With return-seeking assets remaining volatile and in many cases well below the levels reached before the onset of the financial crisis, the difficult environment for defined benefit (DB) pension schemes continues. While bonds have performed well, this has not been enough to ensure that scheme assets have increased sufficiently to offset the rise in liability values as yields continue to fall.
This challenging market backdrop has resulted in on-going volatility in pension scheme funding levels, with the large majority remaining in deficit or seeing their deficits increasing. As a result of this, companies continue to have significant concerns about the risks surrounding DB pension schemes, with around 90% being closed to new entrants and 40% being closed to future accruals. Figure 1 shows how volatile pension scheme funding levels have been in recent years and that schemes remain significantly underfunded in aggregate. It should be noted that this data is generated on the basis upon which the Pension Protection Fund (PPF) values pension payments and therefore understates the true economic picture.
Historically, pension scheme trustees have focused on managing the asset side of the balance sheet making the assumption that maximising the return from scheme assets is the best way to ensure a scheme returns to a fully funded position. In truth, however, this approach only addresses one half of the overall solution to closing pension funding gaps as it leaves liability risks entirely unmanaged. Liabilities can be extremely volatile, with small changes in the interest rate and inflation environment capable of having large impacts on future obligation levels. Indeed the increase in value of liabilities over the past few years has significantly outstripped any growth in a scheme’s assets due to the long duration of a pension scheme’s liabilities, as shown in Figure 2.
With real yields at historically low levels, the current market environment would not appear to be particularly conducive to hedging liability risks (i.e. interest rate and inflation exposure). However, pension schemes need to be ready to act when conditions change such as in 2007 when liability values fell. In recent years, the prevailing market environment has proven its ability to change extremely quickly often leaving those who are unprepared behind. The fact that pension scheme governance structures, where trustees often only meet on a quarterly basis, are not conducive to quick decision-making increases this risk.
One solution that has become increasingly popular is for pension schemes to mandate a specialist investment manager to ensure that when acceptable market levels are reached, the pension scheme is in a position to remove the liability risks. This is instead of commencing a search for a manager that can take months to conclude by which time the opportunity may have passed. An example of this is setting up a series of customised trigger points, where inflation and interest rate risks will be hedged once inflation expectations and interest rates reach levels acceptable to the pension scheme and the sponsoring employer. Investment managers with a specialist capability in liability driven investment (LDI) can also add value for their clients in other areas.
Efficient Use of Capital
Increasing allocations to fixed income assets in an attempt to match liabilities has proved to be inadequate as evidenced in Figure 2. The average duration of a portfolio of fixed income assets remains significantly short of a typical pension scheme’s average duration of liabilities resulting in on-going funding level volatility. As such, the use of derivative instruments to extend the duration of a fixed income portfolio remains one of the key approaches to matching a pension scheme’s assets to its liabilities.
The use of interest rate and inflation swaps typically provided a yield of around 30 basis points (bps) more than the equivalent gilt. Since the collapse of Lehman Brothers, however, this situation has inverted with gilt yields pushed higher relative to swaps, making them more attractive for use in liability hedging, as shown in Figure 3. Specialist LDI managers can currently profit from this by using gilts for hedging rather than swaps, to the benefit of their clients.
Source: Bloomberg and Insight Investment
This is not necessarily the case across the entire inflation or interest rate curve where swaps may still offer better value at certain points. Significant value can be added by an investment manager actively managing these positions and switching between conventional and index-linked gilts, as well as between gilts and swaps, to generate additional returns by exploiting market anomalies. This difference in pricing across the curve is shown in Figure 4.
Source: Boomberg and Insight Investment
DB pension schemes, howver, do not have a surplus of cash available to be invested in gilts and they are unwilling to reduce exposures to return seeking assets, as this will have an impact upon the anticipated time to reaching a fully-funded position. One way of achieving an unfunded exposure to gilts is through the use of sale and re-purchase (repo) agreements. These allow a pension scheme to achieve an exposure to liability matching gilts without having to put up the equivalent amount of capital, allowing this to remain deployed in return-seeking assets in order to reduce the deficit position. Given the use of this market by banks to manage their balance sheets, the repo market is both deep and liquid.
An alternative to this approach is to ‘synthesise’ return seeking assets that are invested on a passive basis. An example of this is a passive equity portfolio where the market exposures of holding physical equities can be replicated by using equity total return swaps. This means that the underlying equity investments can be sold while the equity market exposure is retained through the derivative positions. The capital released from the sale of the physical equities can then be invested in gilts in order to achieve a liability matching exposure as well as obtaining the additional yield over and above that from swaps.
Counterparty Risk Management
Clearly the counterparty to these transactions for a pension scheme is an investment bank. In an environment of downward moving credit ratings, counterparty risk management remains as key as it ever was. Insight Investment independently values all derivatives that it manages on behalf of its clients and requires counterparty banks to post eligible collateral to the value of the mark-to-market valuation on a daily basis. This mitigates counterparty exposure to an overnight movement in interest rate or inflation expectations.
While markets remain tough for pension schemes, it is critical that pension schemes use this time to be prepared for when conditions change. Mandating a specialist LDI manager can not only help pension schemes manage both liability and asset risks, thereby reducing funding level volatility, but can also ensure that they are in a position to react quickly to the changing investment environment. In the meantime, gilt hedging and synthetic positioning are examples of areas where active specialist investment managers can continue to add value for their clients.
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