Over the last ten years, pension funds and their corporate sponsors have found themselves on the sharply pointed horns of a dilemma. How to reconcile, on the one hand, the obvious need to recognize prudently the assets and liabilities of their pension funds with, on the other, the extreme burden of care that results from marking everything to market.
Well, by and large, pension funds and their corporates have grasped the FRS17 stinging nettle to varying degrees. Most have taken some sort of action to try and align the behaviour of pension fund assets and liabilities.
Many have discovered, to their angst, that waiting for the problem to solve itself is a futile strategy. I say this because since 2002 (when I believe I first started advocating the extreme sport of full liability hedging), there have been many who have argued that declining real yields are a temporary phenomenon and, with the passage of time, will rise again to dizzying heights which will shrink the liabilities to nothing. If only.
As I rummaged recently through my archives (what else to do when penned in by six inches of snow?) I came across this article that I wrote back in September 2003. It was, I suppose, an early blog. Anyway, I sent it to my various clients and one of them took fairly immediate and decisive action. On 2 December 2003, Friends Provident stepped out into the void and went where no plan had gone before. They hedged ALL of the interest rate and inflation risk in their pension scheme using swaps. In other words they protected the scheme against a falling real yield. And they did so when all conventional wisdom said such a fall was so improbable as to be virtually non-existent.
Between then and now, the real yield has done many things, but rising to dizzying heights is not one of them. Falling to unprecedented lows and staying there, is.
I’m not trying to pretend it was an easy decision to hedge the liabilities back in the early noughties with the real yield at 2.17%. It wasn’t (ask the guys at Friends Provident), but it should have been more widely acknowledged (especially by advisors) that a failure to hedge was to leave the plan exposed to gigantic and highly unpredictable market forces. A cursory glance at the parlous funding levels of most pension schemes today tells you all you need to know about how ferocious those market forces really were.
And it’s invidious to argue that hindsight is glorious 20:20 vision. You don’t insure your house because you think it will burn down; you take out fire insurance because it might burn down, and, if it does, that will be a disaster. As for your house, so for your pension plan.
Just for the record, I thought you might like to read that 2003 blog. Incidentally, here’s something interesting. Back in 2002/3, I routinely received such an extreme reaction to my suggestion that pension funds should embrace derivatives to hedge risk that I only dared to drop a gentle hint at this solution in the closing paragraphs. In truth, I thought long and hard about the obvious problem posed by writing a recipe and leaving out the main ingredient, but I finally concluded that the only way to be taken seriously was to start the discussion without trying to finish it.
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]