Pragmatic approaches

Fondazione ENPAM
Emilio Giorgi
• Location: Rome
• Assets: €15bn
• Membership: 354.553 (end-2012)
• DB first-pillar scheme for doctors and dentists
• Final salary/career-average

As a defined benefit fund, ENPAM’s investment approach is linked to its future liabilities. We look at our liabilities expressed in nominal value and fluctuating both against a real inflation index and biometric risks.

Simultaneously, our asset structure is weighed against a long-term balance. We move within a framework that is approved both by the board and our regulator, which asks us to monitor our solvency ratio closely. ENPAM’s solvency needs to be guaranteed over a period of 50 years and we are legally bound to keep a reserve valued at five times the amount of pensions paid annually. ENPAM exceeded this requirement in 2013 when it had a legal reserve 12 times pensions paid.

Generally, managing our portfolio consists of a sophisticated asset-liability management exercise driven by risk control. The asset allocation is constructed by weighting different asset buckets against volatility, balancing the different risks within set limits.

Investment selection and implementation are executed via a strict set of procedures. Our guidelines are aimed at minimising drawdown risk.  

Portfolio diversification and liquidity of assets are very important. Even when we invest in real estate or other alternatives we will prefer the most liquid assets. Liquidity allows us to quickly react to market downside, together with a mix of alpha and beta strategies. We prefer to keep risk levels under control by being able to modify the tactical asset allocation with ease.

We are wary of using hedging instruments that we consider inappropriate or inadequate. When it comes to derivatives, for example, we feel that the markets abused these instruments, Investors are often misled about their real nature and function. I would use them only when appropriate. In terms of leverage, we tend to be very pragmatic, providing our external managers with clear guidelines. 

Our knowledge of these so-called ‘sophisticated products’ leads us to rely on a structure that is highly diversified but made up with simple, linear instruments. We do not disapprove of complex portfolio management strategies – rather, our intent is to be conservative and rely on linear instruments in carrying out our liabilities-driven strategy. This  should be seen as an attempt to be as forward-looking as possible. The level of sophistication of an investment strategy is not necessarily linked to the complexity of the underlying instruments.

Jannik Hjelmsted Nielsen
Senior portfolio manager
• Location: Hellerup
• Assets: DKK195bn (€26.1bn)
• Membership: 260,000
• Administrator for five, soon to be merged into three, healthcare sector pension funds

PKA currently administers five industry-wide funds. All the current funds have almost identical hedge ratios and while there may be small differences in asset allocation, they are identical from a high-level perspective. 

All our liabilities are valued on a mark-to-market basis according to the new Solvency II discount rate, based on the ultimate forward rate, employed by the Danish financial regulator.

We have two stages to our liability hedging process. The first is a strategic decision to hedge our liabilities. We employ a benchmark consisting six EONIA swaps, primarily 30-year EONIA swaps, and the purpose of that liability benchmark is to completely match the duration of our liabilities. The next step is the investment and actual implementation of the liability strategy. 

The liability portfolio consists of bonds, swaptions and interest rate swaps. We view it as an overlay to the investment portfolio and it is managed based on the limits set by the board, which is fairly flexible. 

If we believe that rates will rise, we can decide to be underhedged. The underhedge will have a risk charge, which means a proportion of the pension funds’ risk budget will be used to ‘risk-finance’ the position. Our positioning within the hedge portfolio is therefore not only a view on rates, but expected returns on being short rates versus other assets.

The funds have been hedging since 2001 and are very robust. We today have the luxury of being well-funded and have the ability to stomach a lot of mark-to-market volatility. 

PKA primarily uses swaps for hedging, and we have seen that in certain periods it has become more difficult and expensive to trade these. We are currently back to a more normal trading environment, so it is no longer as expensive for us to trade and it is possible to trade in larger clips. 

Once we are forced to centrally clear through a counterparty, it will introduce another layer of costs – among others, client broker fees and costs associated with initial margin. However, we have observed that with other standardised instruments, such as rate futures, when clearing is introduced spread-costs fall. We hope for this positive impact, because many other aspects point to higher costs in future.  

Rates might fall further in the short term, before we see a rise, but I think we’ve seen the worst. Many potential problems are already priced into the current rate level– for example, the possibility of quantitative easing in Europe. 

Pension Protection Fund (PPF)
Opkar Sara
Principal fund manager, asset allocation and investment strategy
• Location: Croydon
• Assets: £15bn (17.5bn) 
• Members eligible for PPF benefits: 172,000
• Fund of last resort for DB schemes in the private sector

Our liability-driven investment (LDI) strategy is, in simple terms, making sure the assets’ interest rate sensitivity is equal to the liability interest rate sensitivity. The difficulty herein arises from a whole raft of practical issues you have in implementing that strategy, especially when, as is the case with the PPF, the liabilities are a moving target. Such a target can help in certain circumstances, but it can also make life more difficult.

When I first joined the PPF, we used physical index-linked Gilts, swaps and regular Gilts to hedge – and that was it. Since 2010, we have introduced the ability to use Gilt repos and Gilt total return swaps (TRS). Some may wonder why this is important, but the PPF has a discount rate basis that is the higher of either Gilts or swaps minus 15 basis points and the approach allows us to increase our Gilt exposure. When you are looking at the yield curve, if Gilts are higher than swaps minus 15 basis points, the hedging tool of choice should be Gilts.

Since the crisis in 2008, there has actually been quite a difference between the way that those two rates move and, as a result, it has been beneficial for us to use Gilt repo to try and hedge out our liability. It effectively reduces the basis risk and the risk on the asset relative to the liability, and that reduction in risk is obviously beneficial to the PPF as a whole. It is critical for our investment strategy to reduce risk relative to the liabilities as much as possible.

An unintended consequence of the increased regulation of the derivatives sector is an increase in the cost of our hedging programme. The Gilt repos are less impacted, and the assets affected are mostly ones that fall under ISDA’s purview – the swaps and TRS – these are impacted by clearing rules. We are looking for new ways to reduce that cost and decrease our reliance on them over the long term.

One idea that we have considered, but have yet to implement, is the use of illiquid assets such as infrastructure and loans, with stable cashflows being used as a hedge in place of interest rate swaps. 

As we are forecast to continue growing, I do not think we can do away with the derivatives programme but we can diversify our hedging instruments of choice. 

However, we also recognise that the increasing costs do also have benefits, and those are to lower the counterparty risk associated with trading swaps.

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