Over the last two years an enormous amount of papers, articles and views have been produced, ever since the plans for the new Dutch financial risk framework (nFTK) for pension funds were revealed. They have focussed on every imaginable aspect of the proposed new framework, from asset and liability management, accounting consequences, practical implementation, responsibilities of the stakeholders, to the political drivers behind the framework. Due to the central position of the fair value approach for liabilities in the framework, combined with the fall in rates over the last years, a lot of attention has been paid to interest rate risk management.
It is now commonly accepted by practitioners in the pension world that the optimal way to deal with the duration gap between assets and liabilities is to use interest rate swaps. These instruments are flexible, highly liquid and can be obtained for very long tenors, and in addition can be engaged in without (funding) costs. Despite these clear advantages, there still has been some resistance preventing many pension funds from using swaps. Amongst the arguments used against swaps, is the perceived complexity of such a derivative product, which is a hurdle for the pension board to agree on the use of swaps. Moreover, the low interest rate environment has not helped either, as many feel that by locking in at a low rate, they would miss the opportunity for better times. From a more practical perspective, pension funds have been struggling with the inherent credit risk of swaps. Also, the ways to deal with this through ISDA and CSA agreements have been regarded as too big a hurdle (from an administrative and legal point of view). Then, pension funds have had difficulty in deciding whether or not swaps would have to be done on a funded or un-funded basis. And finally, in case funded swaps do form part of the portfolio, how should the rest of the assets be managed? These are all valid questions which have to be taken seriously.
However, there is a way around these objections that still achieves the same effect as a regular swap or even better effect. It is called a Forward Duration Neutraliser (FDN) and works as follows. The starting point for the FDN is the current liability profile, containing the projected nominal cash flows of the pension fund. In the FDN the pension fund and bank agree on the forward value of the liabilities. At maturity of the FDN, the value of the liabilities against the prevailing spot curve is compared against the reference forward value agreed in the FDN and the difference between the two is settled between the bank and the pension fund. Effectively, the FDN fully compensates any effects on the liabilities related to the interest rate sensitivity (or duration) of the liabilities. Naturally, the pension fund will take a long position in the FDN, such that it receives any increase in the value of the liabilities relative to the reference forward value.
Using today’s yield curve, the forward value of the liability profile can be determined for instance at one year from today. This is possible, as the current yield curve also contains the information about the position of the yield curve expected by the market in one year’s time.
Naturally a pension funds will be sensitive about any increase of the value of the liabilities in one year from today. Therefore the forward value of the liabilities needs to be protected against any yield curve movements. Note that the net present value as of today is not the right reference value. Because of the timing effect of the cash flows, the net present value of the liabilities at maturity will already be different, even if the yield curve would remain unchanged. Let’s look at a simple example of how the FDN could work in practice. We begin with a liability profile as shown in figure 1.
Suppose the FDN has a start date of 1 November 2005 and an end date of 1 November 2006. Based on the current yield curve (as of 1 November 2005), the future value of the liability profile for 1 November 2006 equals EUR 150 million.
Next, the interest rate sensitivity of the liability profile is analysed. They are determined for various maturity buckets as shown in table 1. In addition the table contains the indicative swap rates as of 1 November 2005 for the corresponding maturities. Both the interest rate sensitivities and swap rates at the start date are agreed upon in the FDN.
The sensitivity per maturity represents the change in the future value of the liability profile if the corresponding swap rate is decreased by 1 basis point, assuming all other swap rates remain constant. Summing the sensitivities over all buckets shown in the table, results in the total interest sensitivity of the liability profile of EUR 356,200 otherwise known as the PV01.
Suppose that at the end date of the FDN, the 15-year swap rate has decreased by 2 basis points to 3.5920%, and the 25-year swap rate has increased by 1 basis point to 3.8125%. We assume that all other swap rates shown in the table have remained unchanged. This corresponds to an amount of EUR 49,000 * 2 = EUR 98,000 at the 15-year swap point, and an amount of EUR 59,300 * -1 = EUR -59,300 at the 25-year swap point. Note that a decrease of a swap rate at one specific curve point results in a positive amount, corresponding to a payment to the pension fund. According to the FDN specifications, we subsequently sum these amounts, resulting in a settlement amount of EUR 38,700 payable by the bank to the pension fund at 1 November 2006. If at the end date more swap rates have changed with respect to the swap rates defined in the Forward Duration Neutraliser, then for each maturity we multiply the change in basis points by the corresponding interest rate sensitivity and sum over all maturities to arrive at the settlement amount at the end date. The pay-off profile of the FDN in this example is shown in figure 2.
Due to the changes in the yield curve over the contract period, the net present value of the cash flow profile at the end date will also have changed to EUR 150,038,700. However, combined with the FDN, the total liability position remains EUR 150,038,700 - EUR 38,700 EUR = EUR 150,000,000. This is equal to the future value of the liabilities agreed at the starting date of the FDN. In case the rates in the example have moved in the opposite direction, the payment resulting from FDN would be opposite. Hence, the Forward Duration Neutraliser is a very effective instrument to compensate any changes in the value of the liability profile due to changes in specific swap curve points over a short term period. The total effect of the FDN on the value of the liability is illustrated in figure 3.
Of course, this is just a simplified example of the way the FDN could work. Several parameters can be altered or added in order to increase of decrease the level of customisation, satisfying the pension fund’s requirements.
The benefits of the FDN to a pension fund are several: first, similar to a swap, the FDN can be entered into without any upfront costs. This means, that no assets have to be liquidated and the portfolio composition can remain intact. Secondly, the FDN is in principle a short term contract, with a tenor that can be anything between one month and one year. As a consequence, although the FDN may involve counter-party risk in case the FDN results in a payment from the bank to the pension fund, this credit exposure will only be limited to a short term horizon, over which the liabilities are exposed to curve movements. This is naturally a clear advantage over long-dated swaps where the counter-party exposure will be much higher, as it will be based on the full tenor of the swap. As a result, the usage of credit limits is going to be smaller. Moreover, at the end of the agreement the pension fund has the choice to roll the FDN forward for another period. A further appealing feature of the FDN is that it is based on the actual liability profile. Contrary to standard swaps, it will be much more accurate in compensating changes in the value of the liabilities due to yield curve movements.
Initially, these types of contracts will be offered as over-the-counter derivatives, and be managed under the ISDA framework or a long form confirmation. As such, they should be considered as the unfunded variant of the solution. As mentioned earlier pension funds may also be interested in a funded version of the FDN, which would eliminate the need for ISDA/CSA netting agreements. The nature of the FDN allows us to do this. A funded security can be created for instance with an ISIN code, making the FDN a tradable security. Similar to stocks or bonds, a funded FDN could be easily handled by the administrative systems of a pension fund, requiring no additional changes.
The Forward Duration Neutraliser is a highly effective instrument for interest rate (duration) management, countering most of the disadvantages associated with swaps. Therefore, the Forward Duration Neutraliser in its various forms can be beneficial for the vast majority of pension funds and definitely is a serious alternative to take into consideration.