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
Sponsor
Contributions
Funding Target
Funding sources
Return-seeking
assets
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Affordability?
Default risk?
Potential covenant issues
Ability to withstand
negative outcomes?
Can covenant be ignored if the sponsor is strong?
FTSE 100 1985-2010 : Corporate activity analysis
• 85% experienced major
transactions
Mergers
• 26% experienced
“financial stress”
Demergers /
restructuring
• 7% defaulted
Takeover
0%
20%
40%
% of FTSE 100 with corporate activity
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60%
80%
No activity
100%
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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Illustrative outputs and metrics from Mousetrap®
Probability of reaching funding targets
Development of funding outcomes
% of Simulated Schemes
100%
Probability of Solvency Funding
90%
Within 20 years
80%
73.1%
60.3%
70%
60%
Probability of Sponsor Default
21.6%
Probability of Scheme Default
5.3%
50%
40%
30%
20%
10%
0%
5
10
15
20
25
30
35
40
Sponsor Default %
Scheme Default %
Solvency Funding %
Remain %
Rating Agency Default %
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45
50
Year
Prob. of TP funding within 10 years
68.4%
Illustrative outputs and metrics from Mousetrap®
Analysis of loss distribution
Range of unrecovered S75 debt
% of Simulated Schemes
10.0%
9.4%
Covenant Risk Value (£m)
21.6
Loss due to Sponsor Default (£m)
19.1
Loss due to Scheme Default (£m)
2.5
9.0%
8.0%
7.0%
6.5%
6.0%
5.0%
4.0%
4.0%
Average loss given default (£m)
80.3
“Weighted” CRV
35.2
3.0%
3.0%
2.3%
1.6%
2.0%
1.0%
0.1%
0.0%
0-40
40-80
80-120 120-160 160-200 200-240 240-280
Unrecovered S75 Debt (£m)
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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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Illustrative outputs and metrics from Mousetrap®
Measuring the impact of correlation
Range of unrecovered S75 debt
No Correlation
Low Correlation
High Correlation
% of Simulated Schemes
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
0-40
40-80
80-120
120-160
Unrecovered S75 Debt (£m)
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160-200
200-240
Illustrative outputs and metrics from Mousetrap®
Measuring the affordability of contributions
Probabilistic coverage ratio
After 1 year
% of Simulated Schemes
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
Coverage Ratio (NCF/Contribution)
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After 4 years
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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Illustrative outputs and metrics from Mousetrap®
Measuring the impact of changes in investment policy
Probability of solvency funding
Average loss given default (£m)
100%
200
90%
180
80%
160
70%
140
60%
120
50%
100
40%
80
30%
60
20%
40
10%
20
0%
0
Holding in return-seeking assets
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Average loss (£m)
Probability
Impact of investment policy
Illustrative outputs and metrics from Mousetrap®
Measuring the impact of changes in investment policy
Impact of investment policy on (weighted) Covenant Risk Value
50.0
Weighted CRV
45.0
40.0
35.0
30.0
25.0
Holding in return-seeking assets
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Illustrative outputs and metrics from Mousetrap®
Measuring the impact of changes in investment policy
Impact of investment policy
Base case
Low Correlation
50.0
Weighted CRV
45.0
40.0
35.0
30.0
25.0
Holding in return-seeking assets
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Stronger sponsor affordability
Our findings from using IRM so far
• Covenant strength is an important “scheme asset”. How is it best
used?
To support investment risk
exposure
• Sponsor can deal with poor
investment outcomes
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To facilitate de-risking
• Less risk from a prolonged
path to self-sufficiency
Our findings from using IRM so far
• 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?
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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 derisked 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
• 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
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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