Breaking Down the Barriers to Hedging Speaker | Calum Mackenzie

Agenda Understanding your risks Why is it important to hedge interest rates and inflation? Overcome the barriers to hedging scheme size complexity of the investment tools; affordability and the need to invest in return seeking assets; and market conditions 2

Understanding your biggest risks ? Focus trustee governance on the biggest risks Equity marketManagerInterest rateInflationLongevityCovenant We believe schemes should be hedging at least 70% of interest rate and even more inflation risk But on average pension funds hedge around 30% Small changes can change liabilities by £, millions 3

Why is it important to hedge interest rates and inflation? What happens when interest rates fall by 1.0%? A Starting position £m Funding level: 95% L A Consider a scheme invested 50% equities and 50% bonds… Without hedging £m Funding level: 79% L A £m Funding level: 95% With hedging L A Small changes can have a major impact on funding! 4

The barriers to hedging Aon Hewitt 2013 Global Pension Risk Survey: “51% of small and 35% of medium sized pension funds have no hedging policy” BarrierCan it be overcome? Size Complexity Cost Affordability Yields are too low There should be no barrier so significant that pension funds cannot manage their biggest risk 5

Overcome barriers – scheme size  Pooled funds are now available to implement liability risk management strategies through many of the fund managers currently used for passive bond mandates  As the use of pooled funds has become more common, the costs have reduced.  As with a typical pooled fund, the manager will arrange the purchase of the necessary contract(s) in line with your investment requirements. Generate LIBOR Pension Fund IMA Investment Manager Invest assets Pooled Fund Pooled funds and standardise documentation mean all schemes can access risk management tools For illustrative purposes 6

Overcome barriers – complexity  Hedging will become the most important component of pension scheme portfolios  Such strategies don't have to be complex and confusing  Focus on big issues – why hedge, what tools work and what could go wrong?  The risks of not hedging are much greater than risks associated with LDI strategies  There are other governance options to implementing solutions such as delegation Complexity can be overcome by trustees with the right support “LDI now covers £446bn of liabilities, an 11 percent increase over 2012 with 686 UK pension scheme mandates now employing LDI” KPMG 2013 LDI Survey 7

Looking pricey, even if profit margins were maintained 8 The hedge level can be addressed without altering return seeking assets Inflation Hedge Rates Hedge Deficit Inflation Hedge Rates Hedge, Diversified Portfolio of Growth Assets Deficit, Liability Driven Investment Diversified Portfolio of Growth Assets Bonds 8 Overcome barriers – affordability

9 20 year duration gilt yield Overcome barriers – market conditions Gilt yields moved much higher in 2013

Overcome barriers – market conditions Gilt yields are projected to go beyond 4% in the next 3 years.. this no longer looks too low… Inflation pricing has improved relative to long-term expectations (blue line v orange line), so looks a reasonable time to hedge inflation risk too… These yield levels are over 4%, which is a much better level than a year ago! Market Inflation Prices Versus Us Now is an appropriate time to consider increasing interest rate and inflation protection 10 How High Will Gilt Yields Go? (20 year duration gilt yields expected in the market) 3.40% 3.50% 3.60% 3.70% 3.80% 3.90% 4.00% 4.10% 4.20% 4.30% CurrentIn 1 YearIn 3 yearsIn 5 years These yield levels are over 4%, which is a much better level than a year ago!

Next steps Understand and quantify the risks your scheme is exposed to. Understand the impact further interest rate and inflation hedging can have on your scheme. Training on liability risk management tools Get hedging! 11

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