Liability Surrogates WorkshopNick Spencer, Director, Client Strategy & ResearchCrispin Lace, Director, UK Pension Solutions

6 MARCH 2013

Imagine the perfect retirement investment

Imagine the perfect retirement investment II Arguably, the perfect investment for a pension fund would be:• highly secure

• inflation-linked long term cashflows,

• matched to their future pension payments,

• and rates above government bonds

even if the returns were expected to be below equities.

Sloth Alert... Are we just being lazy?

Today’s workshop: Liability Surrogates

WHAT ARE LIABILITY SURROGATES?

WHY ARE THEY OF INTEREST?

WHERE DO THEY FIT?

WHAT ARE THE ISSUES?

What are Liability Surrogates?

A steady contractual stream of future cashflows

An income based return

A return premium to compensate for illiquidity

Some inflation hedging (typically real assets)

What are Liability Surrogates?

Value

Time

Assets Liabilties Asset f lightpath Liability f lightpath

Why are they of interest?Liabilities above flight path, assets below – wrong type of outcome!

Rates lower, longer: liabilities remain above flight path

Longer flight paths: refocusing on growth & risk-efficient returns

Source: Russell Investments: For illustrative purposes only, Asset proxy - Russell UK index, Liability proxy – 40% FTSE Actuaries Govt. Securities over 15 Years, 60% Actuaries Govt. Securities UK index linked over 15 Years, data from Jan 2007 to Dec 2012

I’m underfunded: get me out of here!Getting real on the yield you need

Source: Russell Investments, Bloomberg , data from 31/05/1981 – 14/02/2013

LIABILITY HEDGING

Where do they fit?Have we created an artificial divide in the portfolio?

• Hedge embedded interest and inflation exposures• Hedge or not-hedging is active choice• Gilts, futures or swaps

• Seek additional returns• LIBOR+• Maximise return/marginal risk• Duration adds to portfolio risk

GROWTH ASSETS

LIABILITY SURROGATESA third way? Modest additional return,

but low risk to liabilities.

What are the issues?

A. CAN WE MAKE THE SAME MONEY IN 7 YEARS?

B. VALUATION...BY ANY OTHER NUMBER

C. INVESTING FOR THE LONG TERM

D. RISING ABOVE THE NOISE

E. RISK: WHAT RISK?

A. Can we make the same money in 7 years?Better than over 25 years?

7 year opportunity, 6% premium and then match

Represents 1.6% premium for 25 years

Is 7 years the better choice?

It is NOT the same but should be considered!

B.Valuation...by any other numberImagine an asset which was guaranteed to give exactly matching cashflows over the next 25 years.

What’s the value to:

And then there are different allowances for risks, costs orapproximations!

• a private equity manager• an accountant

• an economist • an actuary

C. Are we used to investing for the very long term?

Almost no one invests simply for the long term...even a long term manager is looking for factors that in 3 to 5 years time will make a long term asset look more attractive than it does today enabling them to sell the asset at a premium to today's price.

—Overheard

For illustrative purposes only

http://boundarylaunderette.wordpress.com/boundary-estate-a-history/

1880’s Slum

1890’s Rebuild: Semi-professionals,

rising

1950’s Declining

1970’s Derelict2010’s Young Professionals

Circle of Life: Shoreditch estate - Arnold Circus

What’s that noise...

D. Rising above the noise: back to basicsAIMS OF LIABILITY SURROGATE

To harvest excess returns • of series of long term cashflows

• illiquidity providing most of excess return, not credit or investment risk

• ideally with strong link to inflation

Need to test each proposition against these aims

E. Risk: What risk? Discovering potential flawsCaution & humility

• Long term

Risk Perception• “Ability and willingness”

Credit (skew) risk • Little up & long way down

Beware balloons • Especially real ones

Selling availability• Will anyone want in when you want out?

Asset allocation funds• Most available vs most attractive?

Costs and feeses spread dis-eases

Long term lock up vs attractive shorter term vehicles

Quality of inflation linkage

Investment (manager) selection

3 examples of potential Liability SurrogatesSOCIAL HOUSING

STUDENT ACCOMMODATION

GROUND RENTS

Note: Examples of properties in this presentation are sourced from managers such as AEW, Aviva, Axa & IFM.  These are for illustrative purposes only, some details have been altered and they do not represent endorsement for a particular deal or manager.

Social Housing: Example• Heavily regulated sector,

well established entities

• Deep need for financing: much reduced access to banking capital

• Available in £10 - £50 m sizes

• Inflation plus structures

PROPOSAL FOR 50 YEAR SALE & LEASE BACK; NET ILG + 2.5%

Illustrative purposes only, please see notes on slide 19.

Student Accommodation: Example• Student numbers up by 27% from

2000 - 2010

• Accommodation not kept pace

• Sizes: £10m – £150 m

• Often a squeeze on rents especially in town based universities

PROPOSAL FOR FREEHOLD WITH REVERSION AFTER 45 LEASE; ILG + 2.5%

Illustrative purposes only, please see notes on slide 19.

Ground Rents: Example• Ground Rents existed for 400+ years

• Small payment; extreme loan value – delays occur but forfeit effectively not going to happen

• Active secondary market

• Size £1m - £20 m

• Historic ground rents nominal increases

PROPOSAL FOR 125 LEASE; NET ILG + 3.0%

Illustrative purposes only, please see notes on slide 19.

Infrastructure Debt: Example• Infrastructure has attractive long term,

inflation-related features

• Debt provides tighter return distribution & asset backing

• Nascent UK/Europe but huge potential and large deals £50 m - £1 bn+

• Broad range of asset choice

PROPOSAL FOR 25 YEAR ASSET BACKED LOAN; NET ILG + 2.0%

Illustrative purposes only, please see notes on slide 19.

Long Lease: Example• Long leases (20+ years) provide long

term visibility of cashflows

• High quality tenants, inflation related businesses

• Inflation linked cashflows: direct and indirect linkage

• Sizes £5 m to £100 m

PROPOSAL FOR 25 YEAR SALE

AND LEASEBACK

NET 4.4% Cap/collared annual RPI

Illustrative purposes only, please see notes on slide 19.

Liability SurrogatesExist!

Provide elements of both growth and matching assets

Beware the bandwagon

Scrutinise carefully• AAA investment for long term is hard

Consider alternatives• Shorter term or as part of growth portfolio

But getting there takes real workBeware the sloths...because life’s not a beach

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