
Well diversified portfolio
Skill risk premium
Insurance risk premium
…but equities still
dominate returns (and
risk)
Skill risk premium
Equity risk premium
In building a diversified
portfolio, it is therefore
important to think about
sources of return and
risk, rather than asset
allocation
Equity risk premium
Inflation risk premium
Inflation risk premium
Credit risk premium
Term risk premium
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Credit risk premium
Term risk premium
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Sample DB Pension Fund
Traditional
Unconstrained
Emerging wealth
Private markets
Alternative beta
Emerging wealth
Private markets
Alternative beta
Developed equities
Developed equities
Alternative credit
Corporate bonds
Corporate bonds
Treasuries and cash
Treasuries and cash
Liability hedging overlay
Hedge funds
Source: Towers Watson
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Equities
Most markets look attractive based on simple valuation metrics
12-month forward PE (X)
30
25
20
A sharp sell off leaves equities moderately attractive, albeit
with significant downside risks given the large macro risks
the economy faces
15
11.9
11.4
10
10.5
9.0
5
0
Euroland
US
Asia x Japan
Japan
Sources: Bloomberg LP, Towers Watson
Markets have failed to rally significantly from the August lows
Index, 31/12/10 = 100, last data point 2/9/11
110
105
100
Emerging equities look attractive to developed equities given
recent performance and long term outlook for growth
95
MSCI World, -9% YTD
90
MSCI EM, -11% YTD
S&P, -5% YTD
85
80
Jan-11
FTSE Eurotop300, -13% YTD
Feb-11 Mar-11
Apr-11
May-11
Jun-11
Jul-11
Aug-11
Sep-11
Sources: Bloomberg LP, Towers Watson
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Combined: PV of Cumulative Contribution + TL Deficit ($M)
50th Percentile
Sample Analysis of Dynamic Asset Allocation:
Cumulative Contributions plus Deficits
Asset/Liability Frontier
Year 2019
$200
6%
8%
4%
10%
$210
2%
12%
4%
6%
14%
16%
2%
8%
20%FI (LGC)
30%FI (LGC)
18%
10%
12%
$220
14%
50%FI (LGC)
20%
22%
24%
28%
40%FI (LGC)
26%
30%
16%
18%
22%
24%
$230
$320
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$330
20%
26%
28%
30%
$340
$350
$360
$370
Combined: PV of Cumulative Contribution + TL Deficit ($M)
95th Percentile
$380
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Risk Steering


Dynamic Asset Allocation

Separating funded status trigger into interest rates, returns, and contributions

In declining markets
Enterprise Risk Management


Compare investment portfolio options with core operations
Consideration of investments compared to core business risks

Sponsor Beta

Commodities

Inflation

Cash contributions
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Collared vs. Uncollared Domestic Equities: Annual
Return
75th %ile – Collar
800
700
75th %ile – no Collar
600
Frequency
500
400
95th %ile – Collar
300
95th %ile – no Collar
200
100
73%
69%
65%
61%
57%
53%
49%
45%
41%
37%
33%
29%
25%
21%
17%
13%
9%
5%
1%
-3%
-7%
-11%
-15%
-19%
-23%
-27%
0
Amount
65% Fixed Income - no Collar
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65% Fixed Income with Collar
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Development of Liability Hedging Elements
Basis points
30 yr Swap spread over Treasury
200
150
100
50
Approach is often to obtain the appropriate hedge for a
certain risk exposure at the cheapest possible price
0
-50
-100
Jun-92
Jun-95
Jun-98
Jun-01
Jun-04
Jun-07
Jun-10
Sources: BarCap, Towers Watson
However, markets are complex and we expect negative swap
spreads to continue to persist in the near-term
We outlined rationale for our view in a note to clients earlier
this year
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Risk Pricing

Puts, calls, and collars

Swaps, Swaptions, and Swaption collars

Generally would be a loss of value if done always and passively

Requires good governance to know when to use and how to implement

Could depend on connection with enterprise risks

Put on swaption to avoid “unbearable” situation, like breaking of bond
covenants
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Long-Termism Risk/Return Concepts in Model Portfolio

Risk framework

Risk return framework

Risk return management, not just measurement

Long-term risk return management framework

Risk scenarios

Theme investing

Extreme risks
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Sustainability
Universal
Owner
Social and
Environmental
Goals
Return Goals
Sustainable
Investing
Risk
Management
Goals
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Beyond Investment Policy
FUNDING
STRATEGY
BENEFIT
STRATEGY
Effective at managing short-term
plan cost and volatility
Effective at managing active
liability risk profile and long-term
plan cost
Pension
Risk
INVESTMENT
STRATEGY
Effective at managing long-term
plan cost and volatility
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ASSUMPTIONS
& METHODS
Effective only for short-term
issues
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Closing Thoughts

Holistic

Many tools beyond diversification and liability hedging

Risk return management
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Questions
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Disclaimer

The information included in this presentation is general information only
and should not be relied upon without further review by the appropriate
professional advisors. Towers Watson is not a law firm or accounting
firm, and we are not providing legal, accounting or tax services or
advice. Some of the information included in this presentation might
involve the application of law; accordingly, we strongly recommend
that audience members consult with and involve their legal counsel and
other professional advisors as appropriate to ensure that they are fully
advised concerning such matters. Additionally, material developments
may occur subsequent to this presentation rendering it incomplete and
inaccurate. Towers Watson assumes no obligation to advise you of any
such developments or to update the presentation to reflect such
developments.
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Contact Details

Jon Pliner




335 Madison Avenue, New York, NY 10017-4605
212-309-3811
jonathan.pliner@towerswatson.com
Mark Ruloff



901 N. Glebe Road, Arlington, VA 22203
703.258.8058
mark.ruloff@towerswatson.com
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