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Impact Investing

IPE special report May 2018

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Matching DC interest rate risk

Lowering the minimum interest rate (MIR) from 4% to its present level of 2.25% level has undoubtedly taken some of the pressure off Swiss pension funds. However, Pictet AM has identified what it sees as a serious threat to defined contribution (DC) type pension plans in the new arrangements.
Rather than have a fixed MIR, the Swiss government wants to re-set the rate each year. The BVG Kommission, which administers the second pillar, has proposed a rule for the annual re-set of the MIR for DC pension plans in Switzerland: MIR should be linked to the 10 year yield of the Swiss government bond, calculated as the average of three month end-rates at the year end, plus or minus a 0.5% discretionary premium or discount, depending on the overall investment outlook. This rule has been accepted by all parties involved, including the labour unions.
Meanwhile the markets expect rising interest rates. A typical Swiss bond portfolio has a plus or minus the benchmark equivalent duration risk. So short-term investments or buy and hold of 10 year bonds cannot achieve the necessary liability matching.
For example, an employee aged 45, insured in a DC pension plan, will remain in the plan for a further 20 years. The employee’s current pension capital is CHF100,000 and the capital is paid out fully at retirement age of 65. The money bears interest according to the new MIR rule.
The pension fund has to estimate what this liability is worth today and how much capital is needed to finance the liability risk-free. Final capital, calculated using implied forward rates, is CHF221,585. The net present value of this future liability is approximately 109% of current capital. Therefore the future liability cannot be met without taking on additional risk.
Pension funds cannot simply invest in 10 year bonds, because if interest rates go up the value of the 10 year bond falls. Nor can pension funds invest in short term bonds. Unless the curve inverts, the return of short-term bonds is not enough to provide MIR-like returns.
Pictet AM says, as a result, pension funds face significant liability risk. The MIR rule forces pension funds to take on more alpha or beta risk to achieve the required rates of return. Swiss pension funds will have to find ways to match their new return benchmark, and the MIR rule will have an impact on their investment strategy and risk budgeting.
There is a way out, Pictet suggests. The liabilities can be expressed as a financial instrument where price and risk of change in interest rates can be determined. An individual liability can be covered by a constant maturity bond (CMB) that pays the 10-year bond rate with annual re-set
Since CMBs are not available in Switzerland these instruments can be replicated through specific financial instruments like bonds and swaps. Using a properly managed CMB portfolio, the typical liability risk profile of a DC pension plan can be matched.
Pictet has developed a product called CoreProtect that reduces the liability mismatch relative to changes in the MIR. If a DC has a coverage ratio of , say, 109% the mismatch risk can be fully hedged by investing the overall portfolio in CoreProtect.
Although Core Protect will not close existing funding gaps it protects against a further widening. It also provides a basis for a liability-based core satellite approach.
There is no need to match the risk on an individual basis. The aggregate risk profiles of pension funds are quite similar, so individual risk profiles can be aggregated in a commingled vehicle.
Pictet says CoreProtect will save s pension fund the trouble of building and maintaining its own structure, with swaps, agreements and credit risk monitoring. Udo Von Werne, senior vice-president of Pictet AM, says: “We think this is quite exciting. It is something innovative where we have tried to make people aware there is an issue.
“Clearly it’s a fairly abstract, theoretical concept and also quite challenging to explain to our target audience - the board of trustees. But we are working hard to lobby on that. Since the rule hasn’t yet been fixed it’s obviously difficult to launch a product yet, but we have made a case for it. Everybody is talking about matching assets with liabilities but very few - if any - would for example discount their liabilities with capital market-like interest rates.”

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