Interest rates have been stuck at historic lows since March 2009 and show no signs of increasing any time soon. Chris Panteli looks at how schemes are dealing with the repercussions
The period of low interest rates has lasted far longer than many pension funds would have predicted back in March 2009 and has forced some to look at new and more innovative ways of hedging.
Among the tactics used to deal with these conditions is putting interest rate triggers in place that allow schemes to hedge when the cost to do so becomes cheap. Others, like the US’ California State Teachers Retirement System, have allowed for a certain amount of flexibility around their hedges, while some European schemes are believed to be looking at forward start swaps.
For pension funds, low interest rates ultimately mean higher liabilities. It is estimated that for every 1% fall in rates, liabilities rise 20%. The fall of the UK bank rate from 5.75% in July 2007 to 0.5% in March 2009 – which has not moved since – means funds have seen gaping shortfalls open up in their deficits and have been forced to look at different ways of making up the difference.
When the financial markets plummeted in 2008, stock market losses wiped out trillions of dollars in pension fund assets. The market’s rebound since then has helped make up some of those lost assets, but lower interest rates have made it more costly to meet future liabilities.
In the last year alone, the ratio of assets to liabilities of the 100 largest private pension funds in the US has fallen from 82 cents on the dollar to just 73 cents as interest rates have plummeted to 0.25%.
In Europe the story is no different. Recent research by Mercer predicted German pension plan liabilities will reach an “historic high” before the end of the year due to low interest rates and falling bond yields.
The firm said the liabilities of DAX 30 pension schemes are expected to increase by 23% to €270bn ($380bn) from €220bn by the end of December, while the unfunded status is likely to increase by €40bn to €115bn.
German government bond yields fell after the European Central Bank Council reallocated funds into German and US government bonds. Consequently, the iBoxx AA corporate 10+ bond declined and index corporate bonds’ credit ratings also dropped in Germany and the euro zone as a whole.
Mercer Germany’s chief actuary, Thomas Hagemann said: “A decline in the discount rate by 50 basis points leads to an increase in the liabilities of a pension plan by up to 10%. For this reason the level of pension plan liabilities rose faster than the assets that are held in numerous markets. The end result is much greater shortfall in the balance sheets of companies.”
Russell Investments senior consultant Lloyd Raynor said low rates have meant liability hedging has become too expensive for many schemes. Instead, a growing number are using target-rated tables in anticipation of more favourable conditions.
“What they have done is put target rated tables or trigger-based mechanisms in place, so if the hedging of interest rate exposure becomes cheaper, so if interest rates increase, they effectively have a mechanistic or automatic process in place to increase their hedging of interest rate exposure,” Raynor said. “As interest rates increase, you ramp up the amount of interest rate hedging you have in place.”
Look before you leap
In the US, the California State Teachers’ Retirement System has adopted a cautious approach while keeping a close eye on developments. The fund has been careful to stay within its overall risk and duration guidelines, while reviewing where it finds itself in the investment and interest rate cycle.
“The fixed income unit is constantly reviewing its holdings, projected interest rate and inflation levels and gathering ideas as to how we will structure the portfolio in anticipation of when/how the Fed begins withdrawing the current liquidity in the marketplace. In short, we continue doing what we’ve done in the past but remain flexible,” a spokesman for the fund said.
“While the current environment does not lead us to stretch for yield or increase risk levels in portfolios, we do use all of the resources available to us to develop strategies that we believe will position us well for the environment we foresee over the upcoming three to six months and even further out.”
Meanwhile, research by F&C Investment found UK schemes have changed the way they deal with low interest rates and the associated inflationary risk. Its LDI (Liability Driven Investment) Survey, published in October, found pension funds decreased their inflation hedging by almost a third in Q2 2010, compared to Q1 2010, but maintained similar levels of interest rate hedging.
F&C attributed the fall in inflation hedging to a combination of unattractive market levels, an acute and prolonged period of pre-election wariness, and renewed concerns about the potential for a ‘double-dip’ recession, as well as deflationary fears. This, F&C said, meant a considerable volume of hedging activity was put on hold.
However, Nisha Khiroya, an investment specialist in F&C’s LDI division, believes this has now changed, and schemes are focussing more on inflation hedging while leaving interest rate risk out.
“Schemes still think interest rates are likely to go up,” she said. “The perception has been the same for the last year and a half and look what has happened; it’s actually gone the other way around. Yields have fallen and there has been this constant expectation of interest rates going up. A whole year has passed and it hasn’t happened.
“Pension schemes just don’t want to hedge at these levels because they lock you in to a lower funding ratio effectively. They do want to hedge inflation however, and that has been pretty constant over the last three quarters.”
A new hope?
One option being considered by funds is the use of forward start swaps, which allow hedging to begin at an agreed point in the future. They have been used by the insurance industry for some time, but according to Khiroya are now being looked at by pension funds.
“You are explicitly saying ‘if there is volatility over the next few years I can handle it, but after a few years I want to lock in the rate I’m getting currently, which is actually quite high’” she said. “It could be over 4% because it’s an upward sloping curve. A lot of banks are suggesting pension schemes hedge using forward starting swaps and it’s something I think will take off.
“It’s growing in interest in the UK and Netherlands. I couldn’t say whether we have carried out any transactions but it is definitely being discussed.”
Russell’s Raynor said schemes should be clear from the outset whether they are using assets to hedge their liabilities or to outperform their liabilities to make up the deficit.
“The standard issue is if your deficit has increased because interest rates have reduced, you may say you should therefore take more risk to make up the difference, but it is rarely that simple. The Pensions Regulator might be very chary of trustees taking additional risk because they may be concerned about the company covenant.”
He conceded there isn’t necessarily a simple, clear-cut response to interest rates reducing and deficits increasing, and believes yields aren’t too far off fair value.
“I would be a bit wary about being overly-tactical in this space,” he added. “Some clients may have some form of enhanced or tactical asset allocation in place around interest rates, but it’s pretty rare from our perspective.”
As Raynor pointed out, the current valuation of a lot of the major asset classes is remarkably close to their long term averages despite the massive global shake-up and volatility experienced over the last three years.
M&G head of institutional fund management David Lloyd said the yield on two staple investments for UK pension funds - long-dated gilts and high quality corporate bonds – is now surprisingly close to long term averages.
“The yield on a 30-year gilt has for about ten years now ranged between 4% and 5% and is currently at 4.3%. On investment grade credit it’s at 5%, which is pretty much in line over the last ten years. What has changed dramatically are things like interest rates which are currently very low, but that hasn’t fed all the way up the yield curve. It’s affected 10 year bonds but pension funds don’t have so many of those.
“I think that’s why there is a lot of indecision about at the moment because not only have you got all this uncertainty, but it is against a backdrop of asset pricing that is remarkably unremarkable.”
It is ultimately the uncertainty over what the government and markets will do over the coming months which is making it difficult for schemes to predict where interest rates will go. But whatever the future holds, most believe pension funds will have to put up with low rates for some time yet.
“Official interest rates are going to stay low for a protracted period. Our guess is that rates will start to rise at the back end of next year,” said M&G’s Lloyd. “Similarly in the US, and we should never entirely forget the direction of the US Treasury market always has a significant influence on the direction of the UK and other developed bond markets.”
The PPI has unveiled a policy paper outlining current considerations and policy debates relevant to DC scheme default strategies. Kim Kaveh explores some of its views.
The £30bn local government pension pool has appointed Quoniam and Robeco to manage an active equity portfolio worth around £400m.
The volume of insured buyouts from FTSE 100 defined benefit (DB) schemes could increase from £5bn to £300bn by 2029, according to Lane Clark & Peacock (LCP).