Duration extension - to do or not to do?

The Dutch pension-funds regulator has issued a new consultation document in October 2004. This contains provisions which will form the basis of financial regulation from 2006, when the new Dutch Pensions Act comes into force. The new regulatory framework (Financieel Toetsingskader, or FTK in Dutch) will consist of a solvency test and a continuity analysis. The solvency test means that the asset position must be adequate in the short term. In the continuity analysis, pension funds have to show that they are following a sound policy over the long term in order to meet expectations raised by them. This article looks at the fixed-income investment policy for pension funds, in which we will take account of risks both in the short term (solvency test) and in the long term (continuity analysis).

Market valuation for pension liabilities
As indicated in previous consultation documents, under the new rules pension liabilities will be valued at market value. The most important effect of this is that the interest rate sensitivity of investments and liabilities will be crucial for the development of the funding level, and therefore also future contributions. The new hard benchmark for the strategic allocation will be the unconditional (usually nominal) liability, while indexation will be of secondary importance. If one looks only at the solvency test, the best solution would be to eliminate nominal interest rate risk altogether. If however one looks at the ambitions of the pension fund over the long term, only a partial matching is to be preferred. To be able to finance full or partial indexation, a mismatch between investments and liabilities is actually inevitable, with a portfolio that is diversified across different sources of return as our preferred solution. The total available risk budget – determined by the financing agreement or the solvency of the company and the pension fund – will play an important role as regards the possibility to fully harmonize the investment policy with the long-term goals of the pension fund.

Quantification of risk consideration
We have quantified the trade-off between nominal short-term risk for the solvency test and indexation risk over the long term. In this analysis, we assume that a pension fund has an initial weight of 40% in equities and 60% in fixed-income securities (with an assumed duration of five years, leading to a duration of approximately three years for the whole portfolio). This point is labeled ‘current mix’ in the figure. The duration of the nominal pension liabilities is assumed to be 16 years.
The effect of extending the nominal duration on the short and long-term risk is shown by curves. Take for example the point indicated by ‘investment mix A’. This point, with 40% equities and 60% fixed-income securities with a duration of zero, shows the risks when no interest rate risk is hedged. The short-term risk is high, due to the mismatch between the investments and the pension liabilities. The indexation risk is relatively low however, since short-term interest rates tend to move in line with inflation. If we follow the curve that starts at ‘investment mix A’ to the left, we can see that short-term risk is initially sharply reduced by an extension of the duration while long-term indexation risk rises only slightly. As we move further along this curve, the reduction in short-term risk decreases, while long-term risk increases rapidly. The final point on this curve corresponds to a complete hedge of nominal interest-rate risk.
For comparison, we also show the effect of duration extension for an allocation with 50% equities. This is shown by the broken yellow line with triangles. Note that besides an increase in risk in both dimensions, the expected return of this allocation is also higher than with just 40% equities.
Next we focus on limiting the indexation risk by means of inflation swaps. Here we start from the portfolio in which 60% (the whole fixed-income component) is matched with the nominal liabilities and 40% is invested in equities (shown in the figure as ‘starting situation inflation hedge’). The red line with dots shows the effect of adding inflation swaps to the portfolio in steps of 10%. It can be seen that inflation swaps are attractive, because, for a given level of short-term risk, a lower long-term risk can be achieved.
The pension fund’s funding ratio on an actuarial basis is around 115%, which is equivalent to a nominal funding ratio of around 120% in the current market environment. This means that for this pension fund, the allocations left of the vertical dashed green line meet the FTK solvency requirements. If a strategy to the right of this line is chosen, the pension fund would have to submit a 15-year recovery plan to the regulator, since the probability of underfunding within one year may not be more than 2.5%. With a risk (standard deviation) higher than 10% and a funding ratio of 120%, this condition would not be met. The figure shows that the current investment mix involves a relatively high short-term risk. To limit the short-term risk without increasing the long-term risk, we recommend nominal matching of the fixed-income securities with a partial inflation hedge (indicated in the figure as ‘investment mix B’). Note that a combination of nominal matching and inflation swaps corresponds to an inflation-indexed bond. Mix B is therefore equivalent to 40% equities, 30% nominal matching, and 30% indexed matching from an economic point of view.

The added value of alternative investments

By introducing alternative investments in the portfolio, we may reduce risk even further, without harming the expected return on the portfolio. The recommended non-bond portfolio is changed to 60% equities, 10% private equity, 10% hedge funds, 5% emerging markets, 5% high yield, 5% real estate, and 5% commodities. In the figure, the volatility of equities was assumed to be 20%. This is reflected in ‘investment mix C’ in the figure. At this point the only risk follows from equities, since the nominal interest-rate risk is completely hedged. The weight of 40% in equities, multiplied by their volatility of 20%, implies a short-term funding ratio risk of 8% for this allocation. If we use the diversified portfolio including alternatives as described above, we can assume that volatility declines to 17%. The resulting portfolio is shown by the purple diamond with the caption ‘advice mix’. As shown in the figure, both long-term risk and short-term risk are reduced, while the expected return remains the same.

Recommendation
In sum, we recommend that pension funds consider extending the duration of their fixed-income portfolio and, additionally, set up an inflation swap overlay. The degree of duration extension involves a trade-off between security in the short term, due to regulatory demands, and indexation objectives in the long term. Pension funds with limited financial reserves and/or a weak sponsor may be forced to focus on the short-term solvency requirements and abandon their optimal long-term strategic investment policy aimed at their indexation-ambition. The introduction of alternative investments in the asset mix may provide some, but not a complete relief by improving the overall risk/return profile.