Risk Management Solutions: Liability Driven Investment and Beyond

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Risk Management SolutionsLiability Driven
Investment and Beyond
National Bank Financial Group Strictly Private
Confidential
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Agenda

• Pension plan as a portfolio of risks
• Dealing with Investment Risks
• Identify objectives
• Risk Budget
• Optimization
• Minimum Risk Portfolio and Return Portfolio
• Case study
• Dealing with Non-Investment risk
• Conclusion

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Pension plan as a portfolio of risks
Risk
Impact
Funding volatility, Could be diversified
Rewarded Investment Risks
Equity, Credit, Alternatives (Real estate,
Private equity, Infrastructure, Hedge funds,)
Non-Rewarded Investment Risks
Exposure to Interest Rates and Inflation created
by liability specifics
Funding volatility, Could be hedged
Funding volatility, Could be hedged
Non-Investment Risks
Longevity, Legal, Fiduciary, Database
inaccuracies
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Dealing with Investment risks - Identify and
understand objectives

• Frequent objectives
• Pension expense volatility
• Contribution level
• Contribution volatility
• Minimum Solvency/Going Concern Ratio,
• This leads to the Dual Objective Approach

Objectives
Driver
Solutions

• Contribution volatility
• Minimum Funding ratio

Reduce volatility
Increase correlation between assets and
liabilities

• Reduce contribution
• Generate surplus

Increase return
Get the long term risk premium (alpha) of
equities, credit and alternatives
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Dealing with Investment risks - Determine Risk
Budget

• Quantify risks faced by the Pension Plan in terms
  of the predefined objectives with the current
  investment strategy
• Probability of reaching the objectives
• Identify adverse scenarios
• Quantify severity of the loss when objectives are
  not met
• Establish risk limits
• Define acceptable volatility level
• Establish maximum probability of failure
• Identify minimum or maximum contribution level
  and/or surplus level

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Dealing with Investment risks - Optimization

• Minimum Risk Portfolio and Return Portfolio
• Minimum Risk Portfolio (MRP)
• Minimise the undesired and unrewarded risks of
  the assets relative to the liabilities
• Hedge interest rate and/or inflation (more
  difficult!) risk
• Consisting of physical assets (bonds, strips) and
  synthetic assets (swap, futures)
• Helps to achieve the first set of objectives
• Return Portfolio
• Improves long term funding levels
• Used to cover pension fund fees and reduce the
  plans long term contribution level
• Consisting of a diversified range of asset
  classes (traditional and non-traditional)
• Maximize return within risk budget
• Helps to achieve the second set of objectives
• Need to find the proportion X such that
• Overall Portfolio X x MRP (1-X) x Return
  Portfolio

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Dealing with Investment risks - Optimization

• All of the MRP, the Return Portfolio and the
  proportion X will be driven by many factors,
  including
• Long term vs. short term objectives
• Plan dispositions
• Financial situations
• Demographics
• Stakeholders objectives
• Size of the Pension Plan vs. the Company
• Risk tolerance
• Sophistication
• Level of comfort of the Board with derivatives

No one size fits all strategy
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Dealing with Investment risks - Optimization

• Very mature plan
• Low risk tolerance
• Average rated company

Young plan High risk tolerance Very strong
company
Liabilities
Liabilities
Minimum Risk Portfolio
Minimum Risk Portfolio
Return Portfolio
Return Portfolio
MRP Physical portion
MRP Synthetic portion
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Dealing with Investment risks Case study

• Plan Highlights
• Mature DB plan
• Pensioners represent more than 60 of the total
  liabilities
• Initial solvency ratio of 90 (2 B in assets and
  2.2 B of liabilities)
• Benchmark portfolio 55 Bonds and 45 Equities
• Objectives and Risk Budget
• Control the size of potential deficit
• Control funding volatility
• Keep annual contribution below 80 M
• Limit surplus build up
• Maximize probability of the solvency ratio being
  in the 95 105 range

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Dealing with Investment risks Case study
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Dealing with Non-Investment Risk

• Even with a strong investment management process,
  difficult to remove all the risk and duties
• Longevity risk
• Legal risk (lawsuit, e.g. surplus ownership)
• Fiduciary responsibilities'
• The ultimate solutions to de-risk a pension fund
  are
• Annuity purchase
• Expensive
• Limited liquidity in the marketplace
• Partial Solution
• Close the plan
• Not so simple!
• Sell operating business with plan
• Must make business sense
• Buyer may be no better equipped than seller to
  deal with legacy pension liabilities
• Pension Buyout

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Dealing with Non-Investment Risk

• Pension buyout
• Transfer sponsorship to a third party
• A third party takes control of Assets and
  Liability and also takes on all the fiduciary
  responsibilities
• Plan is not terminated, but remains ongoing with
  all legal protections in place
• Removes all the risk
• Investment related
• Non-investment related
• Type of pension plan buyer
• Asset management firm
• Global investment and commercial banks
• Insurance companies
• Nothing yet in North-America but some in Europe
  (UK)

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Dealing with Non-Investment Risk

• Issues concerning Pension Buyout
• Not clear if Pension buyout will be allowed in
  Canada
• Employee/employer relationship?
• Is-it in the participants best interest?
• No clear direction from OSFI, FISCO and RRQ with
  respect to this
• Similar concerns in the US
• JPMorganChase, Citi, Cerberus, and Morgan Stanley
  are among the firms lobbying Washington to let
  them take over and run corporate pension funds
• Recent discussions indicate that legislators
  dont want to change the law
• NBC Solution Virtual Buyout

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Conclusion

• Liability-Driven Investing is not a new
  theoretical concept, just a different approach
• The current environment requires that pension
  plan sponsors improve their risk management
• National Bank offers customized investment
  strategies based on a pension plans unique
  liability profile
• Customized, risk based solutions tailored to the
  individual needs of the client
• Reduced or eliminated pension risk
• Reduced corporate risk exposure and financial
  statement volatility
• More time to focus on running the business
• Comprehensive solution utilizing the vast
  capabilities of National Bank
• Risk identification and measurement, investment
  management, structuring, balance sheet
  capabilities, actuarial expertise
• Capture the value added of comprehensive, market
  leading risk management platform
• Optimization technology, pension expertise,
  capital markets experience