UK defined contribution (DC) pension schemes should consider using currency hedging to protect members as they become more globally diverse, according to a new paper.

Consultancy Aon Hewitt said in a paper on currency hedging and DC pension schemes that currency movements could have a significant impact on portfolio volatility and, at times, can dominate returns. 

Joanna Sharples, principal consultant at Aon Hewitt, said: “With DC schemes increasingly exploring investment options on a global basis and using overseas assets both to seek returns and to diversify, it is inevitable that there is the potential for members to be more exposed to exchange-rate fluctuations.”

This meant schemes faced the dilemma of how to protect themselves against adverse currency movements.

“In addition to that, in this era of political change we believe that currency markets will be increasingly [more] volatile over the next few years rather than less,” Sharples said.

As a result, DC schemes should give currency hedging serious consideration and take action if necessary.

In its paper, Aon Hewitt said it believed hedging foreign currency exposure back to sterling would generally dampen overall portfolio volatility over the medium term, though the risk reduction benefits may not be so significant for long-term investors.

The consultancy recommended hedging the full currency risk for asset classes with relatively stable underlying values, such as overseas bonds or absolute return strategies. Investors should take a pragmatic approach with asset classes such as equity, hedging half of the currency risk. 

Among things that trustees needed to think about was whether to make a strategic decision for the long term or a tactical decision for the medium term, Aon said.

“Clearly a tactical decision requires ongoing monitoring and periodic adjustment, which increases the required governance capacity, and may also increase tracking error which would require careful communication with members,” the firm said. 

“Following the recent depreciation of sterling, we believe the pound has fallen to a level sufficient for trustees to consider whether to introduce a strategic currency hedge, if not already in place,” it said.

Aon Hewitt cautioned that trustees should consider their scheme’s specific circumstances and investment beliefs to make sure currency hedging cut their risk enough to justify the extra cost.