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Management

Minimising unintended pensions risk

Written by Steve Aukett, Senior Product Specialist, Insight Investment, 2007
Friday, 01 December 2006
After enjoying the fruits of a sustained stock market rally from the mid-1970s onwards, trustees and sponsors of UK pension funds faced a sharp wake-up call at the start of this decade. The three-year equity bear market, compounded by falling bond yields and a steady improvement in mortality rates helped to drive the vast majority of pension schemes into significant deficit in the space of just a few years. Although equity markets have since recovered, most schemes remain under-funded. With interest rates still low and life expectancy on an upward trend, pension fund deficits are proving stubbornly resilient. Historically, actuaries could choose to ignore poor investment returns in the short term as the performance of assets was assessed on a long-term basis. A number of factors have changed this, not least the introduction of FRS17/IAS19. A bad year for a company’s pension scheme now directly impacts its bottom line and, depending on the size of the scheme, can significantly skew the picture of its overall financial health. Furthermore, if a scheme is invested heavily in equities and under-exposed to movements in interest rates, the company’s balance sheet is exposed to significant market risk. A sharp equity sell-off and/or a fall in interest rates prior to the valuation date could be damaging for a company’s commercial interests. Pension deficits are now analysed in the same manner as any other item on a corporate balance sheet and can influence not only decisions to invest in a company’s equity or debt, but can be the deciding factor in reaching a takeover agreement, as evidenced by UK retailers WH Smith and Marks & Spencer. Both companies saw takeover talks fall through as interested parties could not justify acquiring so much debt. An under-funded pension scheme, and all the responsibility that accompanies it, represents a significant risk to potential buyers. With pension funding levels now firmly part of a company’s public accounts, the risks within a pension fund need to be managed in as rigorous and consistent a way as any other risk on the balance sheet. Few finance directors would conceive of allowing sizeable interest rate exposure in their treasury operations and yet the same risks contained within the company pension scheme often go unchecked. This is partly due to the popular misconception that equity exposure poses the main risk to pension funding levels, when the risks from changes to interest rate and inflation expectations can be far greater. The Pension Protection Fund, which became operational in April 2005, requires schemes to pay a pension protection levy comprising two elements: a scheme-based levy and a risk-based levy. All eligible schemes pay the first component and are only exempt from the latter if they are more than 125% funded. The risk-based levy invoiced is directly linked to the degree of insolvency risk posed, meaning that the higher the risk of insolvency, the larger the financial cost to the company. So what are the options for companies saddled with significantly under-funded pension funds? An obvious solution would be to inject more money into their schemes, but since deficits often run into millions, finite resources may render this impractical; even if sufficient financing is available, risks need to be carefully managed to ensure the scheme does not slip back into deficit. A second option would be to seek an investment strategy that not only aims to mirror a scheme’s liabilities, but also ensures that the risks it undertakes are sufficiently rewarded. This is where liability-driven investment (LDI) comes into its own. Whereas traditional approaches to pension fund management have tended to set objectives with a loose relationship to liabilities, an LDI approach places liabilities firmly at the heart of investment strategy. Since the main objective of any defined-benefit pension scheme is to meet its liabilities, LDI is relevant to all these schemes, regardless of their size or funding level. LDI is based on the principle that the ultimate benchmark for any defined-benefit pension scheme should be its projected cashflows (future liabilities). These cashflows, considered in the context of a scheme’s funding status, maturity and the financial strength of the sponsor, will be the driving factors in determining its investment target return and tolerance for risk (relative to its liabilities). LDI does not claim to remove all investment risk, but rather to minimise unrewarded and unintended risk. A traditional investment approach, which typically involves a high exposure to equities, leaves schemes open to a variety of risks, including those associated with the fund manager, stock markets, interest rates, inflation and longevity. While equity market risk often receives the most attention, the main risks to funding levels typically come from interest rate and inflation exposure. An LDI approach will ensure that those two key risks are minimised as much as possible. It will also help ensure that any active investment risk taken is done so in the context of the return a scheme needs to meet its liabilities. By providing an effective framework for managing risk, LDI aims to deliver a significant improvement in a scheme’s risk/return characteristics compared with traditional strategies. LDI strategies generally consist of two key components: a core portfolio that seeks to match liabilities and a portfolio of return-seeking assets that aims to generate growth. The liability matching portfolio is designed to replicate the profile of a scheme’s liabilities and, specifically, their sensitivity to changes in interest rates and inflation. This component may be built from a combination of fixed-income and index-linked bonds, together with interest rate and inflation swaps. While not all strategies will use swaps, they enable much more effective liability-matching than bonds alone. It is certainly possible to achieve a close match through a bond portfolio, but the precision of the match is restricted by the availability of bonds in issue, which can be particularly problematic for long-dated and inflation-linked liabilities, as the supply of appropriate bonds is relatively limited. In contrast, swaps can be tailored to meet an investor’s specific requirements, permitting a much closer match to liabilities. Swaps can also be used on a non-intrusive basis, via a swap overlay, leaving underlying assets unchanged. The return-seeking component, meanwhile, may invest across a diversified range of asset classes, markets and strategies to generate consistent long-term investment returns to help reduce any funding deficit. The return-seeking component is relevant for most schemes, not only because they are rarely fully funded, but also as a means of protecting against changing variables. Since pension liabilities are effectively actuarial estimates based on a number of assumptions, it is prudent to aim to be over-funded to avoid future shortfalls as a result of changing projections, such as mortality rates. Swaps also form an essential part of the return-seeking component as they enable schemes to benefit from a “portable alpha” strategy. Through the use of swaps, a portable alpha approach enables you to effectively attach the return you are seeking to the benchmark that is most relevant – for example, your liabilities within an LDI context. This could involve constructing a portfolio of cash and swaps that is actively managed against an LDI benchmark. Some of the cash that is backing the swaps can be replaced with actively managed funds that aim to deliver attractive returns relative to cash. The process effectively transfers the active management from the cash-benchmarked funds onto the scheme’s liability benchmark. The performance target becomes the LDI benchmark plus the outperformance target of the actively managed funds. The benefits of LDI – and of using swaps within an LDI strategy – are compelling. However, while finance directors may be fully accustomed to using derivative instruments, the complex nature of swaps, and indeed LDI itself, can be daunting for pension fund trustees. With trustees increasingly under pressure to demonstrate adequate understanding of their scheme’s investment strategy, education is essential to provide them with a sufficient level of comfort to adopt a new approach.