Flight paths: designing your de-risking plan

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February 2011
For professional investors and advisers only
Flight paths: designing
your de-risking plan
Mark Humphreys, Head of UK Strategic Solutions, Schroders
and Jonathan Smith, Strategic Solutions Analyst, Schroders
Summary
In our paper “A Flight Path to Self Sufficiency” we introduced the concept of a flight path – a managed plan to
help schemes achieve a buy-out or self sufficiency funding level. As part of a flight path schemes reduce
investment risk over time, with the aim of partially “locking in” gains in the funding level. In practice this means
two things:

Reducing exposure to risky growth assets as the funding level improves

Reducing liability risks by investing in assets that match the interest rate and inflation exposure in the liabilities.
Liability Driven Investment (LDI) instruments, such as swaps, allow trustees to largely separate out growth
asset de-risking from liability risk management. In this paper we discuss how both growth asset and liability
de-risking plans can be designed in practice.
In summary:

Growth asset de-risking is usually driven by the funding level. This helps ensure that growth assets remain
when they are needed to make up the deficit but are reduced at higher funding levels when upside is needed
less.

The buy-out or self sufficiency funding level will usually be the primary focus of the flight path as this will
represent the “end game” for most schemes. However it is also possible to state the triggers in terms of the
technical provisions.

The growth asset de-risking strategy will usually have implications for both the technical provisions discount
rate and the recovery plan, so it is often beneficial to consider the flight path design early on in the valuation
process.

Liability risk can be reduced using funding level triggers and market yield triggers. Trustees wishing to delay
liability risk coverage should be aware of the size of the risks remaining and that long term interest rates and
inflation are more relevant than short term rates.

The more risk adverse trustees are the closer to current levels they should set their yield triggers. Covenant
issues will interact with the funding level to determine the speed of de-risking.

We also discuss some practicalities, including how many triggers to use, which interest rate metrics to monitor
and whether to hedge interest rates, inflation or both.
Both your consultant or fund manager can help you set an appropriate de-risking strategy for your scheme.
February 2011
For professional investors and advisers only
Reducing growth asset risk
For the majority of schemes, growth assets will continue to play an important role in their deficit reduction plan
in the medium term. However as the “end game” for most pension schemes will include a very low risk
investment strategy, trustees may still wish to incorporate a phased de-risking plan for the growth assets into
the flight path design.
Two questions arise: which triggers should be used and how quickly should the growth asset portfolio be sold
down?
Which triggers?
Using funding level triggers ties de-risking closely to the funding level, ensuring that growth assets remain when they
are needed to make up the deficit but are reduced at higher funding levels, when seeking upside is less of a concern
than reducing risk.
Using funding level triggers also helps to reduce market timing risk - the risk of “selling low” or “buying high”. This is
because improvements in the funding level may be a consequence of a rise in growth asset prices and/or a rise in the
discount rate (and so a fall in bond prices).
Which funding level to monitor – buy-out/self sufficiency or the technical provisions?
The buy-out or self sufficiency funding level will usually be the primary focus of the flight path as this will represent the
“end game” for most schemes. These measures also have the advantage of remaining relatively objective over time
and largely independent of the scheme’s investment strategy.
On the other hand, the discount rate used for the technical provisions usually reflects the asset allocation at the time
and also to a certain extent, the funding negotiations between the trustees and the sponsor. Therefore setting derisking triggers with reference to the technical provisions is more complicated.
If the technical provisions are the primary focus for the trustees, a proxy funding level can be calculated with, say, a
fixed margin for outperformance in the discount rate, reflecting the margin used in the most recent funding valuation.
This margin can be fixed throughout the life of the flight path, in which case there is likely to be divergence between the
flight path funding level and the funding level calculated at each valuation. Alternatively, it can be reset after each
valuation, in which case the funding level triggers of the flight path are likely to require recalibrating.
In any case, trustees should recognise that the funding level calculated each day as part of the monitoring process will
only be a proxy to the “true” funding level. In particular, the proxy funding level will be based on a set a cashflows
calculated periodically – the further we are from the cashflow calculation date, the greater the divergence will be.
However, given that the cashflows themselves are only estimations, this additional mismatch would not normally be
material.
How quickly to de-risk?
Two example strategies are presented below:
Strategy 1: Gradual de-risking
Strategy 2: Recovery Plan based
Funding level (buy- out
basis)
Estimated equivalent
Technical Provisions
funding level
Growth exposure
85% (current)
<60
<90%
85% (current)
70%
>60%
>90%
85% (current)
105%
85% (current)
60%
Funding level (buy- out
basis)
Estimated equivalent
Technical Provisions
funding level
Growth exposure
<60
<90%
>60%
>90%
70%
105%
55%
70%
80%
120%
40%
80%
120%
90%
135%
25%
90%
135%
30%
100%
150%
10%
100%
150%
10%
Source: Schroders, for illustration only
2
February 2011
For professional investors and advisers only
In both examples the primary trigger is the buy-out funding level. In the first strategy de-risking begins early on.
However in the second strategy de-risking is delayed until the buy-out funding level is equivalent to more than
100% on an estimated equivalent technical provisions basis.
An issue with the first strategy is that growth is reduced before the scheme is fully funded relative to the technical
provisions, which may result in higher company contributions. Firstly, the discount rate used to value the technical
provisions is likely to include a margin for future growth asset outperformance, so the de-risking strategy may mean a
lower discount rate and therefore higher liabilities. Secondly the recovery plan itself will include an allowance for growth
asset returns – less growth assets over the recovery period will mean a lower expected return and potentially higher
contributions.
In the second strategy growth is maintained throughout the recovery period, so there will be less (if any) impact on
company contributions. However strategy 2 clearly also entails more growth asset risk to the scheme.
As the growth asset de-risking strategy can have implications for both the discount rate and the recovery plan,
it is often beneficial to consider the flight path design early on in the valuation process.
Triggers for re-risking as well as de-risking?
Some schemes may wish to set triggers to add growth asset risk, for example when their funding level has fallen. The
additional growth would then potentially help to improve the funding level. In addition, this may mean buying growth
assets when they are relatively cheap/selling bonds when they are relatively expensive.
However, trustees should be comfortable with the additional risk this would entail. The strength of the sponsor
covenant and its ability to make up the deficit if, for example, growth markets continue to fall, will be an
important consideration.
Reducing liability risks
Liability risk can be reduced using funding level triggers and market yield triggers. Both sets of triggers can be set in
advance to determine when interest rates or inflation coverage should be extended. Schemes can then delegate the
monitoring of market levels and the funding level to their fund manager, as well as the subsequent implementation of
coverage. This helps ensure that action to de-risk is taken quickly when the opportunity arises to do so.
Funding level triggers are appropriate as there is little incentive to take liability risk when a scheme is close to its target
funding level. However at lower funding levels there may be a case for leaving some liability risk unhedged, for
example if trustees believe that yields are low and are likely to rise (rising yields would mean both lower liabilities and
cheaper hedging asset prices). Coverage can then be extended when yields are more favourable, using market yield
triggers.
Figure 1 shows some illustrative market yield triggers. As each trigger is reached interest rate coverage is increased.
As yields will have risen, the triggers will coincide with improved funding levels, so adding coverage will partially “lockin” gains.
Figure 1: Illustrative market triggers for increasing interest rate coverage
Real yield (%)
Source: Bloomberg, Schroders, for illustration only
3
February 2011
For professional investors and advisers only
Important considerations before embarking on a market based trigger approach
How big is the risk being retained by the scheme?
Even if we believe that rates appear unattractive this does not, of course, preclude the possibility that they
could fall further.
Trustees should remember that pension schemes are very long term commitments, and as such have a long
duration and a high sensitivity to changes in interest rates and inflation expectations. A typical scheme’s
duration is around 20 years, meaning that every 1% fall in interest rates results in a 20% rise in liabilities.
Leaving this risk unhedged potentially exposes schemes to significant funding level volatility. Similarly, as the
majority of scheme liabilities are inflation linked, schemes have a high exposure to changes in future inflation
expectations.
Which rates matter the most?
Whereas trustees may have a strong conviction as to what inflation or interest rates will be over the next two or three
years, it’s much harder to form a view over the timescales that matter the most for the majority of schemes – those of
longer durations.
Figure 2 shows the cashflows of an example scheme, split by different pension increase types, together with the
interest rate/inflation sensitivity of its liabilities over various periods of time. The majority of interest rate and inflation
sensitivity (around 95%) relates to cashflows more than ten years away, however investors/economists’ views on
interest rates/inflation typically cover a much shorter period.
Figure 2: Example scheme cashflows and where the risk is concentrated
Sensitivity to interest rates / inflation (% of total PV01)
5%
5%
20%
19%
28%
28%
24%
24%
23%
24%
Payment per
annum £
14,000,000
12,000,000
10,000,000
Increases due to the effect
of future inflation
8,000,000
Index-Linked Pension
Cashflows
6,000,000
Fixed Pension Cashflow
4,000,000
2,000,000
0
2009
2019
2029
2039
2049
2059
2069
2079
2089
Source: Schroders, for illustration only. PV01 = change in liability value for every 0.01% change in interest rates/inflation
expectations
Setting yield triggers
The more risk adverse trustees are the quicker they should aim to cover their interest rate and inflation risk. In practice
this could mean:

Setting trigger levels close to the present level

Putting in place a partial hedge straight away, leaving only a proportion of the risk left to hedge in the future

Weighting the amount of coverage purchased at each trigger so that more is purchased earlier on
Covenant issues will interact with the funding level to determine the speed of de-risking.
4
February 2011
For professional investors and advisers only
Well funded schemes (close to their long term target – e.g. buy-out) should aim to reduce liability risks
relatively quickly, as there is little incentive to take risk once the scheme is fully funded. In practice, however,
schemes may wish to set their final trigger just above the long-term funding level target so as to provide a
buffer against other risks that could reduce the funding level (such as increasing longevity assumptions).
For schemes funded comfortably above the technical provisions but still some way short of their long term funding
target covenant becomes more of an issue. This is because for these schemes sponsor insolvency could result in a
reduction of member benefits (this assumes that the technical provisions are significantly less than the buyout/solvency liabilities – e.g. because there is a sizable margin for growth in the technical provisions discount rate).
Trustees should also consider market levels. If their funding level has benefited from significant rises in interest rates or
falls in inflation expectations, then trustees may look to lock in these gains sooner, e.g. by setting trigger points close to
current market levels.
For schemes funded close to or below the technical provisions the sponsor covenant becomes a key consideration.
Trustees should feel confident that the risk they are leaving unhedged would not lead to deficit contributions that would
be unaffordable to the sponsor.
Example strategies
Two example strategies are set out below. The starting funding level for the scheme in these examples is 69% and the
real yield at the outset is 0.35%.
Both strategies use two real yield triggers to determine when to increase liability risk coverage. For example in
Strategy 1, if the real yield rises to 1.0% a real yield trigger will be reached and liability risk coverage will be extended
to 75%. Higher yields will lead to a higher discount rate and so to a lower liability value. Rising yields also result in
lower hedging asset values, however because the scheme has only covered 40% of its interest rate exposure at the
outset, the assets reduce by less than the liabilities and there is a net funding level gain.
If yields continue to rise and go on to exceed 1.5%, a second trigger will be reached in Strategy 1 and further
cover will be added. The funding level gain between the first and second trigger is less now (3% compared to
8% on reaching the first trigger) as the scheme has reduced its exposure to rising yields by this stage.
The triggers are closer together in the first strategy than the second meaning that coverage will be put on
sooner in Strategy 1.
Strategy 1 results in a more modest funding level gain - coverage is added more quickly, meaning the scheme
benefits less from rising yields. A more aggressive strategy such as Strategy 2 would enable the scheme to
benefit from rising yields to a greater extent, resulting in a larger funding level gain. However Strategy 2 is
potentially more risky as the scheme is exposed to the risk of yields falling for longer.
Strategy 1: Less aggressive (lower risk)
Real yield
Funding
level*
level
Liability
coverage
Real yield
Funding
level
level*
Liability
coverage
0.35%
80%
Current (40%)
0.35%
80%
Current (40%)
1.0%
88%
75%
1.5%
94%
75%
1.5%
91%
100%
2.5%
100%
100%
Source: Schroders, for illustration only
5
Strategy 2: More aggressive (higher risk)
February 2011
For professional investors and advisers only
Some practical considerations
Which metric to use for the triggers?
Examples of metrics that might be used for market level triggers include:

Long dated gilt yield indices (e.g. the FTSE over 5 year index linked gilt yield)

Long dated swap yields (e.g. yields on zero coupon 20 year interest rate swaps)

A liability proxy yield (e.g. the average weighted yield on a collection of swaps that matches the projected
cashflow shape of the liabilities).
A liability proxy yield has the advantage of being unique to each individual scheme. This is preferable as it
avoids “clustering” of a large number of schemes around a particular trigger point, which could have an
adverse impact on market pricing if the schemes all try to add coverage at the same time.
Whether a swaps yield or gilt yield is monitored will largely depend on the hedging instrument used and
whether the most relevant liability discount rate is swaps or bonds based.
Triggers for nominal interest rates, inflation only or real interest rates?
Swaps allow schemes to hedge each of the inflation and interest rate elements of their real interest rate risk
separately.
This might be done if, for example, the trustees believe that either inflation protection or nominal interest rate
protection is expensive at present and that the scheme should wait for more favourable market conditions
before implementing the full real interest rate hedge. However there are risks to this approach; it should be
considered as a way of taking a particular view rather than a pure hedging strategy.
How many triggers?
The more triggers employed, the greater chance of locking in gains, as the triggers will be spaced closer
together. However a large number of triggers will mean higher implementation costs. Also, the gains at each
subsequent trigger become less material as more triggers are added. In practice a balance has to be struck.
In our experience three or four interest rate triggers is usually sufficient (perhaps divided between two or three
for extending coverage of the inflation linked liabilities, where most of the risk usually lies, and one for
extending coverage of the fixed liabilities). In addition there may be one or two funding level triggers for
extending liability risk coverage.
The implementation costs of switching out of growth assets into cash or bonds are usually lower so more
growth asset de-risking triggers may be used.
Conclusions
Under a flight path trustees can largely separate out growth asset de-risking from liability risk management.
Growth asset de-risking is usually driven by the funding level. The buy-out or self sufficiency funding level will
usually be the primary focus as this will represent the “end game” for most schemes. However it is also
possible to state the triggers in terms of the technical provisions.
As the growth asset de-risking strategy can have implications for both the discount rate and the recovery plan,
it is often beneficial to consider this aspect of the flight path design early on in the valuation process.
Liability risk can be reduced using funding level triggers and market yield triggers. A number of issues will
interact with the funding level to determine the speed of de-risking. It is possible to quantify the potential
benefits of using yield triggers in advance.
Both your consultant or fund manager can help set an appropriate de-risking strategy for your scheme. If you
would like to discuss any of the topics raised in this paper, please contact us.
6
February 2011
For professional investors and advisers only
Important information
The views and opinions contained herein are those of Mark Humphreys Head of UK Strategic Solutions and
Jonathan Smith, Strategic Solutions Analyst at Schroders, and do not necessarily represent views expressed or
reflected in other Schroders communications, strategies or funds.
For professional investors and advisers only. This document is not suitable for retail clients.
This document is intended to be for information purposes only and it is not intended as promotional material in any
respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument.
Schroders has expressed its own views and opinions in this document and these may change. The material is not
intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations.
Reliance should not be placed on the views and information in the documents when taking individual investment
and/or strategic decision. Information herein is believed to be reliable but Schroder Investment Management Ltd
(Schroders) does not warrant its completeness or accuracy. The data has been sourced by Schroders and should be
independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion.
This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services
and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expresses its
own views and opinions in this document and these may change. Reliance should not be placed on the views and
information in the documents when taking individual investment and/or strategic decision.
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Registration No. 1893220 England
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