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New regulations such as IFRS require pension funds to bring their interest-rate risk more in line with the interest-rate risk of their liabilities. This usually means that the duration of the fixed-income portfolio needs to be extended or the allocation to fixed-income investments increased. The latter would mean that there is less room for higher-risk investments to create opportunities for indexation. In this article we will use a case study to demonstrate the advantages and disadvantages of the various methods for interest-rate-risk matching.

New regulations and matching
Regulations such as IFRS in Europe or Nieuw Financieel Toetsingskader (FTK) in the Netherlands require pension funds’ unconditional liabilities to be valued at market value. In practice the unconditional commitments only consist of nominal rights as indexation is usually conditional. Movements in the market value of pension liabilities can be compared to those of long-term (nominal) bonds on account of their long maturity. The duration of such liabilities is estimated at 15 years for the average pension fund.
Pension funds need to assess how likely it is that the market value of their investments offers sufficient coverage for their liabilities. Most pension funds put a part of their investments in fixed-income securities with a duration of about five years. This means that there is a large mismatch with the interest-rate risk of the liabilities. Pension funds may therefore choose to match the interest-rate risk.

Matching assessment: the Delta method
One of the methods for matching pension funds’ interest-rate risk is the Delta method. Delta measures the change in value of a series of future cash flows as a result of a change in interest rates. If a series of cash flows has a delta of 20, the value of these cash flows will rise by 20 if interest rates decline by 1%.
As both fixed-income investments and pension liabilities may be considered future cash flows, the interest-rate delta can be determined for both. If the interest-rate delta of the investments and liabilities is the same, the change in value of these investments and liabilities will also be the same.
The value of a future cash flow depends on the interest rate related to the maturity of that cash flow. The different maturities have different interest-rate levels which do not necessarily move in line. This means that matching the overall interest-rate delta is not sufficient. In order to be protected against non-parallel movements in the yield curve, interest-rate matching has to occur at maturity level.
1. The total delta of the liabilities is 600,000. A 10 basis points decrease in interest rates means that liabilities increase in value by 60,000.
2. The pension fund is protected against parallel movements in the yield curve, as the delta of both investments and liabilities is 600,000.
3. The pension fund is not protected against non-parallel movements in the yield curve. Let us assume a scenario in which 1, 5 and 10-year yields fall by 10, 20 and 30 basis points, respectively. In this scenario the value of the investments increases by 130,000, while that of the liabilities increases by 140,000.

Case study: matching for pension funds
In this case study we will use the Delta method to assess pension fund ABC’s interest-rate matching. Furthermore, we will indicate how matching can be optimized. We will also focus on the various financial instruments available.
The maturity of pension fund ABC’s nominal liabilities is 70 years. Their market value is e100 million on the basis of current market rates. Figure 1 shows pension fund ABC’s nominal liabilities.
The pension fund’s liabilities are hedged by a e120 million investment portfolio. The fixed-income investments, representing 60% of the portfolio, are managed versus the Lehman Euro Aggregate Index. The remaining 40% is held in higher-risk investments such as equities, private equity and hedge funds. The pension fund needs the higher expected return of these investments to offer room for pension indexation.
The interest-rate delta can be determined for the investment portfolio and the liabilities. Figure 2 shows the deltas per maturity bucket for pension fund ABC’s investments and liabilities. The liabilities’ delta is 16 million. The investments’ delta is only 4 million. The delta analysis demonstrates that the pension fund is not properly matched.
A scenario analysis is carried out to illustrate the interest-rate mismatch. Figure 3 shows an interest-rate scenario in which the curve shows a parallel decrease of 50 basis points. The change in value of investments and liabilities can be calculated for this scenario.
Table 2 demonstrates that the change in value of the investments lags the change in value of the liabilities.
Pension fund ABC has an interest-rate mismatch which makes it vulnerable to interest-rate declines. In order to solve this, the pension fund will have to buy more interest-rate risk. The pension fund may choose to increase its allocation to fixed-income investments to 85%. Within the fixed-income portfolio all investments will subsequently be made in 30-year bonds. Figure 4 shows the deltas of investments and liabilities if this option is chosen.
Figure 4 shows that the total delta of investments and liabilities is now the same. The pension fund is protected against parallel movements in the yield curve. The interest-rate delta of investments and liabilities is however not evenly distributed across the various maturity buckets. This means that there is no matching for non-parallel movements in the yield curve. This can be illustrated by scenario 2 as shown in figure 5.
Table 3 shows the movements in the investments and liabilities of pension fund ABC. The change in value of the investments lags the change in value of the liabilities. This is caused by the fact that the pension fund does not have exposure to maturities of more than 30 years. It is not possible to create such an exposure using bonds.
There are two additional disadvantages attached to the solution which invests a large portion of the investment portfolio in 30-year bonds. First, in the euro zone 30-year bonds are almost exclusively issued by governments. This means that it is difficult to have an allocation to credits. This limits the expected return on the fixed-income investments. Second, many pension funds depend on returns from, for instance, investments in equities or alternatives such as hedge funds or private equity for pension indexation. If 85% of the investments are placed in long-term government bonds, prospects for indexation are limited.
The disadvantages outlined above can be compensated for if interest-rate exposure is hedged by means of interest-rate swaps (IRS). The use of IRS makes it possible to match the interest-rate exposure of the various maturity buckets exactly. Pension fund ABC invests 60% in fixed-income securities and uses the Lehman Euro Aggregate Index as its benchmark. The liabilities’ interest-rate exposure can be matched using six interest-rate swaps. This is shown in Figure 6.
If ABC opts for the overlay with interest-rate swaps, the fixed-income securities may remain invested according to the Lehman Euro Aggregate Index. Furthermore, it will not be necessary to increase the allocation to fixed-income securities. The pension fund can allocate 40% of the investments to riskier investment categories in order to establish the possibility for indexation.

Implementation
Interest-rate swaps offer the possibility to hedge a pension fund’s interest-rate exposure efficiently. A disadvantage is that they are over-the-counter instruments. This means that the pension fund needs to enter into ISDA contracts with the swap counterparties. Furthermore, collateral deposits have to be made if the swap contracts are out of the money. This is a substantial administrative burden for most pension funds. To solve this problem, Robeco offers long-duration funds that are tailored to the needs of institutional investors such as pension funds. The two variants, which invest in euro government bonds and euro credits respectively, make use of Robeco’s fixed-income investment expertise, combined with an interest rate swap overlay to increase the overall duration. The long-duration funds have a maturity profile which is similar to that of most pension funds. An advantage is that, by investing in a fund, the pension fund does not need to monitor collateral deposits or arrange ISDA contracts itself. This is taken care of within the fund. Moreover, additional return is achieved by active duration management in the government bond fund and active issuer selection in the credit fund.
Return enhancement
As stated above, pension funds are not only interested in matching their long-term nominal liabilities. Most of them also aim to offer their participants a pension that is indexed to inflation. To create the necessary room for indexation, they need to enhance their return by including a portion of higher-risk investments in their portfolio as well. To limit the risk of underfunding, it is important to diversify across various asset classes. This way a pension fund is less dependent on the performance of one or two specific asset classes. In addition to the long duration bond portion of the portfolio, Robeco therefore recommends investing in equities (both developed and emerging markets), property, high yield bonds and alternative investments such as private equity, hedge fund-of-funds and quantitative trading strategies. Robeco offers a wide range of investment capabilities in each of these asset classes. An example of a recommended asset allocation is given in Figure 7. This allocation will allow the pension fund to enhance the return on its portfolio while reducing risk.

Summary
Most pension funds need to bring their interest-rate risk more in line with the interest-rate risk of their liabilities. The most efficient way to do this is using interest-rate swaps. This method allows liabilities to be matched exactly, while leaving sufficient room in the portfolio for investments aimed at creating room for indexation. There are some practical problems related to interest-rate swaps, such as ISDA contracts and collateral which must be managed by the pension fund. Robeco offers long-duration funds that solve these problems.
In addition to asset-liability matching, pension funds may want to enhance the return on their portfolio in order to create room for pension indexation. This can be achieved by diversifying across a wide range of higher-risk investments including equities and alternatives.

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