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Parameter uncertainty – what is the central scenario? A key assumption in our projection of the traditional strategy was the assumed excess equity return over gilts or “equity risk premium”. In fact, it takes about 100 years of reliable data to estimate the equity risk premium to within +/- 2% p.a. with two-thirds confidence.
Furthermore, the impact of this parameter grows as we increase the projection period and, in any event, it is not necessarily constant over time! To put this in context, a 2% p.a. downwards shift from assump- tion to reality reduces the expected proceeds from equity disinvestment in the tenth (middle) year of our amortisation plan by around 20%.
By contrast, for fixed income assets held on a “buy and maintain” basis to maturity, the central outcome is far more predictable. This is because it can be based on the known yield secured at inception less an allowance for defaults which are generally stable (and low) in central economic scenarios.
Market risk - volatility relative to the central scenario The other important difference between CDI strategies and traditional approaches is the market risk exposure on top of any uncertainty in the central scenario. The equity strategy relies on selling a propor- tion of the equity portfolio in the market every year. As discussed above, there is significant uncertainty in the expected (or average) proceeds from these sales, but more importantly, there is also significant market risk.
By contrast the “amortisation process” under CDI involves structuring a series of fixed income assets such that their income and maturity proceeds deliver a planned series of future cashflows. Although these fixed income assets may be subject to significant market risk prior to maturity, investment grade bonds and many alternative credit securities held to maturity have a much narrower risk profile of out- comes compared with selling the equity portfolio in the market.
The role of LDI
Thus far we have described strategies as simple combinations of gilts and either equities in the traditional allocation or non-gilt fixed income assets in the CDI example.
However, in addition to the market risk of equities and default risk of non-gilts, both strategies would also be exposed to interest rate and inflation risks and potential liquidity risk, which could be addressed using an LDI strategy. In this context it is important to stress that CDI is not an alternative to LDI, and in particular for both the traditional equity plus gilts strategy and the CDI strategy:
1) The longest-dated liabilities would be met from long-dated gilts with maturities matching the liability profile of the tail where possible
2) The LDI hedging would be used to add inflation exposure to match that of the liabilities 3) The LDI portfolio would provide day-to-day liquidity as discussed above, acting as a reservoir out of which pension outgo is paid and into which income and proceeds from equity sales or bond maturities are deposited.
24 March 2019 portfolio institutional roundtable: CDI
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