Mind the gap: managing your duration
Like any investment approach, liability-driven strategies need to be used within a mix of tactics and instruments. Liabilities need to be taken into account, but not at the expense of performance. Experience has shown that good managers can still add to performance whilst managing liability, if placed in the right investment mix.
But why is limiting liabilities such a pressing issue for today’s pension schemes? Between 2000 and 2004 European pension funds became engulfed in a ‘Perfect Storm’ and three factors conspired to significantly reduce the solvency of European and pension funds. Falling equity markets reduced fund net asset value, falling bond yields caused the value of liabilities to increase faster than fixed income assets in most funds, and changing regulation is forcing the adoption of market consistent valuation, which has further increased the value of the liabilities. Hence the emerging interest in Liability-Driven Investment (LDI).
LDI experience from the insurance world
But even though LDI may be the buzz word of the day in pension funds, asset managers like F&C have been running successful LDI strategies for many years outside of the pensions realm. Insurance funds, which represent a large chunk of F&C’s client base have always had the same needs to focus on managing their liability profile. They need to make sure they can pay out future policies, whilst still maintain adequate capital growth. Whether you are ensuring you have enough capital to pay out future pensions, or making sure you can honour insurance policies, the skill sets required from your asset manager are essentially the same.
When dealing with the liabilities of insurance funds, there are a number of aims. Firstly, you need to preserve as far as possible the insurance company’s freedom to invest in return-generating assets. It also needs to have the potential to fully close the duration gap between the insurer’s assets and its liabilities. Sound familiar?
In the same way, pension funds now realise that the concept of using equities to provide long-term growth doesn’t work as well as it has in the past. The reason is that a pension fund has more in common with a bond than it does equities. Its requirement to fulfil pension promises in the future suggests a need to focus on an approach that is not dependant on volatile share prices. Shares alone are much too volatile to meet a pensions promise – especially as funds mature and pension beneficiaries live longer. This is why there is a growing need to make assets in pension funds more bond-like in nature. Such a change reduces a portfolio’s asset-class risk and also adds the predictability lacking in equities.
In the Netherlands in particular, the need to reduce the risk of liabilities has been hardwired into the system with the advent of the Financieel Toetsingskader (nFTK). Boards and management are now required to restructure the investment side of their business to limit the risk of not meeting liabilities, hence the specific interest in LDI. The implication is that companies need to look more closely at their risk budget.
Tools and strategies for LDI
F&C uses a range of tools and strategies to manage pension fund and insurance company liabilities. These include: Delta hedging, which is the process of modelling interest rate risk in conventional asset portfolios and removing delta exposure; Capital Constrained Investment Benchmarks, which produce an optimal risk-return trade-off subject to capital constraints; and Dutch U-Rate hedging to hedge liabilities with complex guarantees.
For a typical pension fund that has assets allocated to both fixed income and equities, the duration of the fund’s liabilities is significantly longer than the duration of its assets. This mismatch in duration results in the total fund valuation (assets and liabilities) being sensitive to movements in interest rates. In this case, as interest rates rise, the total fund valuation will rise – because the liability value falls faster than the asset value. The reverse is true as interest rates fall (and therefore the total fund valuation will fall). In market parlance, this gap between the asset and liability duration is referred to as the ‘duration gap’.
The changes to the Dutch Pension regulations have moved the ‘duration gap’ between assets and liabilities on the balance sheet. Funds are being forced to find a solution to extend asset duration to avoid breaching minimum solvency thresholds. In the Netherlands, pension funds are now required by the regulator to have a solvency in excess of 105 per cent.
Achieving a solution for a fund to mitigate this duration exposure is not as trivial as it may first appear. Every pension fund is different, with its own unique risk appetite. The main differences are to do with solvency, size and maturity. Some funds are very solvent, whereas others only marginally so. The total asset value of some funds is in the billions, whereas the assets from others may vary between 20 and 40 million. And some funds a very mature, consisting mostly of cash annuities, although others could be populated entirely by new members. Each characteristic will drive the choice of LDI strategy used to hedge the duration gap.
The quickest and simplest way to try and close this gap is to match it with cash. But matching with cash is inefficient. By simply moving a portfolio from diverse investment into pure fixed income is usually inappropriate for trying to match the duration gap. This is because through such actions, a fund will lose its portfolio diversification. It loses the opportunity to capture the sort of excess returns that, over the long term, various alternative asset classes have demonstrably offered. Cash options offer equally poor dynamics for almost all types of funds, irrespective of size.
Using derivatives to close the gap is a much more complex but much more effective solution, and there are various ways funds can utilise derivatives.
Very large funds have more choice at their disposal principally because they can independently access the derivatives market and the ISDA and CSA. They can deal directly with investment banks and use the appropriate interest rate derivative to extend duration.
Typically, smaller funds do not have this luxury or expertise to deal in derivatives on a standalone basis. It is common for these funds, or some of the larger funds that want to take a collective approach, to invest in a pooled solution.
Using pools to close the gap
Pools help close the duration gap without placing undue constraints on the investment strategy of the portfolio. They do not force a fund that wants to fully close the duration gap to invest all its assets in fixed income securities to cash flow match its liabilities.
F&C’s LDI pools are geared so that a pension fund can hedge 100 per cent of its liabilities without needing to have 100 per cent of their assets invested in the LDI pools. As an example, our 11-15 year pool is leveraged three times. This means that an investment of e10m will have the same investment performance of e30m in 11-15 year zero coupon bonds, (and thus mirrors the market sensitivity of e30mm of 11-15 year liabilities).
It is important to remember that LDI is not just about reducing risk. At its essence it is concerned with approaching an investment from the point of its liabilities instead of trying simply to maximise returns on assets without concern for the risks to meeting liabilities. The resulting strategy could be anything from trying to outperform liabilities, to trying to match them with cash.
So depending on the situation, it is entirely possible that a bespoke LDI strategy can still leave room for alpha generation.
It is a common misperception that LDI has to be “all or nothing” and it is rarely the case that a pension fund will need 100 per cent bond exposure. Even for under-funded schemes, a successful LDI strategy might only need a certain percentage invested in bonds to guard against inflation and interest rate hikes, with the rest able to engage in high-alpha investing. Once liabilities have been considered appropriately, the remainder of a scheme’s investment would likely be free to be allocated to asset classes outside of bonds and equities, depending on the mandate. These areas could still be diverse, covering property, hedge funds, emerging markets, and the like.