Of swaps and swaptions
How do you implement your LDI strategy?
•Invested assets: DKK111bn (€15bn)
•Mainly pure DC, DC with guarantees for a smaller pensioners section
•Date established: 1992
•Solvency ratio: over 409%
Most of the pension scheme was changed from DC with contributions, to a pure DC or market rate based model in 2011-12. The only part left with guarantees consists of those who were already pensioners. Today, €1bn of the €15bn we have in assets under management comes with guarantees, and only for those do we still run an LDI strategy.
Back in 2005, we decided to implement an LDI strategy for our fund. After two years, we changed that initial hedge to a 100% hedge covering all liabilities, meaning all our liabilities were 100% hedged by interest rate swaps.
The main reason for implementing this strategy was that we had an enormous quantity of uncompensated risk from our liabilities.
We were among the first Danish pension funds to have a 100% hedged liabilities side but today a number of other pension schemes do too.
The strategy still applies today for the members that remain in the scheme with guarantees.
We still only use swaps as a hedging instrument. We could possibly make use of bond futures, but generally we hedge through swaps.
The first hedging we did in 2005 utilised interest rate swaps. But, we felt that was not a true hedge of the liabilities as well as expensive, which is why we replaced it with a linear model using a swap portfolio.
The number of members in the DC scheme with guarantees will decrease, meaning there will be an increasingly smaller amount of liabilities to hedge in the future. As it is a shrinking part of our scheme, we are very well funded with a solvency ratio of over 400%.
We have always implemented our LDI strategy in-house, with no external help.
One problem Danish pension funds face is the difference between the discount rates used to calculate the liabilities and the market rate used for the valuation of the interest rate swaps.
In our view, it is a small technical problem but it means that it is impossible to fully hedge.
The hedge may deviate slightly from month to month but the long-term sum of deviations will be zero. Thus it can easily be absorbed if you have higher reserves than required.
Benny Buchardt Andersen
•Invested assets: DKK104bn (€14bn)
•Members: around 400,000
•DB and DC scheme
•Date established: 1985
•Solvency ratio: around 250%
PenSam has had a liability hedging programme in place since 2001.
The fundamental reason for this was the view that we should not invest in assets that do not compensate us for the associated risks. We started concentrating on the risks of equities, real estate and all bonds, as opposed to focusing heavily on fixed income bonds and interest rate risks.
The fundamental issue on the liability side is that duration increases dramatically when interest rates go down. This also means that the value of the liabilities will increase when interest rates fall.
We use swaps and swaptions as a starting point for our liability hedge. These instruments give the smallest tracking error in our strategy because they are being used marked-to-market on the liabilities.
The replication of the liabilities from a marked-to-market perspective makes up the beta part of our LDI strategy.
We do not run a simple passive replicating strategy. We actively try to generate a better return instead of just replicating. In other words, LDI is part of our base tracking error and we try to optimise that. We use a second layer to add value, through elements such as volatility.
All of our LDI strategy is handled in-house. The strategy has developed as our team gained more insight and became more advanced at handling it. It has been a quiet evolution, we did not make any fundamental changes to the strategy.
Our hedging policy has not altered as legislation has changed. However, the fundamental implementation of the LDI strategy has been adjusted by changing discounting curves.
Our collateral management is focused on securing value and therefore consists of government bonds from northern Europe. The collateral is not traded.
On a slightly different note, we undertake regular ALM studies. For us, they are an ongoing process and are annual. They are key to understanding how much solvency we need to have on our investment side.
Pension Protection Fund (PPF)
•Invested assets: £15bn (€17.5bn) + £5bn from schemes in assessment
•Members transferred into PPF: 180,000 + 125,000 in assessment
•Open to DB schemes in the private sector
•Date established: 2005
•Funding level (including schemes in assessment): 110%
The PPF adopted an LDI strategy in 2007 to control balance sheet risks and because interest rate and inflation risks are not rewarded.
We have just completed a major reorganisation of the LDI strategy, which increased our control. Originally, we outsourced LDI management to one fund manager but we have reduced our dependency on that manager by bringing the supervision of the benchmark-setting and performance monitoring in-house and establishing direct relationships with our counterparty banks. We also hired an additional external LDI manager so we have two managers operating in parallel on similar benchmarks.
We have also established a single, externally managed collateral pool to retain offsetting advantages.
We have a target that is expressed in terms of our 2030 funding level. For liability management purposes, we establish a replicating portfolio based on the mark-to-market valuation basis agreed by our board. From that portfolio, we take out the basis risks we cannot control to produce the investable benchmark, which our LDI managers then use to manage liabilities. By this, we can attribute performance and risk accurately.
As the fund has grown, we started using more complex instruments to hedge interest rate and inflation risks. Initially we just used swaps, now we make use of a whole suite of interest rate swaps, inflation swaps, swaptions, Gilt repos, total return swaps and physical assets such as bonds and Gilts.
Growth is a challenge, as we take on about £2bn worth of new liabilities every year. Another challenge is the uncertainty, particularly with regard to the liabilities of the schemes that we take on. The data quality of those schemes is not as good as we like it to be, which creates additional risk.
Our LDI programme is done on an unfunded basis using derivatives. As we continue to grow, our dependency on the derivatives market makes us vulnerable to increases in the cost of accessing this market brought about by post-crisis regulation. We are looking to reduce our dependency on unfunded strategies and run more of a hybrid approach in the long-term. This will involve including more physical assets and making a greater allocation to illiquid asset classes and buy-to-hold strategies to improve performance and maintain our hedge effectiveness.