On the Record: Cost concerns
ABN AMRO Pensioenfonds CIO Geraldine Leegwater, KBC Pensioenfonds managing director Edwin Meysmans and SPK chief information officer Stefan Ros share their views on how the European Market Infrastructure Regulation might affect their liability-driven investment strategies.
ABN AMRO Pensioenfonds, Netherlands, Geraldine Leegwater
• Invested assets: €12.8bn
• Members: 84,000
• DB scheme
• Funding level: 107.5% (Jun 2012)
We have had our liability-driven investment (LDI) strategy in place since 2007. The main reason for us to move to the strategy at that point was to reduce the volatility of our funding level.
We selected a couple of investment managers to whom we awarded the LDI mandate and their goal is to generate the same return as the return on our nominal liabilities. In terms of instruments we give them guidance what they might invest in but in general their target is to achieve the return on our liabilities at the lowest risk possible.
Because our matching portfolio should cover the liabilities, ideally we want the portfolio to be managed as passively as possible. But it is difficult, as it is not possible to replicate the benchmark and our return on the liabilities without risk.
Another challenge in managing the portfolio is that the least risky portfolio in terms of tracking error as a measure of risk is not per se the best portfolio when you take into account other risk factors.
But by reducing the volatility in our funding level, the LDI strategy has fulfilled our expectations.
When implementing our LDI approach, we always try to find the best execution strategy, the criteria for which are cost, operational risks and efficiency. However, it is a continuous trade-off between these individual criteria to find out how we can execute the strategy.
We always evaluate the different instruments that might be used to implement the strategy - going forward though this picture may look different than it does today.
Our LDI portfolio consists of substantial amounts of interest rate swaps and the European Market Infrastructure Regulation (EMIR) is set to have an impact on derivatives trading, particularly in regard to central clearing. It is a possibility that with the new legislation, new cost elements will be introduced, which may change the current picture.
Our trading counterparties may pass on the additional costs they will incur as a result of EMIR, which aims to drive all standardised over-the-counter derivatives trades through central clearing.
Reporting requirements are becoming stricter all the time and with the new EMIR requirements coming into force, more detailed reporting on derivatives transactions is likely to follow.
But as far as we are aware now, there is no direct impact from the EMIR legislation on existing derivatives contracts in the portfolio. The question is how it will affect any new contracts.
KBC Pensioenfonds, Belgium, Edwin Meysmans
• Assets under management: €1.3bn
• Members: 15,000
• Separate €1.15 DB and €150m DC scheme
• DB funding level: 110% (Jul 2012)
We started our LDI strategy in the middle of 2007 following the introduction of the International Accounting Standards IAS19. As our sponsor is a quoted company, under the new accounting rules, it had to include all the pension fund’s assets and liabilities on his balance sheet and wanted to reduce costs and volatility.
We tried to hedge the interest rate and inflation risks by implementing an LDI strategy. To do this, we split the portfolio into two parts - a hedging portfolio, which takes care of the liabilities, and a return-seeking portfolio.
We chose not to use bonds as a hedging instrument because we would struggle to find a sufficient number of long-dated bonds that have the same duration as our pension liabilities and struggle to find good issuers of inflation-linked bonds.
Instead we opted for derivatives to hedge our liabilities, such as interest rate swaps, some of which are inflation-linked.
However, the pension fund is not a party to the interest rate swaps. Our investment manager KBC Asset Management has set up a SICAV fund of institutional investors, which undertakes the interest rate swaps on our behalf.
We saw two advantages in the fund set-up. First, we do not need to go through all the legal documentation if we do not do the interest rate swap transactions ourselves, and secondly, we do not need to post or receive collateral, as this is done by the fund we invest in.
It is also the fund that will be impacted by the EMIR regulation. As the idea behind EMIR is to have a central clearing organisation, it is may lead to increased costs, which will have to be paid for by the people using it.
On the other hand comfort and transparency of the market may increase as a result of this legislation, which may in turn lead to reduced costs,
It also depends on the type of derivative agreements in place. As interest rate swap standard derivative contracts with or without inflation linkage are relatively commoditised, we believe the impact on prices will be limited. Therefore I do not see any immediate reason for a shift from swaps to repos.
Derivative contracts managed by IORPs and similar schemes have an exemption from central clearing under EMIR for a number of years, which will give us time to evaluate the whole situation together with our asset manager.
SPK, Sweden, Stefan Ros
• Invested assets: SEK21.2bn (€2.5n)
• Participants: 176 sponsors; 38,600 beneficiaries
• 99% DB, 1% DC
• Funding level: 127% (Jun 2012)
The starting point for our asset management decisions is the pension liabilities and their characteristics. Our overall objective is to have enough assets to cover the liabilities, both in the short and in the long term, in order to minimise pension contribution risk for the employers, and therefore we have always had an LDI approach in place.
In 2006, Sweden introduced marked-to-market valuation of the pension commitments. It is done by calculating the present value of future pension commitments based on current interest rates.
Interest rate risk on the market value of the liabilities is the largest financial risk for SPK and so following the introduction of the new evaluation method, we had to add a short-term feature to our LDI approach.
We developed a well-defined risk management action plan based on the size of the capital buffer, which indicates when our focus should temporarily shift to short-term risk reduction measures.
As with any short-term strategy there are timing risks, which are exacerbated by global market and regulatory volatility. Over the long term, these could lead to smaller pension pots or higher pension costs for the employer.
The duration of our pension liabilities is 26 years, whereas the Swedish fixed income market is illiquid beyond maturities of 10 years. That duration gap is difficult to manage although we have never been underfunded.
To bridge the duration gap, we work out how much of the interest rate risk in the liabilities should be covered by mitigating features such as bonds and swaps. In short, we try to establish a hedge ratio and risk level we are comfortable with. We change it according to the action plan.
As a non-financial that uses derivatives only to protect its assets and liabilities, to our understanding SPK will not be subject to a clearing obligation under the EMIR regulation. Our derivatives transactions are infrequent so from an administrative point of view the regulation should not be a big issue.
However, we are concerned that our counterparties, the investment banks, will transfer costs to us that they will incur as a result of increased capital requirements in relation to doing business with uncleared counterparties. There may be a cost benefit somewhere as a result of EMIR but it is too early to tell how that will play out. If our hedge strategy becomes too expensive we will have to rethink and perhaps look at other strategies.