Most pension scheme trustees would agree on one thing. Long-term interest rates are at low levels in the UK today (compared to their history). It’s easy to find explanations for this among economists. It's just as easy to find predictions they will go up, down, or stay the same. Unfortunately economists and markets have a poor track record of predicting interest rate moves.
The point of this post is not to offer another view on interest rates.
If we believe rates are rising should we still be hedging?
Pension schemes feel like they are stuck between a rock and a hard place with regard to making decisions about interest rate hedging. They recognise that falls in interest rates may have hurt their funding position by increasing the liability side of their balance sheet (this has been well documented, for example here).
On the other hand…
They know they can’t do anything about the past and the feeling that rates might rise in the future makes them hesitant to put in place hedging now.
It can be tricky to unlock this mindset. The first step is to move away from a binary decision about hedging. It needn’t be a discussion of hedging or not hedging. We believe it's more helpful to turn it into a discussion about how much. There are a lot of choices between no hedging (0%) and fully hedged (100%).
Given the size of the risk and the impact of getting it wrong we believe it's important to right size your view on rates in terms of risk. This protects you from being wrong. It also allows for coherent risk taking across all your investments, for example how much you invest in equities.
Everyone believe rates will rise, why should we hedge at all?
It’s important to acknowledge that very few things are certain in the world of financial markets. What’s helpful for managing your pension scheme investment strategy is a sense of the relative probabilities of different scenarios, including a central case. Janet Yellen made this point in a recent speech:
"I am describing the outlook that I see as most likely, but based on many years of making economic projections, I can assure you that any specific projection I write down will turn out to be wrong, perhaps markedly so."
Janet Yellen May 2015
With that in mind, let’s consider some very simplified possible future scenarios for interest rates.
The chart below shows a neutral view of interest rates ascribing equal probabilities to three scenarios of interest rates going up, down, or staying the same.
Now, a strong view that interest rates might rise would warrant modifying these probabilities. For example, increasing the probability that rates will rise to 50% and reducing the probability that they will go down or stay the same to 25% each. Intuitively, given the magnitude and impact of the risk of rates not rising, you would still be hedging some of your interest rate risk.
If we stretch this this to the extreme then even the most adamant interest rate “hawk” would surely agree that a 100%/0%/0% split of probabilities is unrealistic – very few things are certain in financial markets! Only with this level of conviction would you do no hedging.
How can we incorporate our probabilistic view on rates rising into our hedging decision?
If the probabilities are tilted toward interest rates rising, then there is some reward (expected return) from not hedging interest rates. However, history and models show us that this carries some risk. How much risk should we let ride on this view? It turns out this question is relatively easy to answer, we can do so using some basic financial theory of portfolio construction.
We’ve developed a simple framework for assessing the appropriate level of hedging, it views the pension scheme as a simplified combination of two assets. The return seeking asset portfolio (we will assume as equities) and the liabilities (we will assume as being 30 year gilts).
Using our modelling we can determine the level of risk of each element and the correlation. By having a view on interest rates we can also determine the expected return of each element. Once we have all that we can look at the optimal combination of the two pieces to deliver different levels of risk and return (Do get in touch to discuss in more detail).
Let's take a simple example. Let's consider a pension scheme, 80% funded with a growth asset portfolio invested in line with the typical UK pension fund (around 40% in equities), and a strong view that long-dated interest rates should rise. Let's quantify that interest rate view by saying that rates should be 3 percentage points (300bp) above that implied by the current forward curve.
Currently 30-year gilt rates are 2.6% and forward rates in 5 years’ time are nearly 3%. So, we can express this scheme's strong view on interest rates as saying "I believe there is a 50% probability of gilt rates being above 6%". The last time gilt rates were this high was over 17 years ago (in 1998). This view would imply your interest rate hedge ratio would be around 50% to be congruent with your view on equity risk and return.
An alternative viewpoint might be that interest rates will rise, but not by as much. Let's say the view is a 50% chance they will rise by one percentage point (100bp) above the current forwards, in other words rising to a level of around 4%. This implies a hedge ratio of 70%. A hedge ratio of 70% is significantly above that of the average UK pension fund.
Even with pretty optimistic views on how much long-dated interest rates might rise, it is still logical to hedge at least half of the liability risk for most pension funds.
For a detailed analysis of your pension fund and how much to hedge we would be delighted to run an LDI health check for you and your trustees.