ADOPTING A RISK CONTROLLED APPROACH TO MANAGING EQUITY ALLOCATION

Situation

A c. £3.5bn closed and mature pension scheme with a weak sponsor covenant faced a deficit of c. £300m on a self-sufficiency basis. The Scheme relies primarily on returns from investment strategy to fund its deficit in the absence of signficant sponsor contributions. The Scheme is therefore highly path dependent and vulnerable to stress events that could throw it off course from its Flight Path.

 

Task

The task was to reduce risk from equities while maintaining returns required for the Scheme's path to full funding. Redington recommended for the Scheme to adopt a risk controlled approach to managing its equity allocation; this way, the Scheme's equity exposure is dynamically managed to achieve a target volatility level. More about Vol Control >

 

Action

Following trustee training and board approval, the trustees moved the equity benchmark to a volatility controlled index with a target volatility of 10% and bought a put option at a strike of 90% on the index. Redington also advised on other key parameters of the structure including implementation vehicle, underlying index and management of currency hedging. The structure was executed by the Scheme's LDI manager with oversight by Redington as a total return swap with an investment bank.

 

Result

 

As a result, the Scheme now manages its equity exposure in a risk controlled way through a target volatility of 10%. Equity risk was reduced by two thirds (from c. 30% to c. 10% of notional equity exposure), downside risk was decreased by buying explicit protection at affordable levels while maintaining the path to full funding. The Scheme also diversified its portfolio further through this project, allocating to different risk factors such as credit, illiquity, and insurance risk by reducing relative equity risk.

 

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