investment strategy for pensions reflecting covenant...

Investment Strategy for Pensions

Reflecting covenant strength in investment strategy

Paul Thornton OBE & Simon Willes

Gazelle Corporate Finance

14 May 2014

What this presentation covers

• Why covenant is important

• Problems with current approaches

• Integrated risks solution

• Implications for setting investment strategy

• Regulatory focus

14 May 2014

Why covenant is important

Funding Target

Affordability?Default risk?

Return-seeking assets

Sponsor Contributions

Ability to withstand negative outcomes?

Funding sources Potential covenant issues

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Can covenant be ignored if the sponsor is strong?

• 85% experienced major

transactions

• 26% experienced

“financial stress”

• 7% defaulted

0% 20% 40% 60% 80% 100%

Takeover

Demergers /restructuring

Mergers

FTSE 100 1985-2010 : Corporate activity analysis

% of FTSE 100 with corporate activity No activity

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ALM models and contributions

• Recovery plan contributions are assumed to be paid

• Nil contributions stress test?

• No allowance for uncertainty of sponsor resources

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VaR and contributions

• VaR presents a “deficit” resulting from adverse investment outcomes

• Can VaR be repaired with additional contributions?

• If not then we experience sponsor default or scheme default

• These expose a scheme to losses

• Is there a value for additional contributions?

• Current equity market value?

• Ignores uncertainty, correlation between investment returns and

sponsor covenant

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The solution is modelling sponsor financial resources stochastically

• Net cash flow modelled stochastically

• Overlaying the risk of sponsor default

• Reflecting the legal structure of covenant support

• Compare stochastic sponsor resources with recovery plan

• Expected contributions reflect affordability and default risk

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Scheme funding outcomes now reflect interacting risks

• We examine metrics which reflect this:

• the probability of reaching a scheme funding target over time

• monetary measures of scheme loss resulting from sponsor default

and scheme wind-up outcomes

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Probability of reaching funding targets

Probability of Solvency Funding 73.1%

Within 20 years 60.3%

Probability of Sponsor Default 21.6%

Probability of Scheme Default 5.3%

Prob. of TP funding within 10 years 68.4%

Illustrative outputs and metrics from Mousetrap®

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0%

10%

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100%

5 10 15 20 25 30 35 40 45 50

% o

f S

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d S

ch

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es

Year

Development of funding outcomes

Sponsor Default % Scheme Default %

Solvency Funding % Remain %

Rating Agency Default %

Analysis of loss distribution


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Covenant Risk Value (£m) 21.6

Loss due to Sponsor Default (£m) 19.1

Loss due to Scheme Default (£m) 2.5

Average loss given default (£m) 80.3

“Weighted” CRV 35.2

9.4%

6.5%

4.0%

3.0%

2.3%

1.6%

0.1%

0.0%

1.0%

2.0%

3.0%

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10.0%

0-40 40-80 80-120 120-160 160-200 200-240 240-280

% o

f S

imu

late

d S

ch

em

es

Unrecovered S75 Debt (£m)

Range of unrecovered S75 debt

Integrated Risk Modelling provides new insights

• A more prudent and realistic view

• Information is in a form Finance Directors can relate to

• Valuable new information is accessed:

• A wide range of sensitivities

• Correlation between sponsor resources and investment outcomes

• Affordability of contributions

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Measuring the impact of correlation

0.0%

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12.0%

0-40 40-80 80-120 120-160 160-200 200-240

% o

f S

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d S

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em

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Unrecovered S75 Debt (£m)

Range of unrecovered S75 debt No Correlation Low Correlation High Correlation

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10.0%

15.0%

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25.0%

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Coverage Ratio (NCF/Contribution)

Probabilistic coverage ratioAfter 1 year

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Probabilistic coverage ratioAfter 1 year After 4 years

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Probabilistic coverage ratioAfter 1 year After 4 years


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Measuring the affordability of contributions

The connection is now established between covenant & investment strategy

• Using these integrated risk metrics the scheme loss exposure can be examined for any given investment strategy

• This provides an independent cross-check on the appropriateness of investment strategy given the strength of sponsor covenant

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Measuring the impact of changes in investment policy

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100%

Av

era

ge l

oss (

£m

)

Pro

bab

ilit

y

Holding in return-seeking assets

Impact of investment policyProbability of solvency funding

Average loss given default (£m)


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25.0

30.0

35.0

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45.0

50.0

Weig

hte

d C

RV


Impact of investment policy on (weighted) Covenant Risk Value


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25.0

30.0

35.0

40.0

45.0

50.0

Weig

hte

d C

RV


Impact of investment policyBase case Low Correlation Stronger sponsor affordability

Our findings from using IRM so far

• Covenant strength is an important “scheme asset”. How is it best used?

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To support investment risk exposure

• Sponsor can deal with poor investment outcomes

To facilitate de-risking

• Less risk from a prolonged path to self-sufficiency

Our findings from using IRM so far

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• Covenant weakness presents issues for investment policy as the proportion of benefits members can expect to receive may be low

• Does de-risking reduce or increase loss exposure?

• Can suitable pension credit enhancements facilitate investment

risk exposure?

A key area for regulatory focus

• TPR review letters now regularly question consistency between investment strategy and covenant

• Need to measure the ability of sponsors to repair large potential deficits and “evidence” this

• Risk management reports under IORP II

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Two illuminating examples

• Scheme A: fully-funded on a Technical Provisions basis, fully de-risked but dependent on parent of weak UK formal sponsor to achieve solvency funding or buy-out and still exposed to material unrecovered S75 debt on sponsor default.

• Scheme B: high equity exposure consistent with strong multinational parent but UK formal sponsor unlikely to be able to repair poor investment outcomes

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Example Case Study

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• TPR questions sponsor ability to withstand adverse investment outcomes

• Methodology:

• ALM provides expected investment outcomes

• Mousetrap ® provides matching expected contributions reflecting uncertain sponsor financial resources and covenant support structure

• Integrate ALM and Mousetrap ® to give simulated funding outcomes with correlation

• Resulting scheme loss exposure represents simulations the sponsor was unable to repair

• Examine using statistical measures

• Examine poor investment and poor sponsor scenarios

Interacting risks require integrated solutions where covenant advice and investment consultancy combine

Covenant is a complex risk - if integrated with ALMs it must be properly modelled with full access to detailed covenant input

14 May 2014

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