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Liability-Driven Investment: This sprint finish could get brutal

Things seem to have gone pretty well for UK pension schemes during 2013. A combination of rising bond yields and an equity market rally meant that, at the least, funding levels didn’t get any worse, and at best got schemes two or three percentage points closer to the finishing line. 

According to JLT Employee Benefits, the funding level of FTSE 350 companies’ schemes reached 89%, on an IAS19/FRS17 basis, at the end of April 2014. A year earlier that number was 86%. Mercer’s calculations suggest the ratio hasn’t budged in that time, from 84%, but that is still a long way from the 77% level it was reporting in 2009. Moreover, in this month’s Ahead of the Curve, Goldman Sachs Asset Management reckons FTSE 350 schemes improved funding levels by 10 percentage points through 2013, reaching an aggregate level of 103%-funded.

Market participants should expect schemes to lock in some of those gains, particularly given the extent to which many are behind in their de-risking programmes. Aon Hewitt recently recommended that the average closed scheme ought to be protected against at least 70% of its interest rate risk – but pointed out that the actual amount hedged was more like 30-40%. Sure enough, F&C’s quarterly poll of investment bank derivative trading desks indicates that UK schemes were immunising interest rate and inflation exposure faster than ever in the last two quarters of 2013.

The F&C poll also proposed that the only reason Q4 saw a little less de-risking than Q3 was a reduced supply of index-linked Gilts. This problem is addressed by Harris Gorre of Investec, who suggests that banks could have a much bigger role as linker issuers. High-demand pressures around liability-hedging assets are tackled in another of our articles, which already detects pretty aggressive competitive behaviour by funds desperate to get their hands on rates ahead of the horde. A large volume of leveraged bonds exposure via total return swaps and repo, exercised in the years since the swap spread turned negative at the height of the 2008-09 financial crisis, has now eradicated that spread at the short end of curves and brought it close to zero at the long end (Mind the gap). We see similar signs in swaptions markets, too: out-of-the-money payer swaptions are trading unusually cheap relative to receivers, reflecting constrained volatility of upside interest rates as pension schemes act fast to lock in any modest rate increases (The other 30%). 

As well as the demand pressures, there are some supply issues to contend with – and not only decreasing government bond issuance. Regulation of banks, in the form of Basel III, and their counterparties, in the form of the European Market Infrastructure Regulation (EMIR), is going to make leverage harder and more costly, as well as more operationally intensive to manage. While this is probably going to put even greater demand pressure on the most liquid government fixed income markets in the short term, longer term that pressure must surely necessitate smarter liability-matching strategies that attempt to exploit a broader range of assets (Let’s get physical). In the UK, in particular, recent policy developments on individual annuities look likely to spark the bulk annuities market into life, potentially introducing much greater scope to spend credit and illiquidity risk budgets in liability-matching portfolios.

In just about all cash-flow asset classes – liquid and illiquid – the de-risking sprint finish towards self-sufficiency will be characterised by some pretty brutal jostling for position. We hope our special report will help you get a clear view of the track when the final-lap bell rings.

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