Speculation about rate rises has caused some schemes to delay any further liability hedging. Rosalind Mann looks at why this may be the wrong move.
We hear a lot about ‘fake news' these days.
Being constantly bombarded with information from so many different sources can make it very difficult to know which information to take seriously and which to dismiss.
The same is true when making investment strategy decisions. As many trustees will know, one of the most important investment decisions they will make is how much of the interest rate and inflation risk from their liabilities should be hedged.
Unfortunately there has been a growing misconception among some schemes that, with the UK's interest rates expected to be on an upwards trajectory, there is no longer any need to hedge their interest rate risk.
Speculation on UK rates has been rife and has, in some instances, caused schemes to delay hedging their liabilities, while the ongoing uncertainty regarding Brexit may also be encouraging trustees to hold off making a decision. However, with the rate rise that was talked about with certainly, just a few months ago, not now materialising, it is clear that the decision to delay implementing a liability hedge is far from risk free.
According to Schroders' analysis of the investment risks faced by the average UK pension scheme, liability risk - the risk that changes in interest rate and inflation expectations and will impact liability values - is the biggest hazard.
Indeed, while most trustees recognise the need to diversify investment risk across a range of different assets, many may not be aware that they could be running a much bigger risk with their unhedged liability values.
By filtering out some of the misconceptions about interest rates and funding levels, trustees should be able to make clearer decisions about the right level of liability hedging for their schemes.
Fake news #1: Today's BoE base rate matters
The current base rate set by the Bank of England (BoE) is still seen by many pension funds as the barometer for hedging their liabilities.
And while it's true that interest rates do matter - if rates fall the liability value increases and vice-versa - it's the longer term average rate earned until the liability cashflow falls due that is far more crucial.
For example, the average time to payment for a typical UK pension scheme is somewhere around 18 years. In other words, pension schemes are affected by the expected average future interest rate over the next 18 years.
While of course a factor, interest rate changes by the BoE are far less influential than the anticipated long-term direction of travel.
Fake news #2: Rates can only go up from here
Unfortunately, the anticipation of future base rate rises over the forthcoming months may provide a false sense of security for unhedged schemes.
The market already expects interest rates to start rising eventually. So in order for trustees to benefit from being under hedged, interest rates have to rise by more than the market expects. However, it is very difficult to predict whether rates will rise more or less than is already priced in.
By leaving their liabilities unhedged, trustees would be making a large one-way bet on interest rates. Indeed, it could be one which sees them lose out in a material way if rates do not rise faster than the market projects.
The ongoing discussions at the BoE on the future path of the base rate once again highlights the inherent uncertainty around short-term rates and the heroic task of making even medium-term predictions.
Adding to the level of uncertainty is the potential long-term impact of the imbalance between supply and demand for long-dated government bonds. With the huge potential demand to de-risk, from pension schemes and other institutions, there is a ready queue of investors ready to buy and this in itself could put a lid on how far rates could rise.
Remember it is the future path of interest rates and their anticipated rate of growth that are the key factors - not the shorter-term fluctuations - that need to be considered when making hedging decisions.
Rosalind Mann is a fiduciary manager at Schroders
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