1.  The 2nd Younger Members Convention Use of Swaps in Matching Pension Fund Liabilities Huw Williams 1-2 December 2003 The Glasgow Moat House

2. Using Swaps to Match Pension Scheme Liabilities Agenda n Pension scheme asset allocation – a trend towards greater bond investment n Recent bond market performance – the impact on credit spreads n Structure and capacity of the bond markets nSterling nEuro n How will pension scheme demand be met going forward? n Introduction to swaps n Applications for pension funds nEnhancing investment returns nUsing swaps to meet liabilities n Examples in practice n Risks and other features of the swap market n Summary

3. Pension Scheme Asset Allocation Strategic issues facing pension funds n Reduced scope for risk taking nFunding levels have reduced nSponsoring companies downsizing nIncreased attention from Government, analysts, rating agencies n Increasing focus on “insurance company buy-out solvency” nChanges in the accounting environment – FRS17, IAS19 n Government Action Plan – 11th June 2003 nReduction possible to LPI for future service benefits nOn voluntary wind up full accrued benefits (on insurance company buy out) to be met nInsurance scheme to apply where companies are insolvent. Premiums to be based partly (or fully?) on risk – funding level to determine “riskiness”. n Trustees to be given the right to wind up a scheme where they judge this to be in members’ interests.

4. Pension Scheme Asset Allocation Pensions Protection Fund n Likely mechanics on formal insolvency of sponsoring employer: nBuy-out from an insurer for PPF level of benefits or better nOR if not possible nReceive scheme assets and accept liability for PPF level of benefits n Buy-out basis - How much you would have to pay an insurer to take on liabilities? nImplied yield: gilts – 0.5% (reinforced by emerging actuarial guidance) n Risk-based premium expected - main risk factors are: nCurrent deficit nAsset allocation relative to liabilities nProbability of default of company n But expect a proxy – simplicity and political compromise n US PBGC premium = 0.9% of deficit + $19 per member

5. Pension Scheme Asset Allocation Trend towards a higher bond allocation

7. Factors Influencing Asset Allocation An improvement in funding levels may have an impact?

8. The Impact on Gilt Yields

9. Corporate Spread Performance

10. Euro versus Sterling Market Sterling offers longer maturities n The Sterling market is a long dated market, offering better long matching opportunities for UK pension funds n The maturity of new issues in the sterling market are consistently longer dated the the euro market

11. Euro versus Sterling Market Sterling offers greater access to credit risk n The euro market (£945bn. equiv.) is significantly larger than the sterling market (£258bn.); hence euro market is more liquid n The average credit rating of the sterling market is lower than the euro market; hence sterling offers higher spreads

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

13. How Will Demand Be Met Going Forward? n From increased corporate bond issuance n Government issuance also rising n Greater use of the Euro and Dollar markets n But inflation-linked assets likely to remain a problem n Greater use of the swaps markets is likely to help alleviate capacity constraints both in fixed income and inflation linked

14. The Sterling Debt Market (£bn)  Overall sterling debt supply has increased from £81bn in 2001 to £128bn in 2003, but will stabilise in 2004.

15. Interest Rate Swaps Market Growth

16. Interest Rate Swaps Comparison with UK domestic debt

17. Interest Rate Swaps Tenors  Quotes available out to 50 years  Reasonable liquidity out to 40 years Source: Reuters

18. Introduction to swaps n What is a swap? nSimply an agreement to exchange two sets of cash flows nUsually these are equal in value but different in nature n For example a “fixed for floating” swap nConsider a deposit of £10m paying a floating rate of interest nThe floating cash flows can be exchanged for a specified fixed rate of cash flows applicable for a given period nThis fixed rate is known as the “swap rate” for a given maturity

19. Interest Rate Swap Example BankFund 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

20. Applications for Pension Schemes n Receiving a fixed return is a substitute for a corporate bond return n Achieved by placing funds on deposit and receiving floating cash flows, which are then swapped for fixed cash flows n And the end of the period the Scheme receives a return of principal (by taking the cash off deposit) n Returns are in line with a AA rated bond yield – swaps are effectively a measure of generic bank credit n Flexible instruments as the cash flow proceeds can be tailored to meet the specific circumstances of the fund

21. Different Types of Swap Contract n Cash flows can be structured to meet an investor’s particular needs n For example the swap flows can be tailored to meet specific liability cash flows n An example is where a pension scheme has inflation-linked liabilities, but owns a portfolio of fixed rate bonds n Solution is to enter into an inflation swap: nPension scheme pays fixed flows (as generated by the corporate bond portfolio) nScheme receives inflation linked cash flows tailored to meet the projected liabilities of the scheme

22. Example of an Inflation Swap BankFund RPI-linked cashflows to match pension payments Cashflows generated by bond portfolio. Can be fixed/floating & in any currency RPI-linked pension payments n Buy a diverse portfolio of bonds. This could be sterling fixed income or broader still, e.g. Euros or dollars n Swap the fixed cash flows generated from the bond portfolio for either RPI or LPI linked returns

23. Example Liability Cash flow Graphs

24. Projected Pension Payments Example Liability Profile (Pensioners)

25. Pension Payments Versus Index-Linked Cash Flows

26. Resulting Cash Flow Match After substituting the index linked gilts for the swap

27. Potential for Enhanced Returns n Use of swaps effectively separates the asset and liability management from the investment of the assets n The swap payments to the Scheme can be tailored to meet the liability cash flows which need to be paid n Assets can then be invested independently – Trustees would be free to chose the most appropriate investment strategy without constraint n Hence potential for higher expected returns through: nInvestment in asset classes with higher expected returns (e.g. corporate bonds versus index-linked gilts) nImproved potential for investment manager out-performance

28. 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)* AAA0.56%0.08%0.10%£3.7m AA0.70%0.09%0.14%£4.9m A0.84%0.10%0.27%£7m * Costs include swap transaction costs and purchase of corporate bonds

29. [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 Portfolio Number of bonds57 Portfolio Value£900m Credit Spread (duration w'td)101 Average Mod. Dur10.4 Average Default Probability0.199% Diversity Score43

30. Summary of Benefits of Swaps n Risk reduction through the ability to tailor asset proceeds to meet liabilities nOnly realistic way of obtaining LPI assets nOnly realistic way to achieve a cash flow match to expected benefit payments n Separates asset and liability management allowing potential for more efficient management of asset portfolio nPotential for higher expected returns

31. Counter-Party Risk n Swap contracts introduce counterparty risk to the pension scheme n This is the risk that the bank counterparty defaults while owing money to the pension scheme under the contract n 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. n Reduces the counterparty risk effectively to nil n This process is similar to margin calls on exchanged traded futures and options – collateralisation can be done daily if required

32. Summary n Pension Scheme switches have put the corporate bond market under pressure recently n Continued issuance and return to government issuance will help alleviate capacity somewhat n Capacity constraints are most acute in inflation-linked assets n The Swaps market is far bigger than the corporate bond market and offers significant benefits for pension schemes n A particular area of benefit is in matching inflation-linked liabilities, particularly LPI