Looking for the perfect match
This month’s Off the Record looks at the problem of matching pension fund assets to liabilities. How can pension funds find the appropriate securities to precisely match their long term liabilities – and should they even try?
The problem of unmatched liabilities is well-rehearsed. The duration of some occupational pension plan liabilities is more than 40 years – far longer than the duration of any available security. Although in most pension plans the duration is likely to be shorter than this, the problem of a mismatch remains. The lives of the deferred pensioners are still likely to be longer than that of the available securities.
Traditionally pension funds have relied on a supply of long-dated government issued securities to meet their liabilities. However, in the past 15 years governments have – for a variety of reasons – reduced or even ceased the issuance of very long-dated debt.
A new way is for pension funds to look for an alternative supply of long-dated debt in the credit market. A few companies have issued some very long dated debt, notably the Walt Disney Co which issued $300m of 100-year so-called ‘Sleeping Beauty’ bonds in 1993.
Yet such issuances are exceptional. And in any case, most companies cannot be expected to survive that long. As the mergers and acquisitions of the 1960s and 1970s showed, the life expectancy of European companies is considerably lower than the longevity of Europe’s pensioners.
One possible solution is to use derivatives such as interest rate swaps to repackage securities for pension plans. European pension have tended to steer clear of swaps as too complex to operate. Yet protagonists argue that swaps allow a pension fund to manage its assets more efficiently against its liabilities.
Since the cash flow on bonds is often too ‘lumpy’, a pension fund can use the swaps market to smooth cash flows relative to the liabilities. Currently, swaps are being promoted as a useful tool for liability-driven investment (LDI) strategies.
Another cash flow matching solution is for pension plans to invest in ‘strips’ (separate trading of registered interest and principal of securities).
Because they do not have a default risk, strips can be used to match a pension plan’s long term liabilities. The problem here is that European governments may not be issuing enough strips to satisfy demand.
So is a perfect match between assets and liabilities achievable or desirable? We wanted your views. As so often in Off the Record surveys, there is no black and white response to what is clearly not perceived as a black and white issue.
A clear majority (70%) of the pension fund managers and administrators who responded to our survey agree that pension plans today do not have the appropriate securities to match their long term liabilities.
However, there is little support for the idea that they should strive for a perfect match. Most of our respondents (85%) do not think that pension funds should try to precisely match their asset mix with their liabilities. The excessive cost is the principal reason. “It is not possible at a reasonable cost,” the manager of a UK scheme suggests: “Yes, in an ideal world. No, given that it is too costly to achieve,” another comments.
The only circumstance where a perfect match is desirable is “where a plan is closed and there is no longer scope for further contributions,” says one manager.
The traditional view has been that government fixed income securities and corporate credits provide the best match for pension liabilities. In the UK, this has been endorsed by the new accounting standard, FRS17, which holds that investment grade credits are the best proxy for pension liabilities.
Yet this view gets little support from our managers. A substantial majority (79%) disagree with the suggestion that fixed income is the most appropriate asset for matching liabilities. The manager of a Dutch pension fund comments: “Fixed income is the best match theoretically but not in reality,” while the manager of a Swiss pension fund observes that fixed income is the best match “only if the main objective is to minimise volatility”.
So which asset classes do pension fund managers see as providing the best match for their liabilities? The biggest vote (73%) is for a mix of equities and fixed interest securities. Others spread their net wider. For one UK pension fund manager, the best match is “a mix of appropriate income-generating realisable assets which may include equities and/or bonds”.
The main call is for diversification, and managers cite a wide range of asset classes, instruments and investment strategies including real estate, private equity, inflation linked bonds, funds of hedge funds, swaps, options and ‘swaptions’, and absolute return strategies. As one manager of a Netherlands pension fund says: “Diversity is the motto.”
Maybe the market for debt is driven by issuers rather investors, and the securities available to pension plans are the ones issuers want to sell rather than the ones that pension schemes want to buy? This hypothesis gets lukewarm support. A small majority (54%) agree that issuance is issuer-led. Yet a Swiss pension manager points out that “If there was no demand for such paper, issuers would have to issue others.” As one UK pension fund manager points out, “Like all markets it is a mix of both the wants of both buyers and sellers.”
Opinion is divided about long-dated credits, ‘Sleeping Beauty’ style debt issued by companies, but a small majority (58%) say that it would be inappropriate because of the risks of default.
In contrast, the use of swaps as the way forward. Three in four managers (76%) think that pension funds should make more use of the swaps market - but with the important proviso that pension plan boards should understand how the swaps market works.
There are also some doubts about whether the derivatives market is big enough to supply the needs of pension funds. A slight majority (54%) feel that the derivatives market is a sideshow, albeit a useful one. “You would not want to concentrate too much in derivatives but these can be a useful tool,” one manager comments.
Perhaps there are risks, such as lengthening life expectancy, that currently cannot be matched at all. A small majority of our respondents (57%) agree with the suggestion that the greatest risk pension plans face is longevity since there are no securities available on the market to match this particular risk.
Could European governments help by issuing more long-dated debt to help the annuity market and to encourage private pension provision? The general view is that they could. A large majority of mangers (84%) agree with this suggestion.
And this is seen as the single most important solution to the overall problem of the assets/liabilities mismatch: The largest single proportion of our respondents (70%) say the solution the mismatch is more government long-dated debt. A sizeable proportion (64%) think the solution lies in the greater use of derivatives.
Just under half (48%) feel that governments could also help by issuing more strips. Only a quarter (27%) think the answer lies in more long-dated credits.
There is a plea from some for more inflation linked bonds, and for better asset liability modelling. “You need a varied asset mix to spread risk,” says one the manager of a German pension fund.
There are other more far reaching solutions. One Belgian pension fund manager says “Pension funds should play a community role in supplying long term mortgage loans to young household – mainly the members of the fund themselves so that they can afford to buy a decent houses . This would enable to offset the liability versus its members against the loans.
“Furthermore, the spread they earn on these investments could be considerably more than what they get on a government or corporate bond, and they could still offer lowered interest rates than commercial banks. As far as the members of the plan are concerned, owning one’s home is the first step to a comfortable retirement.”
A Swiss pension fund manager perhaps speaks for all by saying: “There is no 100% solution”. This view gets support from a UK manager, who says: “The risk of a_mismatch cannot be removed entirely from the system. Don’t slavishly pursue matching for its own sake.”
Finally, the administrator of a Swedish pension fund warns: “You have to live with the mismatch.”
So perhaps the aim of a perfect match is best left to dating agencies.