To hedge or not to hedge?

Leif Hasager
Head of investments

• Invested assets: DKK14bn (€1.9bn)
• Members: 44,000
• DC
• Funding level: 128%
• Date established: 1912

The Danish regulator does not directly require pension funds to hedge their liabilities. However, it has sharpened its solvency requirements in such a way that it is difficult for any Danish pension fund not to undertake any form of hedging unless they have no guarantees. The hedging method Danish pension funds use depends on their structure. But the most widely used methods are direct interest rate swaps, inflation swaps and constant maturity swaps.

We mainly manage our liabilities via forward receiver swaptions, which give us the right to enter into an underlying swap, receive a fixed rate and pay a floating rate.

When we started considering hedging our liabilities, we had a look at the various options available to us, including interest rate and constant maturity swaps. But in the end we decided to use receiver swaptions, which we have been using now since 2005. We are fully aware that we pay a premium for those but then again we do not run the risk of suffering substantial declines in asset values if interest rates go up.

While we have not changed our hedging approach since we started out we have increased the scope of our hedge. Initially we started out hedging just a minor portion of our liabilities, around 20%. Now the majority of our liabilities are hedged at a hedge ratio of three quarters. We increased our hedging scope in the wake of the financial crisis because we realised things can become much worse than we would normally assume in less volatile times.

When interest rates rise, we try to opportunistically add a little to our hedge and rebalance again when interest rates or volatilities fall and the hedge is cheap. But in general we try to maintain the same hedge ratio at all times.

When we started hedging some of our liabilities, we of course moved in the direction of liability-driven investments (LDI). However, we do not fully undertake LDI at Bankpension. Other pension funds in Denmark, for example, formally declare to have two or three different portfolios - a hedge portfolio and an investment portfolio - which they might then sub-divide into an alpha and a beta portfolio. For us formally splitting the portfolios would not benefit us in any shape or form, as we are a fairly small organisation.

We have looked at longevity products for risk control purposes but as longevity risk is not a major concern at the moment we decided not to apply longevity swaps or similar for now.

Pensionskasse Stadt St Gallen
René Menet
Head of asset management

• Invested assets: CHF840m (€575m)
• Members: 3,000 active, 1,500 retirees
• Cash-balance plan with a 100% guarantee
• Funding level 86 % (Dec 09)
• Date established: 1922

We undertake an asset liability management study every five years and invest the actual net worth of the Pensionskasse according to different benchmarks.

The basis of our approach is the way we position our liabilities. The assets are aligned according to these only afterwards with the strategic asset allocation. On top of that we can increase or reduce the risk of changes to the interest rate via individual modules.

We are using different approaches to hedge our liabilities, depending on the current interest rate environment. We have not felt the need to make use of duration swaps to a large extent simply because we also have a short duration ourselves, and our bond allocation is fairly limited. However, they will become more important in the next few years.

We also plan to use bond futures in the long term because they would allow us to go short or long in individual markets, according to our liking, and hedge the currency risk. Currently we are hedging our currency risks opportunistically.

All of the hedges, currency hedges, duration swaps and futures are and will continue to be dealt with in an overlay structure.

The reason why we apply overlay strategies is that they allow us to react quickly and increase or reduce the risks. We are invested to a large extent passively and can hedge relatively easily, for example via the futures.

Our target is to restrict the volatility in the portfolio to a maximum of 10%, which is our risk budget according to the asset liability study to be able to achieve our minimum return guarantee of 4.3%.

But our approach to liability hedging has not changed as a result of the financial crisis. We will continue with our current strategy even if interest rates increase.

According to the ALM study the best hedges against inflation and longevity are duration swaps or tangible assets such as equities and real estate.

Longevity swaps are not of interest because we already hold these risks on our books as a pension fund.

The Swiss regulator does not tell pension funds how to or to what extent to hedge. It is mainly concerned with institutional investors remaining in their investments limits. Therefore I do not believe that overlay strategies are already very common among Pensionskassen in Switzerland.

Strathclyde Pension Fund
Richard McIndoe
Head of pensions
• Invested assets: £9.6bn (Dec 2009) (€10.6bn)
• Members: 190,000
• DB public authority scheme
• Funding level: 84% (Dec 2009)
• Date established: 1975

Our focus remains much more on asset management than on management of our liabilities. Interest rate and inflation swaps and pooled LDI vehicles, which are used to hedge liabilities, are relatively recent innovations in the pension industry. And with the exception of one or two, few local authority pension funds in the UK have made use of them.

Corporate pension funds - driven by the UK regulator - pay much more attention to liabilities than public funds. In general, LDI management is more significant to pension funds where liabilities are likely to play a crucial role on the balance sheet. But our balance sheets are not looked at in the same way. For public pension funds their expenses - ultimately the cost to the taxpayer - tend to be more fundamentally important than their liabilities.

Our priority is the management of the assets rather than the management of the liabilities and therefore we are less likely to implement LDI. For our asset management, we have been undertaking asset liability management studies for a number of years, which help us to identify the right asset allocation for the fund.

As a typical UK local government pension fund we have pretty limited internal resources and have never managed our own assets. We have always appointed external investment managers to manage our asset classes such as equities, fixed income, property and private equity - all with a currency overlay. We do not tailor our asset strategy around inflation expectations though we are conscious that some assets offer better inflation hedging than others.

However, we do have a smaller £100m fund which does have an LDI strategy in place because it is closed to new members and has a corporate sector sponsor. Nevertheless, in the wake of the financial crisis, there has been a change in the way investors think, also with regard to liabilities. They keep asking themselves whether a longevity swap or an inflation hedge could be beneficial to their investment process.

Currently we are looking at the potential for inflation and longevity swaps. We are trying to find out whether they could be of any help to the pension fund but this review is unlikely to lead to early implementation. Still, we will give them some thought over the next year.

Most other local authority pension funds in the UK are probably conducting a similar review and one has already arranged a longevity swap.