Welcome to the fifth edition of Outline, Redington’s quarterly collection of thought-pieces designed to help institutional investors make smarter and more informed decisions. This edition features short articles on the future of pensions policy, the complexities of running a pension scheme and how technology can help overcome them, risks inherent from gilt and swap rate differences, an outcome-driven approach to fund management, a review of asset classes in 2013, plus an overview of the global macro environment. We hope you find the articles interesting and helpful as you consider how best to manage the risk-adjusted return of your portfolios

1. March 2014

2. 1
1 Clear Goals
and Objectives
2 LDI and
Overlay
Strategies
3 Liquid Market
Strategies
4 Liquid and
Semi Liquid
Credit Strategies
5 Illiquid Credit
Strategies
6 Illiquid Market
Strategies
7 Ongoing
Monitoring
SEVEN
STEPS
Redington designs, develops and delivers investment strategies to help pension funds and their sponsors
close the funding gap with the minimum level of risk. We take our clients through a rigorous 7 Steps to Full
Funding™, which begins with laying out clear goals and objectives and assigning tasks and responsibilities.
The second step is building an LDI Hub, or putting in place a risk management toolkit. Steps 3-6 involve
crafting the right investment strategy to fit the need using a full range of tools and bearing in mind the
goals and constraints of the scheme. Finally, ongoing high quality monitoring is essential to continually track
progress against the original objectives and guide smart and nimble changes of course.
Introduction 2
The Future of Pensions 3
Helicopter Pilots Required 4
The Evolution of ALM: Towards More Helpful Decision-Making Tools 5
Gilt and Swap Rates May Differ 2 6
Future Widening of LDI Toolkit 2 7
DGFs Revisited 3 8
Redesigning Fund Management Around Outcomes 3-6 9
The Balancing Act: Reinvestment Risk vs Illiquidity Risk 5 10
2013 Asset Class Review 1-7 11
Global Macro Overview 1-7 12
Further Information and Disclaimer 13
Contents
O U T L I N E March 2014Contents
STEP PAGE

3. Introduction
Gurjit Dehl
Vice President, Education & Research
gurjit.dehl@redington.co.uk
Welcome to the fifth edition of Outline, Redington’s quarterly collection of
thought-pieces designed to help institutional investors make smarter and more
informed decisions.
Thiseditionfeaturesshortarticlesonthefutureofpensionspolicy,thecomplexities
of running a pension scheme and how technology can help overcome them,
risks inherent from gilt and swap rate differences, an outcome-driven approach
to fund management, a review of asset classes in 2013, plus an overview of the
global macro environment.
We hope you find the articles interesting and helpful as you consider how best
to manage the risk-adjusted return of your portfolios.
For more information on any of the topics, please do get in touch.
Kind regards,
Gurjit Dehl
OUT
LINE
2O U T L I N E March 2014Introduction

4. If we are looking to the future, we
must understand how we got to
this point and where we may go
from here. Is legislation the best
path to ensure successful Defined
Contribution outcomes, or will the
pensions industry lead the way?
Today, there are a number of notable features to
UK pensions policy:
1. Consensus from all main parties on key
features, such as auto-enrolment, later
retirement and a more generous flat rate state
pension
2. Too few people are saving enough for
retirement
3. Personal responsibility to save lies at the heart
of the policy framework
4. Years of negative pensions headlines and a
culture that values consumption over saving
5. Defined Benefit (DB) is in its final stages,
Defined Contribution (DC) will do the heavy
lifting for the next generation of savers
6. State pension looks like it might be on an
unsustainable course
The key to understanding the future lies in
understanding the progress made by this policy
agenda. Firstly, auto-enrolment (AE) appears
to have been positively received, despite some
influential voices already calling for change. I
think compulsory savings are unlikely to happen
anytime soon. It is much more likely that we will
see a continuing debate about the adequacy of
contribution levels. There is good evidence now
that median earners are those most at risk of
not building up an adequate pension. Secondly,
regulatory reforms in DB have relieved financial
pressure on schemes. However, my view is that
they will not have any profound impact on the trend
away from DB to DC. Thirdly, the real focus on
future reforms will be on DC - governance, structure
and most important of all, outcomes. This is the
most interesting area to me.
Future of DC: Legislation vs Innovation
There is a clear sense in politicians of all Parties
that DC is not delivering sufficient levels of
retirement income when compared to DB. The
Department of Work & Pensions’ (DWP) agenda
is now clear: How can we improve DC? Are big
bang solutions involving all the paraphernalia of
legislation and associated regulation the right way
forward, or can the industry craft a way forward?
Legislation is likely to happen. The top-down
approach by government is looking at two options
– guarantees on the value of an individual’s
pension contributions (and possibly some form
of investment return guarantee), and Collective
Defined Contribution (CDC). I can see the
superficial attraction of both options, although the
real test of any proposal comes when you look
behind the headlines.
Is there an alternative? I would very much prefer
a bottom-up approach with the pensions industry
itself looking at how we can maximise retirement
income and manage the risk of not achieving this.
What sort of pension do savers want to realise and
how do we deliver this for them? What can we learn
from LDI and how can we apply these principles
in a DC context? That’s the debate we should be
having.
The Future Of Pensions
3O U T L I N E March 2014Overview
Lord Hutton Of Furness
Advisor to Redington

5. They say flying a helicopter is one
of the hardest skills to learn. That’s
because it involves hyper-multi
tasking under pressure: making
the helicopter tilt forward and back
(pitch), sideways (roll), and varying
the “angle of attack” of the main
rotor blades - all at the same time.
A delicate combination of gentle pressure and light
touch handling is simultaneously required on the
cyclic stick, the collective lever and the anti-torque
pedals, not to mention the twist throttle. Pull the
wrong lever, press the wrong pedal or squeeze
the wrong bit and it’s Game Over. A helicopter
pilot understands exactly how the levers work
(separately and together) and the constraints
within which they have to be operated.
This is a metaphor for managing a defined benefit
pension fund, which has its own plethora of levers
and complex, interlinked, operating constraints.
For instance, every pension plan requires a clearly
articulated Risk Budget (Lever 1) calculated with
reference to the Sponsor’s Covenant (Constraint
1) and the agreed timeframe to achieve full
funding (Lever 2). The corporate sponsor may
pour extra fuel into the tank (also known as
“making additional contributions”) and, alongside
this Lever 3, the trustees can re-allocate the
plan’s assets, so as to increase Expected Return
(Lever 4).
But, as the Bard put it: “The fault, dear Brutus, lies
not in the assets but in the liabilities”. It is pension
funds’ long-dated, (sometimes inflation linked)
obligations that are the source of the world’s
defined benefit pension deficits. Lever 5, then, is
the all-important application to the pension plan’s
liabilities of a hedge against declining interest
rates, whilst Lever 6 is the reduction of the plan’s
sensitivity to volatile, rising inflation expectations.
These levers (5 and 6) are calibrated against
the Discount Rate (Constraint 2) as well as the
Funding Level of the pension plan (Constraint 3).
Ignore that, and you begin to stress the assets; to
ask more of them than you reasonably ought. And,
as every pension plan trustee will know (at least,
those that have gained their pilot’s licence) the
use of Levers 5 and 6 (namely, the application of
a hedging strategy) dramatically impacts the plan’s
pitch, roll and angle of attack.
Now it starts to get interesting; it may make sense
to apply Levers 5 and 6 utilising your long dated,
investment-grade bonds, or a portfolio of index-
linked government bonds. Sometimes, though,
it’s better to use swaps. It all depends on the
curiously named z- spread (which happens to be
Constraint 4) and the extent to which some of the
pension plan’s assets qualify as Eligible Collateral.
That’s Constraint 5 - which is dictated (to a large
extent) by Lever 1. Talking of Lever 1 (the proper
function of which, as we have seen, is closely tied
to Lever 2), it is critical that its various sub-levers
and pedals are also understood. Without them,
you run the peril of allocating a risk budget that
ignores the pension plan’s all important Required
Rate of Return (Constraint 6).
So, in conclusion, let’s just say this: Those
pension plans that are well funded and en route
to their destination despite the desperately bad
weather? That didn’t happen by accident. And,
if most of the above is impenetrable, that’s
because, like flying a helicopter, it’s hard to
explain in 500 words.
Helicopter Pilots Required
Dawid Konotey-Ahulu
Founder & Co CEO
dawid@redington.co.uk
4O U T L I N E March 2014Overview

6. The Evolution of ALM: Towards More
Helpful Decision-Making Tools
How do an engineering degree
and a pilot’s license help one
build the tools that help pension
schemes reach their goals?
As head of the ALM Development team, my
previous experience in engineering with the
RAF has proved invaluable in building the tools
that help pension schemes better measure and
manage their risk and returns.
As always teamwork is the key. A good
development team will apply consistent hard work
to building software, whilst constantly honing their
skills. This allows the team to regularly deliver
new functionality, but also be able to respond
quickly to ideas or client demands. New ideas can
come from anywhere and often seem insignificant
at the time. It is our role to recognise the good
ones, and act on them, as they can often give the
company a massive leap forward in capability.
Early days
At the start of Redington, with five people in the
firm, we relied on best-of-breed analytics tools
built by external parties. This meant that we
could get up and running quickly, without building
anything ourselves.
Automating the analytics
We pushed these systems hard, modelling multi-
asset portfolios and pension liabilities, and soon
hit limitations. The most pressing problem was
the time it took to run a full ALM analysis using
the web interface of our core system, RiskMetrics.
We set up a small development team to focus
on this problem. Oakley was built to automate
our interactions with RiskMetrics, enabling us
to quickly and easily run analysis directly in
Excel. The outcome was a fivefold increase in
productivity.
Refining the risk modelling
As the firm’s advice to clients developed and
matured we became restricted by pension specific
modelling that generic risk systems just couldn’t
do. This became our clarion call; focus on the
tricky bits which are most important to pension
schemes. From this RedAnalytics was born.
The first module included market consistent
yield and inflation curves. This was driven by the
need for accurate PV01s and IE01s to design
and implement hedge portfolios. Since then
RedAnalytics has been continuously extended to
cover all the complexities of pension liabilities and
LDI portfolios.
What about returns?
Risk is one only one dimension of our advice;
the other is return. Analysts put together a Flight
Plan model to calculate the return needed for
a scheme to reach full funding. By building
this into our system we can run 10,000 Flight
Plans in a Monte Carlo simulation. This gives
us new metrics, Required Return at Risk and
Contributions at Risk –showing VaR-type risks for
the required returns or contributions.
Productivity
Having all these fantastic models and analytics
is great, but not if it takes an age to run the
numbers. Over the last 12 months, the team has
built Portfolio Blender. This can take outputs from
both external and internal systems and mix them
in any combination. Results are instantly updated.
The team’s productivity has leapt forward again.
Freed from much of the manual drudgery analysts
can explore many more strategies for our clients.
Excitingly, RedAnalytics and Blender have been
combined into an interactive Flight Plan. This tool
enables consultants and clients to run “What If…”
scenarios. They can instantly see the effect of
certain key decisions on their long term trajectory
and path, instead of conducting long and drawn-
out assessments of actions that may turn out not
to be appropriate. Client meetings can focus more
on exploring strategies, building consensus and
making decisions.
As pension funds navigate through increasingly
complex circumstances and financial solutions,
we will continue our work in making analyses of
these comprehensive, accurate and digestible.
Our goal is to offer pension funds the chance to
make decisions with greater confidence, thereby
ultimately leading to better results for their
members.
Peter Howarth
Director, ALM & Technology
peter.howarth@redington.co.uk
5O U T L I N E March 2014Overview

7. Gilt and Swap Rates May Differ
Pension schemes with a
set risk budget may find
the spread between gilts
and swaps dominating it.
Daily data for both 30 year sterling swap and gilt
interest rates is available back to August 1999.
For that period the spread between 30 year gilts
and swaps has moved substantially from a high of
169bp in June 2000 to a low of minus 75bp in
January 2009.
These movements have been of a similar order of
magnitude to movements in absolute rates. Any
risk model that is based on historical data during
the 1999 to 2014 period should therefore show
a meaningful risk that this spread will change in
the future. Whilst of course the past does not
necessarily predict the future, it would perhaps be
imprudent to assume that this spread will not move
in the future given the measure’s history.
One of the main risks to a pension fund’s surplus or
deficit comes from the variation in the discount rate
used to calculate the present value of the liabilities.
If a pension scheme discounts its liabilities using a
gilt-based discount rate but hedges the interest rate
risk with swaps, it will be left with a large position
in the spread between gilt and swap rates. For a
pension scheme with a swap-based discount rate
but a gilt-based hedge, the effect will be a similar
sized position but in the opposite direction.
A pension fund can of course take the view that, on
a hold to maturity basis, the spread between the two
rates will converge, but the impact on any deficit or
risk measure in the interim may well be substantial.
The easiest way for a pension scheme to guard
against this risk is to hedge gilt discounted liabilities
with gilts, and hedge swap discounted liabilities with
swaps.
However, many LDI mandates give the manager
the ability to choose whether to hedge with gilts or
swaps according to the manager’s view of which
is currently “cheaper”. A pension fund could easily
end up with a portfolio of swaps hedging a gilt-
discounted liability or vice-versa, depending on
where swap spreads happened to be at the time.
The short-term volatility generated from this
mismatch can easily end up dominating a pension
scheme risk budget for what might be thought to be
a relatively low return strategy.
In order not to let this spread risk dominate a risk
budget, a pension scheme has two choices:
1. If it wants to retain swap spread risk as a
measured risk, then any LDI mandate should
have limits on the amount of swap spread risk
that the LDI manager can take.
2. If it wants to be able to take large amounts of
swap spread risk as implied by an unlimited
LDI mandate then the pension scheme should
choose a risk budget that excludes swap spread
risk.
A similar problem can arise between projecting
forward liability cashflows using inflation derived
from either index-linked gilts or inflation swaps. The
solution in terms of LDI mandate limits or removal
from the risk budget measure is the same.
All in all, a pension scheme must be aware of the
risks that can be inherent in handing over freedom
to a manager or taking what seems like a saving;
there is always a case for deep analysis and
forethought in the allocation of the risk budget.
Philip Rose
Chief Investment Officer - Strategy & Risk
philip.rose@redington.co.uk
6O U T L I N E March 2014STEP
Figure 1: 30 year swap spreads,1999 to 2014
Source: Bloomberg

8. Future Widening of
LDI Toolkit
7O U T L I N E March 2014
Kenny Nicoll
Director, Manager Research
kenny.nicoll@redington.co.uk
An alternative way to manage
interest rate risk is coming. NYSE
Liffe’s ultra-long gilt future will
offer a new way to gain synthetic
exposure to gilts, the biggest
challenge is whether it gains
sufficient market interest to offer
an ultra-long-term alternative.
For pension schemes looking to hedge their
long-term liabilities, the upcoming ultra-long gilt
future could well be of interest. It brings a number
of potential benefits, however, its success is not
guaranteed.
The new future will target a 30 year maturity, with
a 4% implied coupon, £100k notional size and an
underlying maturity of 28-37 year conventional gilts
for delivery into the future. The 30 year government
bond future has been tried before, in Germany, but
the UK debt market and LDI demand is arguably
different – for example, the UK has a far larger
proportion of ultra-long debt outstanding:
Figure 1: UK long dated gilt projections
Source: globalderivatives
Given the high level of issuance (and buying) of
ultra-long gilts, there is clearly sufficient demand
for this amount of duration from the investment
community.
What are the key benefits for investors?
This future provides leveraged exposure to gilts in
much the same way as Total Return Swap (TRS) or
a gilt repo trade, except the future is better than its
Over-The-Counter (OTC) equivalent in a few ways:
• Useful for LDI clients who are full on TRS or
repo lines, or do not have GMRA documents
in place
• Credit risk is versus exchange rather than a
bank
• Margin requirements can be offset against
other futures with the exchange
• Typically cheaper to execute and trade out of,
particularly compared to break costs of a TRS
• Futures are “future-proof” from Basle 3
regulations, unlike gilt TRS or gilt repo
• Gap risk is lower due to shorter close-out
period (2 days) and lower initial margin
• Standardised terms ensure transparency and
tight pricings amongst participants
What are the key challenges for the future?
The main challenge is finding natural buyers and
sellers to provide sufficient liquidity, as shown
by trading volumes of German and US ultra-long
futures. Against this, hedge fund managers should
like the credit and duration properties while banks
are likely to be long gilts so looking to sell the
future, both adding to market liquidity.
The other big challenge is the capability of the
future to meet LDI hedging needs. With fixed
maturity dates, futures cannot provide as exact
a hedge as OTC products for LDI hedging. Also,
since the future is deliverable on expiry against a
basket of underlying gilts with different maturities,
cheapest-to-deliver (CTD) risk arises as the CTD
gilt can change at short notice. This means the
duration of the futures contract will change, so
the number of contracts will need to reflect the
change in duration relative to a client’s hedging
benchmark.
What might the future hold?
For clients who are not set-up to trade futures, or
are unable to post initial margin/cash as variation
margin, TRS exposure to the 30 year future may
also become available from banks as currently
exists for 10 year futures.
Ultimately, meaningful volume and interest from
the wider investor community will determine
whether or not the ultra-long future becomes a
liquid and successful product.
STEP

9. Diversified Growth
Funds Revisited
aniket.das@redington.co.uk
Aniket Das
Vice President, Manager Research
STEP 8O U T L I N E March 2014
Diversified growth funds (or
‘DGFs’) have come to form an
iconic part of the UK investment
landscape. Their evolution is
ongoing and will take them head
on to meet hedge funds.
Multi-asset funds have come a long way in the UK.
Balanced funds employing static asset allocations
dominated the scene during the 1990s and early
2000s. However with time, the sector evolved as
there was increased demand for asset allocation
to be performed within a fund. The success of a
number of managers in navigating the financial
crisis was surely the finest hour for active asset
allocation and a great endorsement for the sector
as a whole in addition to those skilful managers.
These days, we see a large spectrum of multi-asset
managers within the UK and indeed a different
name applied to the group. The term ‘DGF’ has
emerged within the parlance though admittedly
the description is rather vague. We see the DGF
universe ranging from balanced funds, whose
popularity is undoubtedly waning, to vehicles using
dynamic asset allocation in various shades.
Within those funds employing dynamic asset
allocation, one can get more granular still. We
observe some managers tilting the portfolio from
a neutral benchmark (what we term ‘dynamic
allocation’ funds), often flooring a minimum equity
exposure at around 30% of the whole portfolio,
to those that are ‘benchmark-free’ and willing to
swing the portfolio around much more (‘total return’
managers). This latter group does have more
variation in performance between managers though
arguably this flexibility allows these managers to be
better-placed to deliver an outcome (say, cash +
5%) rather than a quartile ranking.
The newest group of DGFs come under the shell
of what we term ‘absolute return relative value’.
Though Standard Life Investment’s Global Absolute
Return Strategies (commonly referred to as ‘GARS’)
has been in existence for nearly a decade, we are
seeing other managers emerge in this area only
much more recently. For these strategies, the focus
on risk allocation (rather than asset allocation) and
tighter risk management form an integral part of
the investment process.
This last category ventures into the territory of
global macro hedge funds, which similarly employ
a range of long and short relative value positions
while utilising options and other derivatives. Indeed
we see increased competition between DGFs and
hedge funds going forward. The battle is likely
to be fought in the crucial areas of skill, fees,
capacity, transparency, appropriate vehicles and
client servicing, though the real winner should be
pension schemes and other investors who will be
able to access more efficient investment strategies
at lower costs.
Figure 1: Classifying the DGF universe

10. The vast majority of investment
management companies are not
structured to help clients meet
their long-term needs. They are
organised around historical fund,
asset class and geographical silos
that do not reflect the outcomes
clients are looking for.
“Hedge funds”, “equities”, “property’ and “bonds” are
unhelpful labels that represent a myriad of different
liquidity, risk and return profiles. Our conversations
with clients begin with an effort to understand: where
they are today; where they want to get to and by
when; how much risk they are willing to take; what
cashflow or liquidity requirements they have and what
other specific covenants, support or contingencies are
in place. We find that most clients want outcomes:
some want capital preservation, others want to draw a
predictable level of income, those with liability hedging
in place want to beat cash and many others want to
beat inflation over the long term.
These and other client outcomes are difficult to
deliver because most products are narrowly managed
against specific benchmark indices that do not
represent clients’ liabilities and the vast majority of
asset managers are fragmented into autonomous
and independent teams, with limited dialogue, each
competing for resources and rewards. Most fund
management groups separate retail, wholesale and
institutional distribution teams which won’t make
much sense in the future, especially with the blurring
of these lines and for example, Defined Contribution
Pensions straddling retail and institutional channels.
Furthermore, too many CEOs become hostage
to stars and successful products of the past that
contribute too much to a firm’s revenue to risk losing
them. This keeps the industry more backward focused
and resistant to change.
There is a need to redesign fund management around
the investment outcomes that clients need. A handful
of houses have created distinct outcome-oriented
teams though the challenge remains to apply this way
of thinking to their whole business.
We think there are 3 key considerations for anyone
building client-centric outcome-oriented fund
management businesses:
1. Focus on your strengths, rather than trying to be
all things to all people. Build internal capabilities
around areas of ‘structural competitive
advantage’ rather than traditional asset or
regional boundaries. Many opportunities exist in
the gaps between adjacent specialists/teams that
don’t talk to each other and use different tools
and approaches.
2. Design client solutions that leverage your
specialist capabilities. This requires some kind
of central allocation or risk budgeting, which
can be hard to execute effectively. It can’t be a
committee of the great and the good, it can’t
be just one star manager and it can’t be larger
than 4-5 people. Each person must bring some
distinct perspective and therefore value to the
group but clear decision-making accountability is
critical.
3. Accept that clients’ focus on outcomes will affect
your whole business model. Fund managers
need to break down silos between funds,
between equities and fixed income, between
manufacturing and distribution, between retail
and institutional and between middle and front
office in order to get their business to work
together to deliver better outcomes for end
clients.
Change is not easy but If we do what we’ve always
done, we will get what we’ve always got. As the
pensions crisis deepens and spreads, we have to
innovate and collaborate or become commoditised
and die.
Redesigning Fund Management
Around Outcomes
Mitesh Sheth
Director of Strategy
mitesh.sheth@redington.co.uk
STEP 9O U T L I N E March 2014

11. The Balancing Act:
Reinvestment Risk vs. Illiquidity Risk
Conrad Holmboe
Vice President, Investment Consulting
conrad.holmboe@redington.co.uk
STEP 10O U T L I N E March 2014
In a quest to reduce exposure
to reinvestment risk are pension
funds jumping out of the frying
pan and into the fire by taking on
more illiquidity risk, or is there a
balance to be struck?
For many pension funds 2013 was a relatively
good year. Developed market equities rallied (the
S&P500 was up nearly 30%), credit spreads
tightened and even real yields showed some
improvements, albeit marginally so.
Those funds positioned to benefit from this would
have seen their funding ratio rise, and for some,
rise faster than anticipated by their flight plan.
Those fortunate enough to find themselves in this
position will likely be contemplating how to “bank”
these gains and take a little risk off the table.
De-Risking
De-risking can take many forms but it will
typically involve moving out of more volatile, less
predictable and higher returning assets (such as
equities and hedge funds) into more stable and
predictable sources of returns, such as credit.
However, as pension funds systematically reduce
their exposure to risks such as equity, interest
rates and/or inflation (i.e. those that can be
measured using a Value-at-Risk model) other risks
that may require additional lenses to quantify and
monitor, start to become increasingly significant.
Some may even come to dominate a pension
fund’s overall risk profile.
Reinvestment Risk
A pension fund’s longer dated liabilities cannot
be perfectly matched with allocations to liquid
credit, such as corporate bonds, as these are
typically much shorter dated. Pension funds will
therefore be exposed to a significant amount of
reinvestment risk, especially as they increase their
allocation to credit through time.
Reinvestment risk is the risk that when it comes
time to reinvest the coupons and/or principal
payments, credit spreads may have tightened to
such a degree that a pension fund might have to
seek riskier/higher yielding investments to meet
their required return, and maintain the flight plan.
To counteract this risk many pension funds are
increasingly making allocations to longer dated,
and more illiquid credit, such as commercial
real estate (CRE) debt, secured long leases and
infrastructure debt.
The main benefits of these asset classes are
typically: longer maturity profiles, an illiquidity
premium and low correlation to traditional asset
classes.
Thus a pension fund is able to lock into higher/
more attractive spreads for longer, which can help
mitigate their exposure to reinvestment risk. But
at what cost?
Illiquidity Risk
As a rule of thumb, the longer dated the asset the
more difficult it will be to sell at short notice for
fair value (i.e. the more illiquid it becomes).
In addition, increasing the allocation to illiquid
assets, at the expense or more liquid assets,
reduces the overall liquidity of a fund’s portfolio.
This could have a negative impact on a pension
fund’s ability to make benefit payments and/or
collateral payments (on any out-of-the-money
derivative positions), in the event of a crisis.
The Balancing Act
There is no one-size-fits-all solution for
determining the appropriate balance between
illiquidity and reinvestment risk.
But the important thing to note is that there is
a balance to be struck. Clearly no pension fund
should be 100% allocated in illiquid assets, nor
100% blind to the risk reinvestment poses to
their chances of meeting their long term funding
objectives.
Pension funds considering what the appropriate
balance might be can develop bespoke tests
aimed at determining an appropriate “Illiquidity
Budget”. This could consist of a maximum
allocation to illiquid assets dictated by the fund’s
short/medium term collateral requirements,
medium/long term cash requirements to pay
member benefits and long term desired asset
allocation.
Integrating the Illiquidity Budget into the day-to-
day decision making of the fund will ensure that
a pension fund always maintains an appropriate
balance between these two risks.

12. As we move from the year of
the Snake into the year of the
Horse, a few key movements
in 2013 are worth a conscious
review.
In 2013, long term inflation expectations
increased, with the 30 year zero-coupon RPI swap
ending the year around 0.5% higher than it started
at 3.74%. This compares to the lows of around
3.2% in 2012 and recent highs over 4% seen in
2008. Real yields generally fell back into negative
territory over the course of the year.
Overall, interest rates in most major markets
ended the year higher than they started. In the
UK, long dated interest rates (measured by the
30-year zero coupon swap rate) ended the year
close to their highs at 3.4%, up 0.5% from the
start of the year. The yield on the 2042 gilt ended
the year at 3.61%, rising by slightly more than
the corresponding swap rate and highlighting the
increasing attractiveness of gilts compared to
swaps for long-dated liability hedging.
Benchmark 10-year interest rates in major
developed markets all followed a similar path over
the year, reacting to investor expectations on the
tapering in the US. The US 10 year yield rose from
1.6% to 3%, the UK gilt from 1.8% to 3%, and the
German bund from 1.4% to 1.9%.
Economic fundamentals in most developed
economies improved, especially in the UK
and the US. The UK’s improvements resulted
in economists’ upward revision of 2013 GDP
estimates, enabling an upbeat Autumn Statement.
Sterling strengthened against both the dollar and
the Euro in the second half of the year, the pound
closing the year on its high against the dollar of
$1.66, having started the year at a similar level
and fallen at times to lows of $1.48.
Most developed equity markets experienced returns
well above long term averages, with the highest
annual return since the 2009 bounce from the
market lows. Significant differentiation among
markets continued. The MSCI World was up 24%,
compared to 14% in 2012, with the Nikkei and
S&P500 leading the way with a 50% and 30%
return respectively, which took the S&P into new
highs, some 30% above the 2007 peaks. The FTSE
100 index experienced a gain of 14% in price index
terms, compared to a gain of 7% in 2012, a -2%
return in 2011 and a +11% return in 2010. In
Europe, the DAX and Eurostoxx both experienced
higher returns than the FTSE in 2013, with the DAX
up 25% and the Eurostoxx up 18%.
Emerging Markets performed badly, reacting to
tapering, with the MSCI Emerging index falling 5%
over the year. The volatility experienced by most
equity indices during 2013 was low by historical
standards, with the market pricing of option
hedging against market falls reflecting this.
The three main classes of credit all performed
strongly for the second year in succession. For
example, UK Investment Grade credit returned
5% in excess of swaps over the year compared to
returns of 7% in 2012.
Commodity indices generally fell during 2013, with
the DJ-UBS index ending the year around 10%
lower than it started, having been flat in 2012. The
main driver of this was Gold.
There is a continuing, growing appetite for risk-
based and risk-controlled approaches to investing
such as Volatility Controlled Equity and Risk Parity,
particularly when they are combined with portfolio
downside protection. Given the large divergence in
returns this year between equity, commodities and
fixed income (with equities substantially positive
and both commodity and fixed income negative)
multi-asset portfolios with an overweight to equities
have outperformed those with an equal balance of
risk among asset classes.
Dan Mikulskis
Co-Head of ALM & Investment Strategy
dan.mikulskis@redington.co.uk
2013 Asset Class Review
11O U T L I N E March 2014STEP

13. Global Macro Overview
The macro outlook appears rosy,
with rising GDP forecasts and
falling unemployment. Is the
global economy finally out of the
woods?
Equity markets are at or close to their all-time highs.
Credit spreads continue to tighten. UK CPI inflation
has finally fallen below the 2% target. Economic
indicators are showing improvements and pension
scheme funding ratios have generally improved also.
Apart from an early wobble in “emerging” markets,
2014 seems set to be a good year for markets. Taking
a closer look though, there are several things which
could derail the recovery.
Risks to the outlook and schemes
At a recent Redington teach-in, Gavyn Davies
(Chairman, Fulcrum Asset Management) outlined four
key macro risks:
1. US unemployment fall prompting the Fed to
tighten too early
2. China being unable to guide its economy to a soft
landing
3. Eurozone is unable to prevent “Japanifcation”
(prolonged deflation and low interest rates)
4. Bubble in equities as rising prices driven by policy
stimulus rather than fundamentals (Gavyn thinks
equity bubble risk remains low at present)
At the same event, Neil Williams (Chief Economist,
Hermes Fund Managers) rightly pointed out that
“tapering is loosening!...” Reducing asset purchases
by $10bn at each Federal Reserve meeting still adds
an extra $460bn in 2014.
Figure 1: The Bank of England’s main policy rate, 1694 to 2014
Since the teach-in, the Bank of England and US
Federal Reserve have softened their guidance on how
the unemployment rate will influence the timing of
tighter monetary policy, replacing it with a stronger
focus on inflation (and deflation).
David Miles, a member of the BoE’s Monetary Policy
Committee, has warned that rates are likely to be
below their historical average of 5% for a sustained
period (see Figure 1). “One factor behind the recent
sharp fall in real yields – changing perceptions of the
level of risk in the world – is likely to be persistent,” he
said. In recent weeks, members of the Fed and ECB
have stated they remain vigilant to downside risks and
are willing to take action if necessary.
Will QE actually end? There is a chance central banks
opt not to sell their QE holdings at all, instead making
use of their balance sheets to lend QE assets to the
market via reverse-repos. This would allow them
to remove liquidity and set short-term rates using
an alternative to Base Rate. The Fed has said it is
investigating this option. Central bank liquidity may
remain abundant for a while yet, holding down rates
(see Figure 2).
Guarding against the risks
It is vital to understand the key asset and liability
risks to your pension scheme, to decide if you are
comfortable running those risks, and then to construct
an investment strategy that is appropriately robust and
resilient to many outcomes. For example, schemes
can make use of risk factor investing and volatility-
controlled equity strategies to diversify and manage
downside risk. Illiquid credit and absolute return bond
strategies can help to boost the expected return
from assets above those available from liquid credit.
Whilst there are still many macro risks, there is also
a growing number of ways to measure, manage and
mitigate them.
Figure 2: Liquidity expectation of global central banks,
% of GDP, 12 months change
Gurjit Dehl
Vice President, Education & Research
gurjit.dehl@redington.co.uk
STEP 12O U T L I N E March 2014
Source: Bank of England Source: Fulcrum Asset Management LLP

14. If you would like more details on the
topics discussed, please contact your
Redington representative, the author,
or email enquiries@redington.co.uk
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