UK - The Boots pension scheme in the UK is using an innovative interest rate swap arrangement to implement its strategy of matching the scheme's assets more closely to its liabilities.
It has increased by £200m the index linked portion of its assets, increasing from one quarter to one third the index linked proportion of the portfolio.
Under an arrangement with Barclays Capital and Royal Bank of Scotland over a 15-year period the cash flow from fixed rate bonds is swapped with cash flow from indexed linked bonds.
The advantage of arranging a swap rather than buying index linked bonds is that the deal can be customised to fit exactly the pension fund’s requirements.
John Ralfe, head of corporate finance at Boots and a trustee of the Boots Pension Trustee Investment Committee said: “Because a swap is a private arrangement between you and the bank, you can incorporate any feature you like. These swaps have a “floor”, so in the event of deflation the amount the pension fund receives doesn’t go down, unlike with index linked bonds. As pensions do not reduce with inflation, this is the perfect asset.”
Any credit risk attached to the banks is minimised through a monthly cash collateral arrangement.
Ralfe says interest rate swaps are innovative for pension funds, though common for corporate financing. “Pension fund use of swaps is 10 years behind companies. Pension funds will catch up over the next five years.”
Ralfe did not rule out further interest rate swaps: “We will keep it under review,” he said.
Guy Freeman vice president at JP Morgan confirmed use of interest rate swaps is uncommon among pension funds. Though he believes Boots is not the first pension fund to use them, it is the first to make public this strategy.
Freeman said swaps could be useful but were relatively unknown: “Many trustees are not familiar with them. They don’t fit into the framework of how pension funds are managed with delegation to specialist managers and management against benchmarks. Swaps are not considered in asset allocation studies.”
Boots’ strategy to move out of equities and into bonds has been justified by performance, according to John Watson, chairman of the trustees. Last year the value of the pension fund rose from £2.3bn at the end of March to £2.4bn at the end of December.
Watson said: “If the Boots scheme had not sold its equities during 2000 and 2001, when the FTSE100 share index averaged 6,000, there would now be a significant deficit and the trustees’ objective could not be met without increased company contributions.”
Ralfe said that Boots pension scheme’s move out of equities and into bonds reduced risk to the 72,000 members, ensuring the fund will be enough to pay pensions regardless of the performance of the financial markets.
It also reduced management costs from £10m to £250,000, because the bonds are held passively.
By Shona Cronin
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