Sebastian Cheek investigates the routes that investors are taking as they search for new ways to reduce liabilities in a volatile market
A sound understanding of financial risk is vital to any defined benefit pension scheme looking to manage its liabilities.
However, the problem scheme managers and trustees are currently facing is that risk is presenting itself in a number of guises. With inflation dropping to unprecedented levels, interest rates following suit and pensioners living longer by the day, risk is omnipotent and making liability management a real uphill struggle.
Added to this is the fact that equity values have fallen by as much as 40% of late. Pension schemes are subsequently finding the asset side of their balance sheet is falling while the liability side is shooting upwards.
The standard practice of measuring liabilities is the IAS19 route using AA corporate bonds. This method has been a bone of contention within the industry recently as corporate bond spreads have ballooned over the past 18 months.
“The reason is because people are genuinely worried about the risk of holding them,” said Pension Corporation partner Dr. Amarenda Swarup.
At present if a scheme is using these high yields to discount then its liabilities suddenly look much smaller, which is painting the wrong picture.
“If you were discounting at a spread of, say, 80 basis points 18 months ago, now you are discounting at say 300 basis points or more,” said Swarup. “That is not particularly informative as to your true liabilities because the perceived risk of these assets has blown out.”
This is for two reasons, according to Swarup. Firstly, it does not take into account the increased risk which the scheme should have made adjustment for; and secondly, strictly speaking, a scheme should only be discounting at AA corporate bond yields if investing in them.
The other recognised way of measuring liabilities is using government bonds (gilts). An interesting phenomenon has recently arisen between yields from government and corporate bonds (see Chart 1 below).
Hewitt Associates UK lead, global risk services, Kevin Wesbroom observed: “Actuarial values can move up or down – or both ways at once – depending on whether you are looking at gilts-based measures or corporate bond measures. The two measures [bond yields] have moved apart in completely different directions and the important question is which one of these to make a priority to control risk because there is a good chance a scheme cannot control both at the same time.”
The corporate bond market reputation has taken a further hit because the AA index comprises mainly financials, which, despite their AA rating, are no longer thought of as high quality following a number of high profile bank collapses.
Opinion was divided on which type of risk actually presented the greatest threat to pension schemes at the moment, although it was quite obvious that longevity risk is among the most worrying.
The Hewitt Global Pension Risk Survey 2008 revealed that longevity was high on the list of risk factors companies are most concerned with. For UK companies in the survey this caused more anxiety than equity market risk.
Swarup concurred with this viewpoint, especially considering each year a person lives adds about 3% to 4% to the liabilities of the pension fund.
Swarup explained: “Longevity is much more than people thought when setting up the schemes. We are now at the stage where you can realistically expect to spend at least a quarter of your life in retirement.”
A number of options are in the market to help schemes hedge against longevity risk, including insurance companies offering buyout solutions. The explosion in the volume of business written by such firms over the past two years alone is testimony to the effectiveness of this form of hedging.
Mercer principal Kevin McLaughlin said in these circumstances it makes sense for insurers to be holders of the risk but the conventional buyout route can be expensive. For this reason there is now an increased momentum in the development of longevity swap products.
McLaughlin said pure longevity swaps are likely to become a more regular part of a pension scheme’s arsenal against longevity risk.
“In the next 12 to 24 months we will see more potential deals coming through,” he said, “because the gap between what pension funds are reserving at and what price the counterparties will take on the risk at has narrowed significantly.”
Counterparty risk – the risk that the company you deal with will still be in existence years down the line – was not considered particularly threatening, or interesting even, until the Lehman Brothers scandal. Suddenly pension schemes using swaps were forced to think about the credit ratings and financial futures of the companies they dealt with.
Insight Investment director Financial Solutions Group and senior LDI product specialist Steve Aukett said the schemes that were stung most after Lehman may have been those that did not collateralise on a daily basis.
“Lehman going bust might have been thought of as the death knell of using swaps to hedge liabilities,” said Aukett.
“But quite the opposite, swap-based hedges were highly rewarded as real swap rates fell dramatically boosting swap values. Those managers and schemes that did not collateralise their swap positions with Lehman daily may have lost out.”
If a pension scheme enters into a swap with a counterparty, the counterparty agrees to post collateral – secure assets that show a firm can pay the current value at any point in time. The collateral process, which is usually standard between the counterparties, assures if the contract is in profit in the name of the scheme then the counterparty has to post an equivalent amount of capital in the form of gilts or cash to the scheme as security for the future.
The case for swaps
According to the experts there are currently opportunities for pension funds in government and corporate bond markets, which are offering higher yields than the swap market. The challenge for pension funds is to get hold of capital to buy those securities.
Barclays Global Investors head of liability-driven investments (LDI) Tarik Ben-Saud said LDI strategies can be expensive, especially if pension funds buy bonds against every single future cash flow for the liabilities. In this case the bonds use up the pension fund’s capital and leave nothing to achieve excess return.
Ben-Saud continued: “When pension funds use swaps they hedge that liability of volatility but they won’t have to commit 10% to 15% of capital to the initial swap position. The remaining capital they can invest in other strategies, such as equities or corporate bonds, to generate the extra return.”
Swarup said: “Swaps are usually more efficient. If you were to use traditional instruments such as gilts and index-linked gilts, you will get great hedging against interest rates and inflation. The problem is if you are underfunded, you may not be able to have enough in return seeking assets to easily generate the excess returns needed to make up your deficit. If you use swaps, however, you can hedge all your liabilities and still leave a significant chunk of your assets free to invest in return seeking assets.”
BlackRock head of the strategic advice service Robert Hayes added clients need to work with their fund managers on an interactive basis because the fund manager needs to understand the client’s fundamental requirements and explain the pros and cons of different solutions.
“We would say from a return perspective corporate bonds look very attractive and swaps look quite expensive. The crucial thing is making sure you are using the right ones for the right fund.”
How are pension funds currently seeking to manage their liabilities? Danish pension fund ATP’s chief actuarial officer Chresten Dengsoe explained the scheme’s strategy: “The hedge programme mainly uses nominal swaps but recently also the purchase of government bonds to hedge liabilities. The objective is to exactly match the duration of liabilities at a series of specific maturities ranging from two to 30 years. The programme is more or less completely executed in derivatives or similar vehicles and therefore does not tie up cash.”
Over the past 12 months ATP has achieved a gross profit of roughly DKK64bn (£7.9bn) but, as Dengsoe pointed out, this was more than offset by a DKK82bn (£10.1bn) increase in liabilities.
The Pensioenfonds KBC in Belgium adopted and implemented an LDI strategy in 2007.
This implied the splitting of the portfolio in two parts: the hedging portfolio in which all government bonds were replaced by interest rate swaps, 200% leveraged and partially inflation-linked, and the return portfolio consisting of equities and real assets.
“In 2008 the hedging portfolio worked as we planned it,” explained Pensioenfonds KBC managing director Edwin Meysmans. “The pension liabilities increased with €40m (£37bn) – because of the falling swap rate – but the LDI funds increased with €80m (£74m) – more than planned because of the inflation-linked part.
“The hedging portfolio had a return of +25% in 2008. The return portfolio suffered because of falling equity markets and the decline in real estate valuations, the return in 2008 was -40%. In total, the portfolio had a return of -15 % but without the LDI strategy the return would have been -25%, the average of Belgian pension funds.”
Meysmans concluded: “LDI makes sense for every pension fund – because unrewarded risks such as interest rate risk are removed – but implementation right now, in this low interest rate environment, is very difficult.”
An innovative funding structure has been agreed for Croydon Pension Fund. However, there are some concerns about the arrangement. Stephanie Baxter reports
Some 52% of red flags raised by schemes on suspected scam pension transfers involve advisers or unregulated introducers, a report by the Pension Scams Industry Group (PSIG) has claimed.
The Norfolk Pension Fund has been successful as the lead plaintiff in a class action case that went to jury trial in California involving securities fraud.
In this week's Pensions Buzz, we want to know whether bosses should have to pay into the same staff DB scheme as their workers rather than their own executive pension fund.