The 2nd Younger Members Convention

Use of Swaps in Matching Pension Fund Liabilities

Huw Williams

1-2 December 2003

The Glasgow Moat House

Using Swaps to Match Pension Scheme Liabilities Agenda Pension scheme asset allocation – a trend towards greater bond investment Recent bond market performance – the impact on credit spreads Structure and capacity of the bond markets

Sterling Euro

How will pension scheme demand be met going forward? Introduction to swaps Applications for pension funds

Enhancing investment returns Using swaps to meet liabilities

Examples in practice Risks and other features of the swap market Summary

Pension Scheme Asset Allocation Strategic issues facing pension funds

Reduced scope for risk taking Funding levels have reduced Sponsoring companies downsizing Increased attention from Government, analysts, rating agencies Increasing focus on “insurance company buy-out solvency” Changes in the accounting environment – FRS17, IAS19

Government Action Plan – 11th June 2003 Reduction possible to LPI for future service benefits On voluntary wind up full accrued benefits (on insurance

company buy out) to be met Insurance scheme to apply where companies are insolvent.

Premiums to be based partly (or fully?) on risk – funding level to determine “riskiness”.

Trustees to be given the right to wind up a scheme where they judge this to be in members’ interests.

Pension Scheme Asset Allocation Pensions Protection Fund

Likely mechanics on formal insolvency of sponsoring employer: Buy-out from an insurer for PPF level of benefits or better OR if not possible Receive scheme assets and accept liability for PPF level of

benefits Buy-out basis - How much you would have to pay an insurer to take

on liabilities? Implied yield: gilts – 0.5% (reinforced by emerging actuarial

guidance) Risk-based premium expected - main risk factors are:

Current deficit Asset allocation relative to liabilities Probability of default of company

But expect a proxy – simplicity and political compromise US PBGC premium = 0.9% of deficit + $19 per member

Pension Scheme Asset Allocation Trend towards a higher bond allocation

Asset Allocation 1993 1996 1999 2002

UK Equities 56.1 53.3 51.0 39.4Overseas Equities 24.0 21.8 24.4 25.0

Total Equities 80.1 75.1 75.4 64.4

UK Bonds 4.0 6.0 8.1 12.5Overseas Bonds 3.8 2.9 3.6 4.0Index-Linked 3.0 5.0 4.9 9.3

Total Bonds 10.8 13.9 16.6 25.8

Property/Other 9.1 10.9 7.9 9.8

Total 100 100 100 100

Pension Scheme Asset Allocation Trend towards a higher bond allocation

Equity Allocation as Percentage of Total

5055

6065

70

7580

85

Dec-8

5

Dec-8

7

Dec-8

9

Dec-9

1

Dec-9

3

Dec-9

5

Dec-9

7

Dec-9

9

Dec-0

1

Series1

Series2

Factors Influencing Asset AllocationAn improvement in funding levels may have an impact?

FTSE 100 31/Dec/2002 to 17/Oct/2003

3000

3500

4000

4500

Oct-0

3

Sep

-03

Au

g-0

3

Ju

l-03

Ju

n-0

3

May-0

3

Ap

r-03

Mar-0

3

Feb

-03

Jan

-03

FTSE 100

The Impact on Gilt Yields

10yr vs 30yr Gilt spreads

-10

0

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20

30

40

2-Ja

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Spr

ead

Corporate Spread Performance

Over 15 year corporate bond spreads

0

50

100

150

200

250

300

01/0

7/20

00

07/2

1/20

00

01/2

6/20

01

08/1

0/20

01

02/1

5/20

02

08/3

0/20

02

03/0

7/20

03

Sp

rea

d A

AA

AAA

Euro versus Sterling MarketSterling offers longer maturities

The Sterling market is a long dated market, offering better long matching opportunities for UK pension funds The maturity of new issues in the sterling market are consistently longer dated the the euro market

Sterling Market

0%

10%

20%

30%

40%

50%

60%

1-3

ye

ars

3-5

ye

ars

5-7

ye

ars

7-1

0 y

ea

rs

10

-15

ye

ars

Gilts

GBP Corporates

Euro Market

0%

5%

10%

15%

20%

25%

30%

1-3

ye

ars

3-5

ye

ars

5-7

ye

ars

7-1

0 y

ea

rs

10

-15

ye

ars

Sovereigns

EUR Corporates

Euro versus Sterling MarketSterling offers greater access to credit risk

The euro market (£945bn. equiv.) is significantly larger than the sterling market (£258bn.); hence euro market is more liquid

The average credit rating of the sterling market is lower than the euro market; hence sterling offers higher spreads

Sterling Market

AAA

AA

A

BBB

Euro Market

Sterling Index Linked versus Fixed marketIndex linked: a small, utility sector dominated market

Fixed Market (£258bn)

AAA

AA

A

BBB

Index Linked Market (£9bn)

Supranational

Financial

Industrial

Utility

How Will Demand Be Met Going Forward?

From increased corporate bond issuance

Government issuance also rising

Greater use of the Euro and Dollar markets

But inflation-linked assets likely to remain a problem

Greater use of the swaps markets is likely to help alleviate capacity constraints both in fixed income and inflation linked

The Sterling Debt Market (£bn)

0

5

10

15

20

25

30

35

40

45

50

2001 2002 2003(E) 2004(F)

Gilts

Corps

ABS/MBS

Fins/supras/other

Overall sterling debt supply has increased from £81bn in 2001 to £128bn in 2003, but will stabilise in 2004.

Interest Rate SwapsMarket Growth

Interest Rate Swap Market Growth - 1989 to 2002

-

10,000

20,000

30,000

40,000

50,000

60,000

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

No

tio

nal

Ou

tsta

nd

ing

in G

BP

£b

n.

Interest Rate Swaps - All currencies Sterling Interest Rate Swaps

Interest Rate SwapsComparison with UK domestic debt

Sterling Interest Rate Swaps vs UK Domestic Debt1989 to 2002

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

No

tio

nal

Ou

tsta

nd

ing

in

GB

P £

bn

.

Sterling Interest Rate Swaps UK Domestic Debt (All Issuers) UK Domestic Government Debt

Interest Rate SwapsTenors

Quotes available out to 50 years

Reasonable liquidity out to 40 years

Source: Reuters

Introduction to swaps

What is a swap?

Simply an agreement to exchange two sets of cash flows

Usually these are equal in value but different in nature

For example a “fixed for floating” swap

Consider a deposit of £10m paying a floating rate of interest

The floating cash flows can be exchanged for a specified fixed rate of cash flows applicable for a given period

This fixed rate is known as the “swap rate” for a given maturity

Interest Rate Swap Example

Bank Fund

Fixed swap rate of 3.9% per annum on £10m, paid semi-

annually for 5 years

6 month Libor from cash deposit for 5 years

6 month Libor earned on 5 year cash deposit of £10m

Applications for Pension Schemes

Receiving a fixed return is a substitute for a corporate bond return

Achieved by placing funds on deposit and receiving floating cash flows, which are then swapped for fixed cash flows

And the end of the period the Scheme receives a return of principal (by taking the cash off deposit)

Returns are in line with a AA rated bond yield – swaps are effectively a measure of generic bank credit

Flexible instruments as the cash flow proceeds can be tailored to meet the specific circumstances of the fund

Different Types of Swap Contract

Cash flows can be structured to meet an investor’s particular needs

For example the swap flows can be tailored to meet specific liability cash flows

An example is where a pension scheme has inflation-linked liabilities, but owns a portfolio of fixed rate bonds

Solution is to enter into an inflation swap:

Pension scheme pays fixed flows (as generated by the corporate bond portfolio) Scheme receives inflation linked cash flows tailored to meet the projected liabilities of the scheme

Example of an Inflation Swap

Bank Fund

RPI-linked cashflows to match pension payments

Cashflows generated by bond portfolio.

Can be fixed/floating & in any currency

RPI-linked pension payments

Buy a diverse portfolio of bonds. This could be sterling fixed income or broader still, e.g. Euros or dollars

Swap the fixed cash flows generated from the bond portfolio for either RPI or LPI linked returns

Example Liability Cash flow Graphs

ALL LIABILITIES

-

50,000,000

100,000,000

150,000,000

200,000,000

250,000,000

300,000,000

350,000,000

2004

2007

2010

2013

2016

2019

2022

2025

2028

2031

2034

2037

2040

2043

2046

2049

2052

2055

2058

2061

2064

2067

2070

2073

CASH

FLO

W (£

)

LPI Post 88 GMP Pre 88 GMP

PENSIONERS

0

50,000,000

100,000,000

150,000,000

200,000,000

250,000,000

300,000,000

350,000,000

2004

2007

2010

2013

2016

2019

2022

2025

2028

2031

2034

2037

2040

2043

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2058

2061

2064

2067

2070

2073

CASH

FLOW

(£)

LPI Post 88 GMP Pre 88 GMP

ACTIVES

-

50,000,000

100,000,000

150,000,000

200,000,000

250,000,000

300,000,000

350,000,000

2004

2007

2010

2013

2016

2019

2022

2025

2028

2031

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2037

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2043

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2058

2061

2064

2067

2070

2073

CA

SH

FLO

W (£

)

LPI Post 88 GMP Pre 88 GMP

DEFERRED PENSIONERS

-

50,000,000

100,000,000

150,000,000

200,000,000

250,000,000

300,000,000

350,000,000

2004

2007

2010

2013

2016

2019

2022

2025

2028

2031

2034

2037

2040

2043

2046

2049

2052

2055

2058

2061

2064

2067

2070

2073

CA

SH

FLO

W (£

)

LPI Post 88 GMP Pre 88 GMP

Projected Pension PaymentsExample Liability Profile (Pensioners)

Projected Pension PaymentsMarket Implied RPI

£0

£2,000,000

£4,000,000

£6,000,000

£8,000,000

£10,000,000

£12,000,000

£14,000,000

2003

2005

2007

2009

2011

2013

2015

2017

2019

2021

2023

2025

2027

2029

2031

2033

2035

RPI-linked pension payments

Pension Payments Versus Index-Linked Cash Flows

Pension Payments versus Index-Linked Gilt FlowsMarket Implied RPI

£0

£10,000,000

£20,000,000

£30,000,000

£40,000,000

£50,000,000

£60,000,000

20

03

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05

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35

Index-linked gilt flows RPI-linked pension payments

Resulting Cash Flow MatchAfter substituting the index linked gilts for the swap

Pension Payments versus Swap InflowsMarket Implied RPI

£0

£2,000,000

£4,000,000

£6,000,000

£8,000,000

£10,000,000

£12,000,000

£14,000,000

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RPI-linked pension payments RPI-linked Swap Inflows

Potential for Enhanced Returns Use of swaps effectively separates the asset and liability management from the investment of the assets

The swap payments to the Scheme can be tailored to meet the liability cash flows which need to be paid

Assets can then be invested independently – Trustees would be free to chose the most appropriate investment strategy without constraint

Hence potential for higher expected returns through:

Investment in asset classes with higher expected returns (e.g. corporate bonds versus index-linked gilts) Improved potential for investment manager out-performance

Corporate Bonds: Benefits & Risks Table

Bond Rating

Yield Over Gilts

(per annum)

(20yr spread)

Historic Default Rate

Over 10 Years

(per annum)

Historic Default Rate

Over 20 Years

(per annum)

Present Value of Performance

Improvement after costs & expected

losses. (Based on £100m of LPI/RPI

swaps)*

AAA 0.56% 0.08% 0.10% £3.7m

AA 0.70% 0.09% 0.14% £4.9m

A 0.84% 0.10% 0.27% £7m

* Costs include swap transaction costs and purchase of corporate bonds

ISSUER COUPON MATURITY VALUE RATING

Lloyds TSB Bank PLC 6.63 30-Mar-15 10,290,106 AA-

BOC Group Plc 6.50 29-Jan-16 11,235,999 A

Aviva Plc 9.50 20-Jun-16 14,144,150 AA-

Aviva Plc 9.50 20-Jun-16 14,144,150 AA-

Smiths Group PLC 7.25 30-Jun-16 11,676,480 A-

Coca-Cola Enterprises Inc 6.50 7-Dec-16 11,414,127 A

British Telecommunications PLC 7.75 7-Dec-16 12,455,145 A-

Safeway Plc 6.00 10-Jan-17 9,757,781 BBB+UPM-Kymmene Oyj 6.63 23-Jan-17 10,968,204 BBBNorthern Rock Plc 5.75 28-Feb-17 10,606,924 A-Northumbrian Water Finance Plc 6.00 11-Oct-17 10,688,722 BBBJapan Finance Corp for Municipal Enterprises 5.75 9-Aug-19 10,361,388 AA-Bank of Scotland 6.38 16-Aug-19 11,749,455 AA-GKN Plc 6.75 28-Oct-19 11,152,232 BBBMcDonald's Corp 6.38 3-Feb-20 10,849,527 ATussauds Finance Ltd 7.08 15-Mar-20 11,578,448 AGeneral Electric Capital Corp 6.25 29-Sep-20 11,464,344 AAAAXA 7.13 15-Dec-20 11,535,899 BBB+Enterprise Inns Plc 6.88 15-Feb-21 11,176,158 BBBNorsk Hydro ASA 6.50 7-Jun-21 10,793,528 ACoca-Cola Enterprises Inc 6.50 7-Jun-21 11,075,926 AEGG Banking PLC 6.88 29-Dec-21 10,489,361 A-Innogy Plc 8.13 9-Jun-22 12,007,357 A-Annington Repackaging No 1 Ltd 5.32 10-Jan-23 10,048,878 AA-Annington Finance No 4 8.07 10-Jan-23 11,753,029 BBB3i Group Plc 6.88 9-Mar-23 11,628,523 A+Highbury Finance NV 7.02 20-Mar-23 11,328,599 A-Land Securities Plc 6.38 27-Feb-24 10,781,392 A-THPA Finance Ltd 7.13 15-Mar-24 10,035,829 AUnique Pub Finance Co Plc 7.40 30-Mar-24 11,871,898 BBB+PowerGen U.K. PLC 6.25 29-Apr-24 10,920,646 A-United Utilities Electricity PLC 8.88 25-Mar-26 14,633,263 A-Citigroup Inc 5.15 21-May-26 9,894,166 AA-GHG Finance Ltd 7.78 15-Jul-26 12,210,456 BBBAviva Plc 6.13 16-Nov-26 10,475,923 AA-Canary Wharf Finance Plc 7.43 22-Oct-27 11,875,557 AAUnited Utilities Water Plc 5.63 20-Dec-27 10,381,756 A-HSBC Holdings Plc 5.75 20-Dec-27 10,859,364 ABAA Plc 6.38 4-Aug-28 10,792,676 A+Italy Government International Bond 6.00 4-Aug-28 11,217,067 AATesco Plc 6.00 14-Dec-29 11,001,081 A+Canary Wharf Finance II Plc 6.80 22-Apr-30 11,629,499 AARWE Finance BV 6.25 3-Jun-30 10,662,078 A+Deutsche Telekom International Finance BV 7.63 15-Jun-30 12,460,191 BBB+Electricite de France 5.88 18-Jul-31 10,331,396 AAGeneral Electric Capital Corp 5.63 16-Sep-31 10,712,488 AAAInnogy Plc 7.13 1-Oct-31 11,680,575 A-BAA Plc 5.75 10-Dec-31 10,132,652 A+Legal & General Finance Plc 5.88 11-Dec-31 10,776,728 AAJ Sainsbury Plc 6.00 5-Apr-32 10,138,924 A-McDonald's Corp 5.88 23-Apr-32 10,138,701 AEquity Release Funding Plc 5.88 26-May-32 10,873,951 AAASchlumberger PLC 6.50 4-Oct-32 11,917,490 A+Vodafone Group PLC 5.90 26-Nov-32 10,778,422 A3i Group Plc 5.75 3-Dec-32 9,522,388 A+Legal & General Finance Plc 5.88 5-Apr-33 10,729,260 AATrafford Centre Finance Ltd 6.50 28-Jul-33 11,913,727 AAA

Extreme Portfolio Default Losses

7.00%

9.20%

11.50%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

One in 10,000 event One in 100,000 event One in 1,000,000 event

Siz

e o

f lo

ss

as

a p

erc

en

tag

e o

f p

ort

folio

va

lue

SIZE OF DEFAULT LOSS VERSUS PROBABILITY OF OCCURRENCE(ANNUAL LONG-RUN AVERAGE)

6.7129%

1.3427%

0.3176%0.0800% 0.0207% 0.0054% 0.0014%

0.0000%

1.0000%

2.0000%

3.0000%

4.0000%

5.0000%

6.0000%

7.0000%

8.0000%

9.0000%

10.0000%

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%

SIZE OF LOSS AS A PERCENTAGE OF PORTFOLIO VALUE

PROBABILITY OF LOSS GREATER THAN X%

[1] Based on long-run average historic default loss rates from Moody’s and S&P annual reports published in February 2003.

[2] The diversity score is an idea used by Moody’s for rating portfolios. A lower number means less diversity so it is a useful statistic for comparing portfolios. A portfolio may contain many different bonds but these might be issued by the same company, companies with common parents or companies in closely related industry sectors. The diversity score reduces the number of bonds to a number of bonds that are independent (except for common reliance on the global macro-economic environment).

Example Broad Investment Grade PortfolioNumber of bonds 57Portfolio Value £900mCredit Spread (duration w'td) 101Average Mod. Dur 10.4Average Default Probability 0.199%Diversity Score 43

Summary of Benefits of Swaps

Risk reduction through the ability to tailor asset proceeds to meet liabilities

Only realistic way of obtaining LPI assets

Only realistic way to achieve a cash flow match to expected benefit payments

Separates asset and liability management allowing potential for more efficient management of asset portfolio

Potential for higher expected returns

Counter-Party Risk Swap contracts introduce counterparty risk to the pension scheme

This is the risk that the bank counterparty defaults while owing money to the pension scheme under the contract

Counterparty risk can be mitigated by collateralisation – I.e calculating the mark to market exposure and passing collateral between parties to hold in the event of default.

Reduces the counterparty risk effectively to nil

This process is similar to margin calls on exchanged traded futures and options – collateralisation can be done daily if required

Summary

Pension Scheme switches have put the corporate bond market under pressure recently

Continued issuance and return to government issuance will help alleviate capacity somewhat

Capacity constraints are most acute in inflation-linked assets

The Swaps market is far bigger than the corporate bond market and offers significant benefits for pension schemes

A particular area of benefit is in matching inflation-linked liabilities, particularly LPI