The exchange of cash flows from a given security in return for a different set of cash flows. In LDI, typically the exchange of the cash flows on a gilt in return for a series of floating rate payments related to LIBOR.
Auction (gilt auction)
Process by which the Debt Management Office (DMO) sells conventional and index-linked gilts to market via Gilt-edged Market Makers (GEMMS).
A contract between two parties where one party agrees to buy a bond and the other agrees to sell a bond at an agreed future date, but at a price established at the start of the contract.
The difference between the nominal yield on a fixed interest security and the real yield on an inflation-linked security in the same currency and of similar maturity and credit quality.
Buy in (and Buy out)
A pension scheme can insure all or part of its liabilities (obligations to pay member benefits) with an insurance company. Such a transaction is termed a ‘buy-out’, and has the effect of extinguishing the obligations to members as these liabilities are transferred to the insurer in exchange for the premium paid. Similarly, a scheme can enter into a ‘buy-in’ contract whereby the contract is held as an asset of the pension scheme. That is, while the liabilities remain with the pension scheme the scheme holds a contract that matches the obligations of the scheme.
Process designed to reduce counterparty risk which is present in bilateral OTC over the counter derivative trades by clearing with a single central counterparty.
Central clearing margin
The margin (initial and variation) required by a central counterparty for central clearing of derivatives contracts.
Central Counterparty (CCP)
Clearing house authorised by regulators under EMIR.
An organisation that facilitates communication between an investor and a central counterparty clearing house (CCP).
A bank or broker dealer that is a member of a Clearing House or Central Counterparty (CCP) under European Market Infrastructure Regulation (EMIR).
When entering into an OTC derivative, the risk that one party becomes unable to meet its obligations under the agreement is mitigated by transfer of assets (i.e. collateral) between the two parties with the same mark-to-market value as the swap. In the event of default, the party in profit keeps the collateral and retains the benefit accrued on the contract up to that point. In this case, the swaps contracts are ‘collateralised'.
Collateral transformation allows the conversion of existing securities not eligible as margin with a clearing house, into eligible, high quality securities, typically cash or government bonds.
Consumer Price Index (CPI)
An index used to measure price inflation. CPI is similar to the Retail Price Index (RPI), being constructed from the prices of a bundle of goods and services. However due to differences in the way CPI is calculated and some differences in the basket of goods (CPI excludes housing/mortgage costs while RPI includes them), CPI has historically been lower than RPI. Therefore schemes that have increases now linked to CPI rather than RPI would expect to have lower liabilities.
The party taking the other side of an OTC derivative contract (such as a swap contract) to the scheme. Usually an investment bank.
Counterparty credit risk
The risk that the counterparty to a contract is unable to fulfil their obligations under the terms of the contract. Counterparty risk can currently be managed via diversification, collateralisation with high quality securities and appropriate due diligence on prospective counterparties will be significantly mitigated by moving bilateral, OTC derivative contracts to central clearing.
The strength of the company sponsor standing behind the pension scheme. A weak company sponsor is a concern for trustees as the company sponsor may not be able and willing to afford the contributions required to fund the pension scheme.
The difference in the yield between two different bonds, due to different credit quality. The credit spread reflects the additional yield an investor can earn from taking incremental credit risk. It is often quoted in relation to the yield on government bonds.
Credit support annex (CSA)
Documentation associated with an ISDA document and is one-leg of the overarching legal derivative documentation between two counterparties to bilateral OTC derivative trades. The CSA covers the key credit terms and conditions designed to mitigate the parties' exposure to each other's credit risk. The CSA includes details of eligible collateral, frequency of collateral and other key terms designed to mitigate counterparty credit risk associated with derivatives.
Debt Management Office (DMO)
An agency of the UK Treasury which is responsible for issuing gilts to meet the Government's borrowing requirements.
Depository Clearing Member
An organisation that is permitted to clear trades via the Clearing House (or CCP).
Derivatives are an instrument whose price is dependent upon, or derived from, one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is mainly determined by fluctuations in the underlying asset price. Examples of derivatives include futures, options and swaps.
Used by the actuary to place a present value on the pension scheme's liabilities. For example if a payment of £100 is due in one year's time, then using a discount rate of 5% would give a present value of £100/(1+5%) = £95. The higher the discount rate the lower the present value of the liabilities.
A risk mitigation technique under EMIR. Counterparties to agree detailed procedures and processes in relation to the identification, recording, monitoring and resolution of disputes relating to the recognition or valuation of the contract or to the exchange of collateral between counterparties. Any amount in excess of €15m must be reported to the regulator.
The Dodd Frank Wall Street Reform and Consumer Protection Act is the US version of EMIR that was enacted July 21, 2010, and affects nearly every aspect of the financial services industry. Dodd-Frank introduced, among other things, clearing in the OTC derivatives market in the US.
A measure of the sensitivity of a scheme's liabilities or LDI assets to changes in interest rates or expected inflation. Duration is measured in years and calculated as the weighted average time to payment or receipt of the pension benefit payments and asset cash flows. A higher duration indicates a greater sensitivity to changes in interest rates or expected inflation.
Equity toal return swaps (TRS)
These are used to achieve synthetic exposure to equity markets in swap format. Investors agree to pay a fixed or floating rate of interest and receive the total return on a particular equity index.
European Market Infrastructure Regulation (EMIR)
A European regulation that aims to increase transparency and reduce counterparty risk in the OTC derivative markets.
European Securities and Markets Authority (ESMA)
ESMA is an independent EU authority overseeing the European Union's financial system, promoting stability by ensuring the integrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection. ESMA is responsible for regulation of the European OTC derivatives market.
European Financial Transaction Tax (The FTT)
The European Financial Transaction Tax is a proposed Europe wide tax on all financial transactions. The details of the tax are currently under negotiation with potential for substantial changes prior to implementation. Current proposals are tax of 0.1% on all financial transactions with some exceptions (notbalt derivatives to be taxed at 0.01%). Could have significant impact on repo market if maintained under its current form. Proposals to change the application to Repo or remove completely from the scope of the regulation.
An estimate of the inflation rate expected to apply to the pension scheme's benefit payments over the lifetime of a pension scheme. Expected inflation is used by actuaries to estimate the value of a scheme's inflation-linked liabilities. The rates implied by index-linked gilt yields or inflation swap rates are often used as a starting point, making scheme liabilities sensitive to changes in these rates.
This is a process by which pension scheme trustees set a funding and investment plan in order to reach full funding over a specified time period and typically on a self-sufficiency basis. The plan typically entails progressively reducing investment risk over time, either in response to increases in the funding level or improved market conditions. A flightpath would typically also aim to manage investment risk. Typically, reduced risk would be accompanied with a lower expected return.
Forward interest rates
The interest rate which markets expect to apply at a specified future date and for a specified term.
Forward starting interest rate swap
An interest rate swap where one party agrees to receive a fixed interest rate for a specified term but where that period only commences on a specified future date.
The swap comes into force on the date on which the agreement is struck so that any future changes in the market implied forward interest rate will impact the value of the agreement and result in collateral transfers under the Credit Support Annex (CSA).
Funding level triggers
Predetermined funding levels at which the scheme will de-risk (e.g. by switching growth assets into better matching assets such as bonds, swaps or synthetic gilts).
The ratio of pension scheme assets to liabilities. The funded ratio equals 100% when the value of the pension scheme's assets and liabilities are equal.
Financial contracts obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.
Technique to multiply gains and losses as a result of borrowing money or using derivatives.
Gilt Edged Market Makers (GEMMS)
A Gilt Edged Market Maker is a dealer recognised by the Debt Management Office (DMO) as being a primary dealer in UK gilts. Such a dealer creates a market through two-way price quoting and competitive bidding and can actively trade in conventional gilts, indexed linked, or both.
Gilt repo (repurchase agreement)
Under a gilt repo, the scheme sells a gilt to an investment bank and agrees to buy it back at a later date at a fixed price. The scheme can then use the cash received to increase their exposure and buy additional gilts. This is an example of an unfunded gilt instrument. If gilt prices rise during the term of the contract (i.e. if interest rates fall) then the scheme will expect to make a profit, if gilt prices fall (i.e. if interest rates rise) the scheme will expect to make a loss.
Return received from investing in UK government bonds (gilts).
Gilt total return swap (TRS)
Gilt TRS's are economically similar to gilt repo. Investors agree to pay a fixed or floating rate of interest and receive the total return on a particular gilt. The scheme expects to make a profit under the terms of the contract if the total return on the gilt is greater than the interest rate paid.
Hedge ratio (or hedging position)
The interest rate (or inflation) PV01 (or IE01) sensitivity of assets divided by the interest rate (or inflation) PV01 (or IE01) sensitivity of liabilities.
Seeking to protect against unfavourable movements in the value of a liability or asset using financial instruments.
A measure of the sensitivity of the present value of a series of cash flows, to a 0.01%p.a. increase in inflation expectations.
The average rate at which prices (of products and services) increase over time. It gradually reduces the value of money over time – the higher the rate of inflation, the greater the erosion of value.
Under an inflation swap a pension scheme makes a series of fixed payments over the term of the swap. The payments are fixed by reference to inflation rates expected to apply over the swap term and as at the date on which the swap is traded. In exchange the pension scheme receives a series of payments over the same term based on the actual inflation rate which materialises over the term of the swap. When inflation rises, the scheme expects to make a profit under the terms of the swap contract that is expected to (partially) offset the increase in liabilities.
An upfront payment when initiating a derivatives trade that acts as security or collateral on the trade.
Interest rate swap
Under an interest rate swap, a pension scheme makes a series of payments at specified intervals based on a floating rate of interest (typically LIBOR) and, in return, receives payments from another party based on a pre-agreed fixed rate of interest.
The fixed rate of interest is typically set such that the contract has zero value on day one i.e. at outset the expected future stream of fixed and floating payments have the same value in present day terms. When interest rates fall, the scheme expects to make a profit under the terms of the swap contract that is expected to (partially) offset the increase in liabilities.
International Swaps and Derivatives Association (ISDA)
International Swaps and Derivatives Association – the global trade association for OTC derivatives that sets out the industry-standard terms for OTC derivatives documentation (ISDA Master Agreement).
A measure of the difference between future implied inflation rates in the government bond and swap markets. Positive iota broadly implies that the cost of buying inflation protection through index-linked gilts is more expensive than the cost of buying inflation protection through inflation swaps and vice versa.
A specific European legal framework regulating the activities and supervision of Institutions for Occupational Retirement Provisions (IORP) or pension funds (IORP Directive 2003/41/EC).
ISDA Master Agreement (ISDA)
ISDA is the International Swaps and Derivatives Association and an ISDA is a Master Agreement is a document agreed between two parties that sets out standard terms that apply to all the OTC derivative transactions entered into between those parties. ISDA documentation can be agreed directly between a pension scheme and a bank or pension schemes can use ‘umbrella' documentation agreed between the fund manager and the counterparty.
The estimated amount required by a pension scheme to cover the cost of paying all accrued future pension benefits.
Liability Driven Investment (LDI)
A strategy employed by pension schemes to understand and manage interest rate and inflation mismatching between the scheme's assets and liabilities.
Limited Price Indexation (LPI)
Some pension schemes provide pension increases based on the Retail Price Index (RPI) or Consumer Price Index (CPI), but with a cap and/or floor applying. A common example is to provide RPI increases annually, but with a floor of 0% to ensure payment amounts do not fall from year to year. An example of a cap is (say) a 5% cap which means that pension increases are the lower of 5% or RPI each year. Where caps and/or floors are applied to the CPI, the term LCPI can be used.
An index-linked gilt.
London Interbank Offered Rate (LIBOR)
An interest rate at which banks believe they can borrow funds from other banks in the London interbank market. The LIBOR rate is fixed on a daily basis by the British Bankers' Association.
Amount of money or collateral that needs to be provided initially (initial margin) and on an ongoing basis (variation margin) for derivatives that are traded on an exchange.
These are predetermined market levels (e.g. interest rate or expected inflation levels) at which the scheme will implement further interest rate or inflation hedging.
Nominal interest rate (Nominal yield)
The interest rate on a fixed interest gilt or interest rate swap is known as the nominal interest rate. Nominal interest rates are also used to value fixed liabilities which, similar to fixed interest bonds, are a series of known Liability Driven Investment cash flows occurring at specified future dates.
The amount of an instrument which is being bought or sold. It is also the amount that is used to calculate payments made on that instrument.
A pension scheme valuation that looks at the plan's funding level on the basis that the plan will continue to operate indefinitely. Also known as ‘technical provisions'.
Over-the-counter (OTC) Derivatives
Securities traded in some context other than on a formal stock exchange are said to be ‘over-the-counter' transactions. Financial instruments, such as derivatives trade via a dealer network, directly between two parties, as opposed to on a centralised exchange
Pension Protection Fund (PPF)
The PPF is the lifeboat fund for UK corporate defined benefit pension schemes. Its main function is to provide compensation to members of eligible defined benefit pension schemes, when there is a qualifying insolvency event in relation to the employer, and where there are insufficient assets in the pension scheme to cover the Pension Protection Fund level of compensation.
The ability to maintain exposure and transfer a collateral position even if a clearing member defaults.
Present value (PV)
The value in today's money terms of a series of cash flows expected to occur in the future. The future cash flows are discounted to reflect the time value of money.
A measure of the sensitivity of the present value of a series of cash flows, to a 0.01%p.a. rise in interest rates.
Quantitative Easing (QE)
A form of unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank implements QE by buying financial assets from commercial banks and other private institutions, thus creating money supply, and injecting a predetermined quantity of money into the economy.
Qualifying Investor Fund (QIF)
A QIF is a regulated, specialist fund vehicle targeted at sophisticated private investors and institutional clients. The funds are typically domiciled in Ireland and authorised by the Central Bank of Ireland.
These funds are often used for client's LDI mandates as they are flexible and reduce the documentation requirements (e.g. ISDAs, CSAs) when compared with segregated LDI mandates.
Real interest rate (real yield)
A nominal interest rate (yield) that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower, and the real yield to the lender.
The risk that future coupons and redemptions from a bond will not be reinvested at the interest rate prevailing when the bond was initially purchased.
See 'Gilt Repo'.
Retail Prices Index (RPI)
The key measure of inflation used in the UK and, together with CPI, commonly used by DB pension schemes to ensure that pension benefits keep pace with the cost of living.
The ability of an individual/ retirement fund to accept variability in returns or losses from an investment due to any type of risk. Typically set in terms of VaR (value at risk) and will likely take into account volatility of assets relative to that of the liabilities.
This describes the position whereby a pension scheme is sufficiently funded and its assets are expected to be sufficient to fully discharge its liabilities under a prudent set of assumptions. Being self sufficient means low/ minimal reliance on the sponsor covenant.
A pension scheme valuation that assumes that the plan suddenly stops operating as of the valuation date. It is intended to test whether the plan has sufficient assets to provide an immediate payout of all benefits to members that have been earned to that date.
SONIA (Sterling overnight Interbank Average Rate)
An index that tracks the sterling overnight funding rate. This rate is important in an LDI context as it is the rate that underpins the calculation of an interest rate curve used for discounting sterling OTC derivatives that are transacted under ‘clean CSAs'. It is also the required rate of interest to be paid to counterparties on any cash received as collateral to support derivative positions.
A supranational entity is formed by two or more central governments with the purpose of promoting economic development for the member countries. Supranational institutions finance their activities by issuing debt, such as supranational bonds. Examples of supranational institutions include the European Investment Bank and the World Bank. Similarly to the government bonds, the bonds issued by these institutions are considered very safe and have a high credit rating.
A derivative contract where a stream of payments is exchanged for another stream of payments, in order to transform the nature of a given set of cash flows. The most common type is an interest rate swap where a variable rate of interest (e.g. LIBOR) on a nominal amount is swapped for a fixed rate of interest.
An option on an interest-rate swap, that gives the buyer the right – but not the obligation – to enter into an interest-rate swap agreement at some specified date in the future.
Syndication is a process whereby an issuer appoints a group of banks to manage the sale of a bond on its behalf. In the case of a conventional or index-linked gilt syndication four banks are typically selected and these banks must commit to buying all the gilts being issued if other buyers cannot be found. Gilt syndications have been used regularly since 2009 and are typically only used for bonds with over 20 years to the bond's maturity date.
Synthetic equities/bonds (unfunded equities/bonds)
Using derivatives or other instruments to replicate the payoff and risk profile of physical equities/ bonds. The most common types of synthetic equities are equity total return swaps and futures and synthetic bonds are gilt futures, gilt repos and gilt total return swaps.
An entity that centrally collects and maintains the records of OTC derivatives. These electronic platforms, acting as authoritative registries of key information regarding open OTC derivatives trades, provide an effective tool for mitigating the inherent opacity of OTC derivatives markets.
The Transfer Value (or more accurately – the Cash Equivalent Transfer Value) is the cash amount that would be paid out from a pension scheme in respect of the members benefits accrued in that pension scheme. Members who are no longer active members of a pension scheme but have accrued benefits may request a transfer value quotation, and may subsequently request that the cash be transferred into another pension arrangement in exchange for giving up the accrued benefits. Some pension schemes provide an incentive for members to take transfer values by providing an Enhanced Transfer Value.
Value at Risk (VaR)
A statistical method of measuring risk of loss. VaR is often used as a measure of funding level risk. It can be defined with different levels of probability, e.g. VaR95 denotes the 95th percentile loss. In other words, the funding level is expected to deteriorate by at least that amount, one year in twenty.
A chart plotting the interest rates available on bonds (or swaps) of various lengths of term. The yield curve is relevant because often pension scheme benefits due to be paid at different points in the future will be valued using different interest rates depending on the time to payment.
Z-spread (on government bonds)
The flat or constant spread over a swap curve such that the present value of the bonds cash flows is equal to the bond's dirty price. A measure of the difference in yield between swaps and gilts.