Aligning assets with liabilities
Investment managers have been quicker than government to respond to the liability matching needs of UK pension funds.
Before the UK government had announced plans for 50-year bonds, two leading European fund managers had rolled out solutions of their own.
Both solutions tackle the shortage of suitable pooled liability matching vehicles in the asset management marketplace. First off the mark has been State Street Global Advisors (SSGA) with its Pooled Asset Liability Matching Solution (PALMS).
PALMS is a series of pooled fixed income funds with maturity dates reaching from today to 2045. Pension funds can invest in PALMS through a unit-linked insurance policy written by Managed Pension Funds (MPF) part of the State Street group.
This provides access to a basic suite of nine funds holding different maturity limited price inflation (LPI) swaps. Eight of these funds hold different maturity, zero coupon LPI swaps out to 40 years. The ninth is a cash pool generating a return of three-month Libor.
The eight funds are divided into five-year increments extending over 40 years. These individually deliver annual cash flows when they are needed. SSgA says this enables pension funds to remove 95% of their uncontrolled risk by allocating different percentages to the different maturity funds.
The LPI swaps are created from standard UK retail price index swaps. (A European version of PALMS is currently under construction.) On top of this there is protection against deflation (a floor) and the sale of inflation rights above 5% (a cap). At the maturity of each of the LPI swaps, the pension scheme receives future projected cash flows linked to its projected LPI liabilities.
In PALMS, SSGA is providing a
single portal to what would otherwise be a series of separate swap agreements. Joseph Moody, portfolio manager, global fixed income at State Street Global Advisors explains: “All clients will enter at different periods the same swap at different market rates, because every quarter the swap is brought back to a value of zero. This means that even if different clients come in at different times they can all buy the same swap.
“This protects the pension funds in terms of collateral credit risk, because a physical transfer of cash takes place between the cash fund and the counter-party. It also means that over the long term you don’t get a proliferation of swaps.”
The arrangement has two components – what Moody describes as a “belt and braces” approach: “The first is an economic component to ensure that economic exposure to the swap for the pension fund is reduced to 90 days, a quarter. The second is an accounting component to ensure that in the interim period assets are moved in an accounting sense.
“So if at any point of time the investment bank runs into trouble then the pension money is inside the structure. That’s very important to the trustees.”
In the swaps transaction, the Libor swaps market’s fixed maturity rates, which are known today, are used to match real future cash flows. The inflation component, which is also known today, is used to deliver the unknown realised protection on future pension payments.
Moody uses the swap curve, with a 10-year rate yielding 5%, as an example to illustrate how this works. “Within that 5% there is an inflationary component – say 3% – and a real component of 2%. So if a pension fund buys an equivalent conventional bond, it gets 5% and if inflation moves up to 3% to 4%, it is going to lose money.
“In an inflation swap the pension fund is taking the 10-year fixed rate and essentially transferring the risk of the 5% return into the cash fund, which is a Libor return. So it has gone from fixed to floating. That floating return has to print three months Libor every quarter because that is what the pension fund has agreed to swap. So it’s like a cash tracker.
“The fixed inflation of 3% projected today is known. The pension fund can swap that for a floating inflation amount. So what it is left with is a locked-in rate and a floating rate. The cash fund is using its assets – that proportion that is equivalent to the inflation rate – to swap away for the floating. So the pension fund accrues the real rate on zero coupons, and then whatever inflation becomes, it gets as well.”
Moody suggests that, in this way, a pension fund can earn a spread of between 20 and 30 basis points over index-linked government bonds
in the shorter maturities.
One attraction of the PALMS approach is that it separates the inflation-linking protection of the eight MPF funds from the alpha generation in the
cash management fund. This enables pension funds to add some extra alpha if they wish.
One way of adding alpha is investing in credits. PALMS offers a credit enhancement strategy whereby pension funds can invest in a 10th MPF fund – a credit fund. This fund gains exposure to 200-300 credits by investing into diversified investment grade credit default swaps (CDS) indices.
The investor receives the credit spread above Libor in return for
selling credit protection on the underlying credits within the index. The investor also receives corporate excess returns, over swaps, of the underlying credit
“The credit option is aimed at people who want to take corporate risk, but in essence they’re still doing the same thing. The fund is still selling them protection, and what they have done is moved it around, controlling the risk for the reward they’re getting,” says Moody.
Edinburgh-based Standard Life Investments (SLI) has also confronted the problem of how pension funds
can invest their assets in bonds of the appropriate maturity with the launch of its Liability Managed credit funds.
Liability Managed credit funds are a suite of 20 funds that enables pension schemes to tailor their bond exposure to fit their future cash flow needs within a single pooled bond fund.
Euan Munro, head of strategic solutions at SLI, says the Liability Managed credit funds offer pension schemes an alterative to conventional corporate bond funds: “A typical corporate bond portfolio holds bonds of varying coupon levels and maturities. Ideally this should provide similar cash flow attributes to the pension schemes liabilities, but in practice this is rarely the case.
“Corporate bond fund cash flows tend to occur far earlier than those of a typical scheme. This disparity can leave scheme’s funding levels dangerously exposed to changes in bond yields.
“By combining the liability profiles of all investors in a single underlying fund, we can invest actively and cost effectively in corporate bonds to generate additional returns, while simultaneously offering interest rate protection for an individual scheme’s liability profiles.”
To invest in the funds, pension funds first provide SLI with a stream of projected cash flow payments for the next 30 years or less. In return, SLI provides an estimate of the amount that needs to be invested in each of the 30 credit funds.
All the money invested is pooled in a single underlying corporate bond fund. The underlying fund is managed in such a way that its interest rate sensitivity mirrors that of the combined pension liabilities of all investors.
Each of the liability managed credit funds has a different maturity and one of them matures each year. At maturity, the face value of the units is paid out to investors. A new fund is also then created with a maturity date 30 years in the future.
The pricing of the funds is based on the assumption that one unit will buy £1 (e1.4) of cash flow in the required maturity year. Therefore, the longer dated the maturity year, the cheaper the units will be today.
“By combining our bond managers’ stock selection skills with the
additional expected return from investing in a higher yielding bond portfolio, we expect the funds’ unit prices to grow.” says Munro. However, he emphasises that this is not a guarantee and that unit prices may fall as well as rise.
New investors will be able to buy units in the funds quarterly. At each quarter existing investors will be able to amend their holding according to their pension liability profile. They can also cash in units at face value if they wish.
The funds are available to UK pension funds through Standard Life’s insured Trustee investment plans. A trustee investment plan allows trustees of UK Inland Revenue-approved occupational plans to invest in range of low-cost pooled pension funds. The plan allows access to a range of 40 investment funds. Trustees can choose the mix of funds that suits the needs of their scheme, and can change this mix as the scheme matures.