Hedging liabilities with benchmarks
What are your fixed income benchmarks?
• Invested assets: SEK19.5bn (€2.2n)
• Participants: 150 sponsors and 38,000 beneficiaries
• 99% DB, 1% DC
• Funding level: 166% (Dec 2010)
• Date established: 1944
Approximately 70% of our overall asset allocation is invested in fixed income, all of which is allocated to Swedish government bonds.
We have outsourced most of our asset management and our external managers have an active mandate. This allows them to move a little bit outside of the benchmark at a controlled level - for example, into covered bonds - and, to some extent, deviate from the benchmark duration-wise. In other words, it is an active bet on their side but the benchmark remains government bonds.
We only make use of one fixed income benchmark - the Swedish government bond index, OMRX-Tbond, which is an index of Swedish treasury bonds issued by the Swedish National Debt Office.
We introduced it just before 1 January 2006. Until that date we had a shorter-duration benchmark but when the traffic light system regulation came into force at the beginning of 2006 we changed it to a longer-duration one.
While the regulation did not require a change in benchmarks, it made the hedging of liabilities a lot more important, which is why we wanted to move the portfolio into longer-duration instruments.
From a matching and operational point of view, the benchmark has worked well because it is fairly liquid and long duration - currently about six-and-a-half years - and gives us low counterparty risk.
Nevertheless, one thing we have considered is the separation of the fixed income portfolio into a very active part and a very long-term duration portfolio. In that case we would have a different set of benchmarks. The duration of our current benchmark is six and a half years, which is very short, given that we have a liability duration of 25 years. So if in the future there are longer benchmarks they could be of interest to us. But currently there are no benchmarks in Sweden that are longer and still liquid.
Other Swedish pension funds operating under the traffic light system may use the same benchmark as us. A few may also make use of its sister benchmark, the OMRX-bond index, which is an index of the Swedish National Debt Office’s and the mortgage institutions borrowings via bonds, meaning it can also include some corporate bonds.
Apart from pension funds, Sweden has another type of entities, the pensionsstiftelse, which do not fall under the traffic light regulation. These entities have more freedom in choosing their duration and other benchmark characteristics, so they are able to select their benchmark from a wider range.
Swedbank Investment Funds
• Invested assets: €532.5m (Jan 2011)
• Participants: around 339,000
• DC scheme - four mandatory second pillar and three voluntary third pillar funds
• Estonia’s second pillar pension system was established in 2002
Our five balanced pension funds - in other words those that have an equity allocation of approximately 25-75% - use custom-made fixed income benchmarks. They are a composition of three different indices - the EMU government bond index, the EMU investment grade credit index and the euro-denominated emerging market sovereign debt index.
The fund with the most conservative strategy uses a composition of the EMU government bond and the EMU investment grade credit index excluding the emerging market bond index because we expect some legislative changes in the near future, which will make the credit rating limit for conservative funds more restrictive by only allowing securities with a credit rating of investment grade or better into conservative strategy funds.
These amendments were approved by Parliament at the end of January. They are set to come into force in August 2011 and be implemented by 1 January 2012 but we have been preparing for them.
Our fixed income benchmarks were established in January. Last year’s benchmark, included short-term assets in Estonian kroon but with Estonia’s adoption of the euro this year this type of asset class disappeared. Because of this structural change we had to change our fixed income benchmarks.
After a two-year break we have different fixed income benchmarks for our conservative and balanced funds again. As late as last year we applied the same fixed income benchmarks to our balanced and conservative funds, which included euro-zone government, euro investment credit and Estonian kroon-denominated investment grade credit assets.
Structural changes in the market, the long-term economic outlook and the legal environment are the most influential factors in determining which benchmarks we use. Estonian investors follow closely what happens to the assets in their pension funds.
Estonian pension fund management companies do not publish their benchmarks. One of the discussions has been that maybe they should be published but so far no position has been taken on this.
Over the next three months we will work on a plan for more investable fixed income benchmarks on both government bonds indices and the investment grade credit index. We hope to be able to switch to indices over the year that contain fewer asset classes and therefore can be more easily replicated and are, in our opinion, the underlying for more attractive exchange traded funds (ETFs).
ABN AMRO Pensioenfonds
• Invested assets: €9.9bn (Dec 2010)
• Members: over 77,000
• DB scheme
• Date established: 1907
• Funding level: 108% (Dec 2010)
We have two types of fixed income portfolios: a liability driven investment (LDI) one and a credit portfolio. The LDI portfolio uses the return on the liabilities of the pension fund as the benchmark, while the credit portfolio has a tailor-made benchmark consisting of various Barclays [Capital index] constituents.
Initially it was one fixed income portfolio containing both parts - with the LDI portfolio being set up in 2007 - but it was split up in 2010 to make the portfolios purer. Back then the portfolio used more common fixed income benchmarks like euro government indices which, at the time, were still called the Lehman government bond indices.
With the separation of the portfolios, the credit part introduced the tailor-made fixed income benchmark. To decide upon a benchmark we first establish the intention of the portfolio, its risk characteristics and what it should generally look like. Then we search for an appropriate benchmark in the universe. It has been difficult for us to find appropriate benchmarks, which is why we have a tailor-made benchmark, which consists of sector indices. But it is still too early for us to judge its benefits on the credit portfolio. It is not our aim to find a benchmark that generates better returns - instead, we are looking for a benchmark that provides better diversification or other improvements. In the quest for a better basket of securities we are also looking for alternative, new-generation benchmarks.
We review all investment categories and portfolios at least once a year and during this in-depth evaluation, the benchmarks can be up for discussion as well. Obviously we do not change them every year but we review whether we should undertake new research into benchmarks. However, with the credit portfolio benchmark being so new it is unlikely that it will be up for serious discussion soon.
With regard to the LDI, our most important fixed income portfolio, we still believe the return on the liabilities represents the most appropriate benchmark. In this part of the portfolio we aim to invest in low-risk or risk-free assets. From the perspective of a pension fund, the lowest risk benchmark for us is the return on the liabilities of the fund.
Among Dutch pension funds our LDI approach is not mainstream. Many of the institutional investors in the Netherlands undertake an overlay construction with derivatives or similar.