A few pointers in the long duration debate
The European debate over pension fund liabilities is in full swing, led by forthcoming regulatory change in the Netherlands. Further details from the Dutch regulator, the PVK, are likely to come to be released over the next few weeks and should finalise the approach to be used by pension funds from January 2006 onwards. Recent consultations with institutions across Europe suggest that similar discussions on the need to identify and hedge long-dated liabilities are occurring across the continent, particularly in the insurance sector. Given the greater focus on the subject of asset liability management and long duration fixed-income mandates, we wish to highlight a number of aspects that should be considered.
While regulatory change will have an impact on the asset allocation of pension funds and insurance companies, changes in the International Accounting Standards (IAS) will have a more immediate impact
In the specific case of the Netherlands, the current framework states that pension plans that do not meet the liquidity test, with a 105% funding level, have one year to achieve it. However, the framework also states that under the solvency standard, pension plans will have 15 years to attain a funding level that has only a 2.5% chance of falling below the threshold set by the PVK.
Current funding levels for Dutch Pension Funds suggest that the second test will be more relevant in the immediate future. Therefore, it is more likely that Pension Funds will face more pressure to adjust their asset/liability structure from the implementation of IAS 19 rather than due to the new framework. The requirement of IAS 19 to state clearly any deficit relating to the Pension Fund in the annual report will result in greater pressure on CFOs to limit the extent of negative headlines given the loss of strategic flexibility for the operating part of the business resulting from large deficits.
Passive matching of liabilities through the use of swap overlays may not be the best solution
While swaps are attractive due to their liquidity, pension funds will find the operational and governance issues surrounding a passive swap overlay problematic. These ‘friction costs’ are not always taken into consideration when opting for a pure cashflow matching program. We believe that using an active portfolio manager in this instance presents several advantages.
The most apparent benefit is that active portfolio managers who employ swaps are more able to achieve best execution. By managing positions and standardising transactions there is much better liquidity, which means that exposures may be altered more effectively and conveniently. These issues are more relevant in the case of inflation swaps where market liquidity, pricing and operational issues can overwhelm the apparent advantage of a tailor-made solution.
The risk budget should be based on the marginal risk/return impact on the surplus, rather than taking an asset-only approach. In this context, bond-based alpha strategies (strategies that produce a return over and above the liability-driven benchmark) provide a better risk-adjusted return and lower the volatility of the surplus.
The main task of the pension fund manager, or insurance asset manager, is to evaluate risk/return needs in asset liability matching space, rather than asset-only space. Traditional sources of return have relied heavily on market (beta) risk, rather than skilled managers who can produce excess returns in any given market. In an environment where the volatility impact on the surplus dominates and returns are expected to be lower, bond-based alpha strategies should dominate
Long-duration portfolios should be seen as an opportunity to match or reduce the duration gap, but also as a practical way to incorporate alpha opportunities.
The combination of e425bn of Dutch Pension Funds trying to extend duration in a euro bond market with only e471bn in government bonds with durations in excess of 15 years, underlines the need to combine the objective of matching duration with the objective of achieving excess return. The problem is more evident in the European inflation-linked bond market where assets with a duration in excess of 15 years currently amount to just over e12bn and there are only two French government issues outstanding that fit this criteria.
We believe the solution is to choose a benchmark that is in line with the liabilities, but manage the assets with the flexibility to diversify risk. The key problem of a narrower mandate is that the existing pool of assets with sufficient duration is too shallow to optimise the total return. In the UK market, where this problem has been tackled by pension funds for a few years, we have seen several different approaches. Some pension funds have opted for liability driven benchmarks with very specific allocations to nominal and inflation-linked assets, while others have opted for long duration government/corporate or even swap benchmarks.
However, in most cases, pension funds have been accepting a slightly higher tracking error objective to avoid narrow benchmarking in a sector where government and corporate bonds have traded expensively as a result of disproportionate demand. Duration extension and the attempt to capture the alpha that can be achieved by avoiding an ‘index-hugging’ mode have been common to many of these solutions.
Alpha strategies in long-duration mandates are not inherently ‘riskier’ than in standard mandates (eg, euro aggregate mandates)
Whilst a long-duration mandate will be more sensitive to interest rate movements as a function of the chosen risk profile, the alpha sources can be found in a wide array of fixed income opportunities. The tracking error around the benchmark determines the risk budget within a given mandate. Hence, an active fixed-income manager should spend the risk budget in a diversified way, by overlaying the benchmark portfolio with an array of fixed-income opportunities. This ensures a robust portfolio and exploits opportunities all along the yield curve, not necessarily only at the long end.
Fundamental changes require thoughtful and decisive action. PIMCO has been a trusted adviser for many pension funds and insurance companies dealing with these challenges.
As a global active fixed income manager with local expertise, PIMCO can share extensive knowledge and insights tailored to your specific situation and requirements. Call us today to find out more on long duration solutions and other innovative strategies that help you meet your goals.
Marc van Heel, director of business development Benelux PIMCO Europe
Emanuele Ravano, head of portfolio management in London, PIMCO Europe