Derisking: Unintended risks
Carlo Svaluto Moreolo asks whether UK trustees are taking the right approach to interest rate and inflation risk
The Bank of England (BoE) has hardly raised base rates more than a few quarters of a percent since UK pension funds began to embrace liability-driven investment (LDI) in the last decade.
The liabilities of UK private sector defined benefit (DB) pension funds have not only steadily risen throughout that period – the consultancy Hymans Robertson reported in June that they total £2trn (€2.8trn), a figure obtained by adding 44% in buy-out costs to the Pension Protection Fund’s £1.5trn total – but hedging instruments have become more expensive.
As LDI professionals recall, it is an irony that pension fund trustees have been rather reluctant to undertake LDI since the concept’s advent.
Dan Mikulskis, co-head of ALM at the consultancy Redington, says clients tend to have a binary view on the hedging decision – either embracing it, or not.
The counter argument has been that because interest rates are at historic lows, trustees can wait for them to rise. And that argument has been valid for a long time, in theory. The prospect of rising rates is more realistic today, but funds seem to have accepted the view that hedging interest rate risk should be a priority, regardless of the direction of interest rates.
John Belgrove, senior partner at Aon Hewitt, says clients have come to accept that “mean reversion is not the normal state of play”, and as a result they are reassessing the view of what constitutes fair value in LDI assets.
Indeed, the LDI market is growing impressively. This year’s KPMG industry survey reported that in 2014 the number of LDI mandates rose by 208 to 1,033, and the total amount of liabilities hedged increased 29% to £675bn.
KPMG expects the market to grow further, as 30% of existing mandates have hedging triggers, and with new business coming from pension funds that are new to LDI. Yet more than 60% of liabilities, most of which are inflation-linked, still remain unhedged.
Comparing that figure with UK outstanding sovereign bond issuance, the main type of physical matching asset, one might ask whether supply will match demand. According to the Debt Management Office (DMO), total outstanding issuance stands at £1.47trn, and UK pension funds are not the only investors hungry for Gilts.
The question becomes more relevant when it is considered that the UK government has made it clear that Gilt issuance will be reduced in the future as it tries to achieve a budget surplus by 2020. The answer is yes – pension funds will still be able to hedge. Gilts and inflation-linked bonds are just two of the various possible components of an LDI portfolio – others being corporate bonds, Gilt repos and derivatives such as swaps and swaptions.
But it does not take a complex analysis to understand that the issue is not the availability but the price of those assets. Even when the Bank of England ends its quantitative easing programme, there will be many sources of demand driving Gilts upwards, including insurers, retail investors and foreign investors.
Meanwhile, the use of derivatives is becoming complex and riskier. Although, under the EMIR Directive, pension funds are exempt from central clearing of over-the-counter (OTC) derivatives until the end of 2016, central clearing may become a future requirement, and the fact that other actors have to comply may influence the market as a whole.
But it will be crunch time for derivative portfolios when interest rates start rising. Although rising rates will reduce pension liabilities, pension funds holding swap contracts will need to post extra collateral to counterparties if interest rates exceed swap rates.
The issue of collateralisation is well understood. LDI managers run conservative stress tests on clients’ derivative portfolios to ensure pension funds hold enough collateral to satisfy counterparty requirements, including in extreme cases. This suggests that even with large and sudden increases in interest rates, pension funds would have little risk of running out of collateral.
LDI managers do not have a significant track record in dealing with a rising interest rate environment, so caution is required. Jonathan Crowther, head of UK LDI at AXA Investment Managers, believes rising interest rates may be a challenge, not because of limits to collateralisation, but because of the knock-on effect on market liquidity. “The extent of the problem depends on how much real liquidity is available in the market,” Crowther says. “If rates rise quite rapidly, with banks unable to take risk as much as they used to, pension funds may be forced to sell assets at sub-optimal prices.”
Taking a gamble on interest rates, therefore, seems beside the point. Mikulskis says what matters is ‘right-sizing’ risks. “One might think interest rates will rise. The question you have to ask is how much risk do you want to attach to that view. We find that historically pension schemes have really attached far too much conviction and risk to that view.”
Naturally, most consultants and asset managers, including Redington, advocate higher hedging than the current implied 30-40% rate, but there may be compelling reasons to do so.
Robert Gall, head of market strategy at Insight Investment, says the market should have discounted expected rises in interest rates, therefore the long end of the yield curve would not be affected, even when rates rise.
As Belgrove explains: “The fact that the market prices in interest rate rises is sometimes misunderstood. In delaying their hedging programmes, pension funds will only gain if future rate rises are faster and higher than what is priced in by the market.”
But the decision whether to increase hedging does not depend only on the shape of the yield curve. “Each fund has to decide how comfortable they are with staying under-hedged, given the strength of their sponsor, particularly their covenants.”
Furthermore, after closing to new accruals, it appears DB schemes are maturing faster than expected, which means that an increasing number of them will become cashflow negative. In short, the clock is ticking for DB pension funds.
The best solution, says Crowther, is therefore to start “chipping away” at the liabilities, which means beginning an LDI programme regardless of rates and the price, picking opportunities as they come.
However, for the majority of UK pension funds, falling interest rates is only one of the two major risks – the other being rising inflation. The BoE is still behind on its inflation target of 2%, but that does not mean pension funds should disregard the impact that unexpected inflation rises may have on their funding ratios. Insight’s Gall points out: “An inflation shock could be a bigger risk, since central banks all talk about a slow upward movements in rates.”
All this only mean that UK pension funds with LDI programmes will have to focus on the long-term implications of their strategies and on diversifying their portfolios. There is a range of options at the disposal of trustees. From global credit to swaptions, asset managers are pushing new strategies, with the aim of offering, at the same time, diversification and higher returns.
Illiquid assets – ranging from loans to infrastructure – are often part of LDI asset allocation discussions, although there is little consensus on whether they bring value at current prices, or on whether they should be used as LDI assets in the first place.
Robert Pace, LDI product strategist at Legal & General Investment Management (LGIM), says: “In terms of the actual funding level hedge that those assets give you, it won’t be as good as an index-linked Gilt, which moves exactly as yields and inflation expectations change. But it does give you extra premium and cashflow matching. We believe that there is space for other assets in a broader portfolio sense.”
But the industry wants to be ready for when investors demand those assets. Pace says that LGIM, for one, has been looking at pooled fund solutions for illiquid assets.
The UK LDI industry is innovative, but the real issue is that 85% of LDI assets are managed by the top three players – LGIM, Insight Investments and BlackRock – according to KPMG. A fourth contender, F&C, is gaining ground with its offering of pooled LDI funds.
Greater competition might be a vain hope since LDI is a business that requires scale. Any asset manager wanting to enter the UK LDI market needs to make large initial investments, particularly in technology, which constitute a natural barrier to entry.
Smaller LDI asset managers are therefore focusing on convincing clients to take a core-satellite approach, which would allow them to step in and take responsibility for part of the LDI assets.
It is debatable whether adding a second LDI manager makes sense. And there is a danger that pension funds will focus on return-generating capabilities when selecting an LDI manager. As Belgrove points out, LDI portfolios have recently looked heroic in terms of returns, although that is not their purpose.