Transcript Aspects of Risk

Aspects of Risk
Risk Management Within The Investment Portfolio
September 28, 2011
© 2011 Towers Watson. All rights reserved.
Conference Logistics


This conference is being recorded.
If you would like to submit a text question during today’s presentations, please click the
question mark icon located on the floating tool bar in the bottom right of your screen. This
will open the Q&A panel. Next, type your question in the space at the bottom and click
the Send button. Please be sure to direct your questions to all Panelists. Your questions
can not be viewed by other attendees and will be addressed during the Q&A session at
the end of the webcast. Please keep in mind that we will respond to as many questions
as possible at the end of this webcast. We will follow up individually on any questions that
we don’t get to today.

If you would like to toggle between fullscreen mode and meeting mode (to send
messages or submit questions), you may do so by clicking on the curved arrow on your
floating panel.

If you experience technical difficulty during this event, please contact WebEx tech support
at 866 229 3239. International attendees should call +1 408 435 7088.

The presentation and a replay will emailed to participants on September 30, 2011.
towerswatson.com
2
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Today’s Presenters

Jon Pliner, Investment Strategy Consultant

Mark Ruloff, Director of Asset Allocation
towerswatson.com
3
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Today’s Discussion

Opening Thoughts

Payout/Liability Hedging

Better Diversification

Risk Steering

Risk Pricing

Long-Termism Risk Return Concepts

Beyond Investment Policy

Closing Thoughts
towerswatson.com
4
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Opening Thoughts

Holistic

Many tools beyond diversification and liability hedging

Risk return management
towerswatson.com
5
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Standard Efficient Frontier
Illustrative Efficient
Frontier
9%
8%
Most
Desirable
7%
6%
70% 60%
5%
4%
90%
80%
Efficient Frontier
Point Labels represent % fixed income
100%
3%
12%
towerswatson.com
13%
14%
50%
10% 0%
20%
40% 30%
15%
16%
17%
18%
19%
6
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Asset/Liability Efficient Frontier
XYZ Retirement Plan
Asset/Liability Frontier - Year 2020
($375)
PV Contributions + PBO Deficits/(Surplus) ($M)
50th Percentile
Most
Desirable
0% LGC
10% LGC
With Surplus
20% LGC
30% LGC
($225)
40% LGC
50% LGC
60% LGC
($75)
70% LGC
Without Surplus
80% LGC
90% LGC
$75
$225
$125
towerswatson.com
$275
$425
$575
$725
PV Contributions + PBO Deficits/(Surplus) ($M)
95th Percentile
$875
7
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Liability Hedging
$175
Asset/Liability Frontier - Year 2019
Desirable
Cumulative PV of Plan Year Contributions ($M)
50th Percentile
$200
$225
$250
$275
$300
$325
$250
$275
$300
$325
$350
$375
$400
$425
$450
Cumulative PV of Plan Year Contributions ($M)
95th Percentile
towerswatson.com
8
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
An Eventful Couple of Months
Consumer confidence indicators
120
0
US (LHS)
Eurozone (RHS)
-5
100
-10
Recent signs of slowing economic growth in the developed
world have led to falling bond yields and a sharp sell off in
equities
80
The USD has strengthened against many currencies,
reinforcing it’s “safe haven” status
40
-15
60
-20
-25
-30
20
-35
0
Jan-07
Dec-07
Nov-08
Oct-09
-40
Aug-11
Sep-10
Sources: Thomson, Towers Watson
Speed of global rebalancing
(EM policy choices)
Fast
(EM FX appreciation)
Slow
(EM inf lation, DM def lation)
High
(Fiscal stimulus,
high market liquidity)
This in turn has led to rising uncertainty and increased
market volatility, consistent with our “Bumpy Path with Slow
Recovery” central scenario
Public policy
and financial
conditions
EM Overheating
High DM
inflation
High
DM
growth
Bumpy path
with slow
recovery
DM
sovereign
debt
crisis
(DM policy choices)
DM Deflation
Low
(Fiscal austerity,
tight market liquidity)
towerswatson.com
Global growth
slowdown
EM: Emerging Markets DM: Developed Markets
9
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Government Bonds
Bond Yield Curves (As of August 31, 2011)
4.5
US
4
UK
Despite low absolute yield levels, the long end of the curve
implies a normalization of cash rates in line with our outlook
for anaemic economic growth in the US and Europe
Percent (%)
3.5
Euro (Germany)
3
Japan
2.5
2
1.5
1
0.5
0
1
5
10
15
20
25
Source: Bank of England, Deutsche Bundesbank, Federal Reserve, Bank of Japan
Global Markets Overview
Global Investment Committee, September 2011
In this issue
Though moderately unattractive versus cash, yield curves
still support hedging long-term liabilities
2
The outlook for EM equities
4
Summary of market views
Asset allocation in volatile
times. What now?
•
Valuations of risky assets fell sharply in early August. In a “normal” business
cycle current market levels (especially global equity markets) would look
attractive, supported by a new global easing cycle in reaction to the current
broad-based economic slowdown.
•
However, the high debt levels and deleveraging needs in developed countries
that are constraining governments and households and weakening conditions
have important structural elements. This is not a “normal” cyclical/liquidity
environment and a sustainable solution for growth and jobs requires both
money printing on the monetary side and specific structural reforms (eg public
finance reform in Europe and housing reform in the US) on the fiscal side.
•
Recent mediocre growth rates in the developed world and a necessary
slowdown in over-capacity emerging economies have been an important driver
of falls in risky assets. However, economic and financial outcomes remain
highly dependent on policymakers and politicians, especially in the euro area.
This will continue in the short-term, keeping investor sentiment fragile and
market volatility high.
•
When thinking about asset allocation it is important to balance perceptions of
value against a forward-looking view of the macro risks. Our central outlook is
still for policymakers to adopt a gradualist approach to addressing the
headwinds undermining economic growth and jobs and avoiding the very bad
economic and market outcomes. Nevertheless, there are still significantly
more positive and more negative risk scenarios that are plausible based on
policymakers boldly addressing the structural problems or failing to address
Towers
Watson and Towers Watson client use only.
sovereign, bank or household solvency concerns. Moreover, these policy
actions are very difficult to predict accurately.
5
World markets statistics
6
Notes
10
towerswatson.com
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For
Figure 01. Our current views
Modest opportunities due to recent moves,
relative to cash
•
While risky asset valuations are moderately attractive, we do think them
Diversified Portfolio: Risk/Return Buckets
Source of returns as a percentage of total return
The typical portfolio
includes some
diversification….
Typical portfolio
Well diversified portfolio
Skill risk premium
Insurance risk premium
…but equities still
dominate returns (and
risk)
Skill risk premium
Equity risk premium
In building a diversified
portfolio, it is therefore
important to think about
sources of return and
risk, rather than asset
allocation
Equity risk premium
Inflation risk premium
Inflation risk premium
Credit risk premium
Term risk premium
towerswatson.com
Credit risk premium
Term risk premium
11
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Sample DB Pension Fund
Traditional
Unconstrained
Emerging wealth
Private markets
Alternative beta
Emerging wealth
Private markets
Alternative beta
Developed equities
Developed equities
Alternative credit
Corporate bonds
Corporate bonds
Treasuries and cash
Treasuries and cash
Liability hedging overlay
Hedge funds
Source: Towers Watson
towerswatson.com
12
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Equities
Most markets look attractive based on simple valuation metrics
12-month forward PE (X)
30
25
20
A sharp sell off leaves equities moderately attractive, albeit
with significant downside risks given the large macro risks
the economy faces
15
11.9
11.4
10
10.5
9.0
5
0
Euroland
US
Asia x Japan
Japan
Sources: Bloomberg LP, Towers Watson
Markets have failed to rally significantly from the August lows
Index, 31/12/10 = 100, last data point 2/9/11
110
105
100
Emerging equities look attractive to developed equities given
recent performance and long term outlook for growth
95
MSCI World, -9% YTD
90
MSCI EM, -11% YTD
S&P, -5% YTD
85
80
Jan-11
FTSE Eurotop300, -13% YTD
Feb-11 Mar-11
Apr-11
May-11
Jun-11
Jul-11
Aug-11
Sep-11
Sources: Bloomberg LP, Towers Watson
towerswatson.com
13
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Combined: PV of Cumulative Contribution + TL Deficit ($M)
50th Percentile
Sample Analysis of Dynamic Asset Allocation:
Cumulative Contributions plus Deficits
Asset/Liability Frontier
Year 2019
$200
6%
8%
4%
10%
$210
2%
12%
4%
6%
14%
16%
2%
8%
20%FI (LGC)
30%FI (LGC)
18%
10%
12%
$220
14%
50%FI (LGC)
20%
22%
24%
28%
40%FI (LGC)
26%
30%
16%
18%
22%
24%
$230
$320
towerswatson.com
$330
20%
26%
28%
30%
$340
$350
$360
$370
Combined: PV of Cumulative Contribution + TL Deficit ($M)
95th Percentile
$380
14
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Risk Steering


Dynamic Asset Allocation

Separating funded status trigger into interest rates, returns, and contributions

In declining markets
Enterprise Risk Management


Compare investment portfolio options with core operations
Consideration of investments compared to core business risks

Sponsor Beta

Commodities

Inflation

Cash contributions
towerswatson.com
15
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Collared vs. Uncollared Domestic Equities: Annual
Return
75th %ile – Collar
800
700
75th %ile – no Collar
600
Frequency
500
400
95th %ile – Collar
300
95th %ile – no Collar
200
100
73%
69%
65%
61%
57%
53%
49%
45%
41%
37%
33%
29%
25%
21%
17%
13%
9%
5%
1%
-3%
-7%
-11%
-15%
-19%
-23%
-27%
0
Amount
65% Fixed Income - no Collar
towerswatson.com
65% Fixed Income with Collar
16
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Development of Liability Hedging Elements
Basis points
30 yr Swap spread over Treasury
200
150
100
50
Approach is often to obtain the appropriate hedge for a
certain risk exposure at the cheapest possible price
0
-50
-100
Jun-92
Jun-95
Jun-98
Jun-01
Jun-04
Jun-07
Jun-10
Sources: BarCap, Towers Watson
However, markets are complex and we expect negative swap
spreads to continue to persist in the near-term
We outlined rationale for our view in a note to clients earlier
this year
towerswatson.com
17
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Risk Pricing

Puts, calls, and collars

Swaps, Swaptions, and Swaption collars

Generally would be a loss of value if done always and passively

Requires good governance to know when to use and how to implement

Could depend on connection with enterprise risks

Put on swaption to avoid “unbearable” situation, like breaking of bond
covenants
towerswatson.com
18
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Long-Termism Risk/Return Concepts in Model Portfolio

Risk framework

Risk return framework

Risk return management, not just measurement

Long-term risk return management framework

Risk scenarios

Theme investing

Extreme risks
towerswatson.com
19
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Sustainability
Universal
Owner
Social and
Environmental
Goals
Return Goals
Sustainable
Investing
Risk
Management
Goals
towerswatson.com
20
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Beyond Investment Policy
FUNDING
STRATEGY
BENEFIT
STRATEGY
Effective at managing short-term
plan cost and volatility
Effective at managing active
liability risk profile and long-term
plan cost
Pension
Risk
INVESTMENT
STRATEGY
Effective at managing long-term
plan cost and volatility
towerswatson.com
ASSUMPTIONS
& METHODS
Effective only for short-term
issues
21
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Closing Thoughts

Holistic

Many tools beyond diversification and liability hedging

Risk return management
towerswatson.com
22
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Questions
towerswatson.com
23
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Disclaimer

The information included in this presentation is general information only
and should not be relied upon without further review by the appropriate
professional advisors. Towers Watson is not a law firm or accounting
firm, and we are not providing legal, accounting or tax services or
advice. Some of the information included in this presentation might
involve the application of law; accordingly, we strongly recommend
that audience members consult with and involve their legal counsel and
other professional advisors as appropriate to ensure that they are fully
advised concerning such matters. Additionally, material developments
may occur subsequent to this presentation rendering it incomplete and
inaccurate. Towers Watson assumes no obligation to advise you of any
such developments or to update the presentation to reflect such
developments.
towerswatson.com
24
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Contact Details

Jon Pliner




335 Madison Avenue, New York, NY 10017-4605
212-309-3811
[email protected]
Mark Ruloff



901 N. Glebe Road, Arlington, VA 22203
703.258.8058
[email protected]
towerswatson.com
25
© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.