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IPE special report May 2018

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Matching liabilities in unique circumstances

With assets of €887m and some 16,000 members, Pensioenfonds KBC is the pension fund for employees of KBC Group, a leading quoted banking and insurance group in Belgium. With changing accounting standards across Europe forcing companies to reveal the value of their pension schemes liabilities from year to year on their balance sheets, many schemes have had to go back to the drawing board and overhaul how they match their liabilities to their investments more closely. This gave birth to the liability matching revolution and KBC is proving adept at striking the right balance.

A QUESTION OF COMPROMISE

"With the introduction of IAS19 in 2005, the sponsor of the pension plan was faced with the volatility of the pension liabilities being reflected in the company's balance sheet," Pensioenfonds KBC begins. "And as of 2007, the Belgian pensions regulator requires pension funds to calculate their technical provisions with a discount rate linked to the expected return of the assets of the fund, not a fixed discount rate of 6% as in the past," it adds.

But there was a slight snag. While the sponsor was willing to continue funding a defined benefit scheme, Pensioenfonds KBC says that in return it was seeking to reduce the volatility the fund created on its balance sheet. But Pensioenfonds KBC was reluctant to go so far as abandon the return-seeking central philosophy of the strategic asset allocation it has just introduced for the period 2006-09 based on an asset-liability modelling exercise.

"A typical bond-heavy LDI strategy would increase the costs of the DB scheme," Pensioenfonds KBC claims. "The new strategic asset allocation for the period 2006-09 consists of a 50% exposure to equities, 40% to fixed income and 10% to real estate. The expected return of this portfolio is 6%. The LDI-strategy must fit within this strategic asset allocation.
 
VICIOUS CIRCLE
Moreover, Pensioenfonds KBC believes it is in a potentially more sensitive position than other Belgian pension schemes in that unlike most others; both it and its sponsor are basically in the same business. "If the pension fund has a bad year due to downward spirals in the markets, it would have to raise the sponsor's premiums. But the sponsor would also have had a bad year for the same reasons, so the fund would be asking for more money at absolutely the worst time," it explains.

So, Pensioenfonds KBC asked itself how could it reduce volatility without giving up on returns? "Firstly, one has to understand the nature of the pension liabilities and what causes the mismatch between those liabilities and the scheme's assets."

In Pensioenfonds KBC's case, the mismatch between the pension liabilities and its assets was two-fold :

with an allocation to fixed income of only 40%, but IAS19 requiring the value of the liabilities to be matched against bonds, 60% of the pension liabilities were not matched, and the average duration of the pension liabilities was 12 years, whereas the average duration of the bonds portfolio was only seven years

 "A mere increase of the fixed income allocation or a lengthening of the duration of the bonds would not suffice. A more substantial intervention was required," Pensioenfonds KBC mused.

RETHINK

Pensioenfonds KBC says this led to it restructuring and splitting its portfolios into three parts:

The matching portfolio.
Pensioenfonds KBC says the fixed income part of the portfolio was replaced by structured LDI maturity buckets. To achieve this, KBC Asset Management created a Luxemburg UCITS III vehicle - with a European passport - with a full range of constant duration sub-funds covering durations of zero to five  years, five to 10 years, 10-15 years, and so on. These are with and without a link to inflation. The vehicle works with derivatives in the form of interest rate swaps to create leverage that allows the fixed income part to hedge twice as many liabilities with less money. "For cost reasons, it was decided to hedge the inflation risk for 50% of the liabilities and only for those with a duration of more than 10 years," says Pensioenfonds KBC.

The return portfolio.
Pensioenfonds KBC says no changes have been made to the equity allocation of the portfolio, which remains at 50% and is equally split between the Euro-zone and the rest of the world. "This includes a 5% allocation to private equity," the scheme adds.

The matching and return portfolio.
Pensioenfonds KBC  says the 10% it set aside as allocation to real estate has been restructured, with part of the quoted real estate securities being replaced by non-quoted real estate funds, infrastructure funds, timber funds and long term government leases. "This type of property has similar return expectations as quoted real estate but shows less correlation with the equity markets and  because of its term and inflation linked nature offers a better match for the pension liabilities," Pensioenfonds KBC argues. Pensioenfonds KBC claims the results of the implemented LDI strategy are two-fold.

Firstly, by matching more or less 85% of the pension liabilities, Pensioenfonds KBC says it has substantially reduced balance sheet, profit and loss, and funding volatility.
Secondly, Pensioenfonds KBC stresses that its portfolio can continue with an expected return objective of 6 percent. "There has been no reduction in the exposure to equities or real estate exposures, while we have actually increased the expected return from the fixed income part because of longer durations and the use of swap curves and leverage," it says.

HIGHLIGHTS AND ACHIEVEMENTS
You may be forgiven for thinking Pensioenfonds KBC arrogant in its refusal to abandon its return-seeking investment strategy to accommodate new legislation prompting Belgian schemes to adopt a liability matching solution that helps the sponsor control the risk the scheme poses to its balance sheet. But this scheme is different: its sponsor is a banking and investment group, so when the markets go haywire, it cannot rely on the sponsor to inject more cash, as the sponsor's own cash flow will suffer at the same time. The solution is simple but effective: three complementary portfolios that have distinct objectives which will allow Pensioenfonds KBC to continue seeking high levels of return while constantly matching liabilities as the law demands.

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