What does running a successful lab experiment have in common with managing a pension scheme to full funding?
The final hurdle of my biochemistry degree was a 10,000 word report on the results of a 2 month lab project. The aim of the project was to identify the role of an unknown protein, in a newly discovered cellular system, in a mildly contagious strain of Escherichia. Coli. A hard task! Not least because there are thousands of reagents and hundreds of experiments that could lead down a path of years of work with no guarantee of achieving any useful results. I only had 2 months and my degree rested on a successful outcome.
My supervisor sat me down on day 1 and taught me a very important lesson that happens to be transferable to any project in any aspect of life.
The key to a successful lab project is background reading, preparation and, most importantly, goal setting. Before I set foot into the lab I had to find answers to:
– What is known about the cellular system we were looking at?
– What am I hoping to achieve at the end of the 2 months? And at the end of each week?
– Using the experimental techniques available, how can I do it?
I documented the answers to these questions in a lab book that I referred to continuously during the project to benchmark the importance of all the data I recorded.
Fast forward to now to my role at Redington, and when looking at a pension scheme’s investment strategy similar questions are asked:
– What are we looking at? The liability cash flows
– What are we hoping to achieve? Deliver sufficient assets to meet the pension payments
– How can we do it? Adopt a Liability Driven Investment (LDI) approach, an investment strategy that utilizes hedging instruments (such as swaps and gilts) to match the interest rate and inflation sensitivity of the assets to that of the liabilities
3 Key Factors Affect Liability Values
Defined Benefit (DB) Pension Scheme liabilities are sensitive to three main factors:
· Mortality expectations – higher mortality expectations = higher liability value
· Inflation expectations – higher inflation expectations = higher liability value
· Interest rates – lower interest rates = higher present value of liabilities
As DB Schemes commit to paying their members a defined percentage of their final salary until they die, the longer people are expected to live the more money a pension scheme is expected to have to pay out. Therefore if mortality expectations rise member benefits will need to be paid for a longer timeframe; this is illustrated in the graph below:
As prices rise with inflation the purchasing power of each pound falls so pension payments are often linked to inflation to prevent the value of an individual’s pension pot eroding with time. Therefore as inflation expectations rise, the expected future benefit payments (liabilities) for each year increase; this is illustrated in the graph below:
Mortality and inflation are “hard cost” risks in that if they go higher, then the future value of each liability cash flow rises; this is not the case with interest rates. Interest rate movements only affect the present value of the cash flows.
What is the present value of cash flows? If you had to pay £100 in 10 years how much would you need to have now, considering the interest rate you can earn on that money between now and then? The value you need to hold today to pay £100 in 10 years is the present value of that cash flow.
How is the present value calculated? The cash flow, i.e. £100 in 10 years, is discounted by the appropriate interest rate for the tenor of that cash flow, i.e. 10 year gilt rate (let’s say 2.7%).
…What is the impact of interest rate movements? If the 10 year gilt rate rises to 3% or falls to 2.5% this will not have any effect on the £100 you have to pay in 10 years but it does impact the present value of the cash flow (the amount of money you have to hold today in order to pay that £100 in 10 years)
Similarly with a pension scheme, you discount the expected liability cash flows, or the expected pension payments, for each year in the future using a tenor matching interest rate (cash flow/pension payment in 10 years will use the 10 year gilt rate; cash flow/pension payment in 11 years will use the 11 year gilt rate). Therefore the present value of liabilities are sensitive to movements in interest rates such that when interest rates fall the present value of liabilities rises and when interest rates rise the present value of liabilities falls.
Ok, so what?
Sensitivity to interest rates, inflation and mortality translates directly into risks faced by the pension scheme, these are known as liability risks:
– Interest rate risk: the risk that interest rates fall and the present value of the liability rises;
– Inflation risk: the risk that inflation rises and the cash flows increase in value;
– Mortality risk: the risk that people live longer and the cash flows have to be paid for longer.
As a pension scheme, to be sure that you can pay every pension payment as and when it falls due the assets must be at least equal to the present value of the liabilities, this is fully funded. But as you can see in the graph below, if interest rates fall the present value of the liabilities rise but the assets may stay the same and now the pension scheme is underfunded.
Using an LDI approach these liability risks can be hedged using assets that also have interest rate and inflation sensitivity, such as nominal/inflation linked gilts and interest rate/inflation swaps, so that when interest rates fall and the liabilities increase in value so do the assets.
As with scientists running lab experiments, preparation and clearly articulating goals could well be the key to a successful outcome for pension schemes aiming for full funding.