LIABILITY HEDGING IN 10 MINUTES

The main aim of this blog is to leave readers with two key thoughts:
 
  • Firstly, hedging is not a method to increase expected return but rather a way of further ensuring that a scheme will meet its objectives by removing the biggest risks in a scheme’s portfolio.
  • And secondly, the market has already priced in interest rates rising in the future. If rates remain lower for longer, then unhedged schemes should be prepared for falling funding levels. 

To provide some context, I recently had the opportunity to speak at a ‘Future Influencer Breakfast’ event hosted by UK Actuarial and Administration firm, Spence and Partners. I was given a 10 minute slot to talk about an investment topic of my choosing. I chose to speak about Pension Scheme Liability Hedging, a topic that has come to fruition over the past few years and one that is particularly relevant given the current economic environment. In particular the focus of my presentation would revolve around why pension schemes should hedge their liabilities against interest rates and inflation. 

This was going to be a tough sell in 10 minutes: real yields are at historical lows and implementing a hedging strategy can limit the upside return on your assets if real yields start to rise. I intended to challenge this perception of hedging strategies and provide a fresh way of thinking. 
 
Introduction

LDI (Liability Driven Investment) is now a common phrase amongst UK pension schemes but many still don’t have a hedging strategy in place and achieving full funding is one of the greatest challenges facing defined benefit pension schemes. Firstly, if we look at the funding level for a standard unhedged pension scheme1 versus a hedged pension scheme2 over the last ten years, then we clearly see, from figure 1 below, that the hedged scheme not only has a higher funding level over the period but the volatility is also greatly reduced (assuming they both start 80% funded).
Funding-levels.PNG

Unhedged liabilities and falling real yields over the last 10 years have been a toxic combination for many Schemes who are now facing an uphill battle. In 2013 the average UK pension scheme was just 61% funded on a self-sufficiency basis.3

With the scene set I concluded my introduction with the key to why pension schemes should hedge their liabilities. For any pension scheme the first step to achieving full funding is to set clear goals and objectives. There are many elements to this but the purpose is to increase the clarity of the problem, to drill down precisely what it is they are trying to achieve and make it is easier to evaluate the problems they will face along the way.
 
Why should pension schemes hedge their liabilities?

Pension schemes struggling to reach full funding, volatile deficits and uncertain economic conditions all sounds very bleak. Luckily the rest of my presentation focused on how to go about solving this problem. This was step 2; implementing an LDI framework. First we take a look at the average asset allocation of a UK pension scheme3 and measure the risk in that portfolio using a Value at Risk (VaR) measure at a 95% confidence level. That is, in a 1 in 20 downside scenario, what is the minimum amount the scheme could lose? We see from the light blue bar in figure 2 that in a downside case, for example interest rates falling and inflation rising, the deficit could worsen by 22.7% of the liabilities. But more crucially the chart shows that when attributing by risk factor, we clearly see that the biggest risks in the portfolio are interest rate and inflation risk, shown by the bars in red. Now when we look at the goals and objectives we are in a better position to answer; what is going to stop pension schemes from reaching their objectives? At the moment the bonds held in the average portfolio are not sufficient hedging instruments and an adverse move in interest rates or inflation could put full funding out of reach. If, however, we measure the risk compared to a portfolio with a hedging strategy in place, as shown in figure 3, we see the risk of the portfolio is dramatically reduced and consequently the total VaR is reduced to 12.9% of the liabilities. 
 

Var95.PNG

This is achieved by implementing a portfolio of interest rate and inflation swaps that mirrors a proportion of the mark to market change in the value of the liabilities. In particular, the strategy targets the hedge ratio, which is the sensitivity of the assets as a proportion of the sensitivity of the liabilities, to be equal to the funding ratio. This has a few key effects; it severely reduces the biggest risks in the asset portfolio, it immunises the funding level from interest rate and inflation movements and the outperformance required from the scheme’s assets remains relatively stable from movements in interest rates and inflation.

In an ideal world I would have covered implementation in more detail and the advantages of pursuing various hedging strategies, however given the limited time I didn’t want to convolute the underlying message that the path to reaching full funding and to achieving what you set out to do, starts with a coherent LDI framework that sets out a clear hedging strategy.
 
Why hedge in a low interest rate environment?

Part two of my presentation focused on hedging out interest rate risk. Pension liabilities are linked to inflation and given the risk inflation poses in the portfolio it’s not too difficult to see that removing this risk and immunising yourself from inflation movements is a good idea. What is often asked is; why should pension schemes hedge their liabilities from interest rate movements? The risk is that interest rates will fall and the present value of your liabilities will go up but interest rates are at historical lows already. This was what I intended to tackle next.

It is important to note that there are many schemes in the UK that have hedging strategies in place but this is far from common. If we look at figure 4 below, the black line shows the 30 year interest rate and the red line shows the year on year change in that rate. If we take a downside case as interest rates falling by 100 basis points over a one year period then figure 4 shows that interest rates fell by this margin in 2009 and 2012. Figure 5 then shows that in recent history UK funding levels were at their lowest in 2009 and 2012. Interest rates remain the biggest liability risk to UK pension schemes and exposing deficits to movements in interest rates is asking for trouble.
 

Now for the climax, the point I was sure would win everyone over and have them cheering for 
Capture-Rolling.PNG
pension schemes to hedge their liabilities (possibly a little bit over the top but you can’t fault the ambition). If we look at the current shape of the yield curve, interest rates are expected to rise in the future. Liabilities are discounted on the basis that interest rates will be higher in the future so even if interest rates remain static the present value of the liabilities will rise. This concept is called the “Rolldown effect”, or carry, and it is defined as the mark-to-market of the portfolio that results assuming that nothing changes in the market except for the passage of time. If interest rates follow the projected forwards rates then carry will be zero. If forward rates are not realised however and interest rates remain lower for longer, then carry will result and the present value of the liabilities will go up. If a hedging strategy is in place then the hedging assets will earn the carry on the rolldown of the yield curve. Redington’s research, conducted in 2013, found that for the standard UK pension scheme, if interest rates remain static then this would see an annual increase of approximately 2.5% in the present value of the liabilities.4 Now consider rolling this up over five or ten years and factor in market volatility and we see that pension schemes are in for a rough ride. Uncertain economic conditions means it is very plausible that interest rates will remain lower for longer which will push back full funding targets further into the future. This is time that pension schemes simply don’t have but hedging out this risk will help ensure that schemes reach their goals and achieve full funding.
 
Conclusion

The two key points that I would like to reiterate are:
 

  • Firstly, hedging is not a method to increase expected return (there are 4 other steps to consider that) but rather a way of further ensuring that a scheme will meet its objectives by removing the biggest risks in a scheme’s portfolio.
  • And secondly, the market has already priced in interest rates rising in the future. If rates remain lower for longer, then unhedged schemes should be prepared for falling funding levels.
 
I would like to thank Spence and Partners again for a great event and a fantastic opportunity to meet young people in the Pension’s industry. You would have to ask the attendees as to whether I managed to convince them or not but until then, as sure as we can be that real yields ‘will’ go up in the future, I leave you with the same quote that I finished the presentation with:

The market can stay irrational longer than you can stay solvent” – John Maynard Keynes
 

1. Assuming a 60% allocation to global equity and a 40% allocation to gilts and index linked gilts.
2. 
Assuming the hedge ratio equals the funding level.
3. Source: PPF Purple Book 2013.
4. 90% inflation-linked, duration 20, swaps flat; note that there is a (much smaller) offsetting carry effect from inflation on the liabilities; carry would have been even higher if a lower proportion of inflation-linked liabilities were used and/or it was calculated on a gilts basis.  


 
Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer

 

Author: Sam Shaw

Sam joined Redington in 2013 as part of the ALM and investment strategy graduate team, and now works closely with senior ALM team members to deliver world class analysis to a range of trustee and sponsor-side clients. Sam holds a first class BSc degree in Mathematics from the University of Bath. In his spare time he enjoys playing the guitar, as well as a range of sports, including golf and football.