2009 Annual Meeting ● Assemblée annuelle 2009Halifax, Nova Scotia ● Halifax (Nouvelle-Écosse)

Canadian Institute

of Actuaries

L’Institut canadien desactuaires

Christian-Marc Panneton2009-06-25

WS-30 LDI for Pension Plans:Moving from Theory to Practice

AT-30 Les placements fondés sur les passifs pour les régimes de retraite:

de la théorie à la pratique

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LDI for Pension Plans• Agenda

• Liabilities• Interest Rate Risk• Credit Spread Risk• Risks• Management Process• Conclusion

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Interest Rate Risk• Objective: Mitigate interest rate risk

• 1st Step: Determine risk exposure– Duration is a simple metric

• A single number indicating sensitivity to interest rate changes

• Duration gap between assets and liabilities

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0 5 10 15 20 25 30 35 40 45 50

Retirees Cashflows

Interest Rate Risk– Need liability characteristics– Typically monthly expected CF– Must be updated regularly

• Adjust for actual vs expected

– Case Study: retirees

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PV @ 4.50% = 106,63 millions Duration = 8.50

• Duration – rule of thumb– Given a duration of D, a variation of y in yields will change the value by Dy

• Duration = 8.5, y increases by 1% => decrease of 8.5%

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PV @ 4.50% = 106.63 millionsPV @ 5.50% = 98.23 millions = 7.88%

8090

100110120130

3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0%

PV as function of yield

• Duration metric is not precise– PV is not a linear function

• Convexity– Indicates Duration sensitivity to interest rate changes

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Duration @ 4.50% = 8.50Duration @ 5.50% = 7.92

Convexity @ 4.50% = 132.65

– Expected change in PV– with duration only: - 8.50%– With duration and convexity: - 7.83%

– Actual change: - 7.88%

• Assumptions• Liability duration: 8.50• Funded ratio: 100%

• Traditional 60-40% Mix• Equities Duration: 0• DEX Universe Duration: 6.57 (2007-12)• 60%-40% Mix Duration: 2.63

– Impact of a decrease in yield of +50bps• Assets increase by 1.32%• Liabilities increase by 4.25%• Funded ratio decreases to 97.07%

Case Study20

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Material interest rate risk with Traditional 60-40% Mix

• Using Long-Term Bonds• Equities Duration: 0• DEX Long-term Duration: 12.61 (2007-12)• 33%-67% Mix Duration: 8.45

– Impact of a decrease in yield of +50bps• Assets increase by 4.23%• Liabilities increase by 4.25%• Funded ratio almost unchanged! (99.98%)

Case Study20

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Taking into account the liability’s CF duration in selecting assets can reduce exposure to interest rate changes.

• Not So Easy!– From Dec. 31, 2008 to March 31, 2009

• TSX Total return: 2.0%• DEX Universe: + 1.5%• DEX Long-term: + 0.3%• Solvency liability: 1.5%• Liability valued with Canada yield curve: 0.3%• CF Matching Liability (AA yield curve): + 4.4%

– From Sep. 30, 2008 to Dec. 31, 2008• TSX Total return: 22.7%• DEX Universe: + 4.5%• DEX Long-term: + 5.2%• Solvency liability: + 3.2%• Liability valued with Canada yield curve: + 8.9%• CF Matching Liability (AA yield curve): 4.8%

Case Study20

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Case Study20

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Assets (at market) Stocks TSX Total Return Bonds DEX Universe DEX Long-term

Solvency Liability

Funded Ratio

Sep 30, ‘08

60.0

40.0 -

100.0

100.0

100.0%

Dec 31 ‘08

46.4

41.8 -

88.2

103.2

85.4%

Mar 31 ‘09

45.5

42.4 -

87.9

101.7

86.5%

Sep 30, ‘08

33.0

- 67.0100.0

100.0

100.0%

Dec 31 ‘08

25.5

- 70.5 96.0

103.2

93.0%

Mar 31 ‘09

25.0

- 70.7 95.7

101.7

94.1%

60-40% Traditional Asset Mix 33-67% Alternative Asset Mix

Taking into account the liability’s CF duration in selecting assets did reduce exposure to interest rate changes!

Case Study• Solvency Liability

– Based on a single rate:• Canada over 10-years bond + spread

– Doesn’t capture full yield curve dynamic

• Better Approach to Risk Management– Consider the complete yield curve

• Start with the Canada Bond yield curve• Bootstrap to get spot curve…

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Case Study• Partial Duration

– Measure the sensitivity of change in yield for a given maturity– Sums to duration (2008-12-31)

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1 0.003 0.006 0.01

12 0.0524 0.1036 0.1548 0.1960 0.3584 0.72

120 0.82144 0.88180 1.38240 2.06360 2.15

Total 8.86

Term (months)

Partial Duration

Low sensitivity to short-term rates

High sensitivity to long-term rates

Case Study• Evolution Canada Yield Curve

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0.00%0.50%1.00%1.50%2.00%2.50%3.00%3.50%4.00%4.50%5.00%

0 5 10 15 20 25 30

Canada Bonds - Yield Curve

2007-12-31

2008-09-30

2008-12-31

2009-03-31

• From Dec 07 to Sep 08• Large short-term rates decrease dominates => +0.3%

• From Dec 08 to March 09• Long-term rates increase dominates => 0.3%

Case Study• Yield Curve for Liabilities

– Investment Policy: Assets allowed– Based on Target or Benchmark portfolio– Provincial spreads vs Canada

• Ontario spreads increased by 47bps in Q4 2008

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0.0%0.2%0.4%0.6%0.8%1.0%1.2%1.4%1.6%1.8%2.0%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Credit Spreads - 10-years Bonds

Quebec 10 yrsOntario 10 yrs

Case Study• Yield Curve for Liabilities

– Spreads on Corporate raised even more in 2008• Ontario spreads increased by 93 bps• A-rated Corporate spreads increased by 305 bps

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0%

1%

2%

3%

4%

5%

6%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Credit Spreads - 10-years Bonds

Quebec 10 yrsOntario 10 yrsAAABBB

Case Study• Credit Spread Risk

– Can be more material than interest rate risk– From Sep ‘08 to Dec ’08

• Canada curve decreased => + 8.9%• Ontario curve decreased by smaller amount => + 4.2%• A-rated Corp. curve increased => 5.5%

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0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

0 5 10 15 20 25 30

Yield Curves from Sep '08 to Dec '08

Can 2008-09-30 Ont 2008-09-30 A-rated 2008-09-30

Can 2008-12-31 Ont 2008-12-31 A-rated 2008-12-31

Liability

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

0 5 10 15 20 25 30

Yield Curves from Dec '08 to Mar '09

Can 2008-12-31 Ont 2008-12-31 A-rated 2008-12-31

Can 2009-03-31 Ont 2009-03-31 A-rated 2009-03-31

Case Study• Credit Spread Risk

– From Dec ‘08 to March ’09• Canada almost unchanged => 0.3%• Ontario stepped lightly => 0.2 %• A-rated Corp. curve decreased => + 5.8%

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Liability

Type of Bonds in portfolio can make a huge difference!

Risks• Financial Risks

– Interest rates– Credit spread– Liquidity– Inflation– Market risk– …

• Non-financial Risks– Mortality– New entrants / Turnover– …

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Portfolioconstruction

Development of an investment

policy

Analysis of client’s needs

Optimization

Reports toclients

Portfol io

rebal ancing

Fo l

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LDI - ALM Process

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Portfolio Management• Not “Active” in traditional sense,• Not “Buy-and-Hold” either!

• Decision-making process– Continuous process– Close collaboration between Team members– Assumption testing– Portfolio Decision– Validation

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Portfolio Management• Yield curve analysis and bond pricing

– Internal and External sources– Securities allowed in portfolio: detached coupons, asset-backed securities, asset-backed mortgages, synthetic bonds, corporations (public and private), derivative products, RRB, …

• Buy and Sell decision– Portfolio Rebalancing– Opportunities– Market Events

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Portfolio Management• Portfolio Construction Process

– Objective:• Ensure matching of liabilities according to risk metrics defined in investment policy.

– Steps:• Replication of the benchmark portfolio with a portfolio of zero coupons and/or bonds,• Diversification of fixed income securities (issuers, activity sectors, geographic regions,…),• Credit risk limited (e.g., maximum concentration rules by asset item class, sub-class, activity sector, issuer),• Currency risk must be managed if allowed,• Counterparty risk limited by concentration rules,• Portfolio optimization,• Final portfolio construction.

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Conclusion• Managing the Financial Risks associated with a Pension Liability Requires:

– A very good understanding of the liability financial characteristics.– Risk tolerance limits which reflect the risk appetite of the Pension Plan.– Tools to measure and assess current risk position.– Portfolio managers which can generate added-value within pension plan risk appetite.

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Thank You!

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