Iain Morse looks at how two pension funds, Henkel and PME, are addressing risk in management of liabilities
In 2005, the German industrial company Henkel raised €1.3bn to finance its book reserve pension liability. "We issued a hybrid bond to fund the current scheme," recalls Andre Hagen, head of treasury control and pension fund management at Henkel. "The timing was right and the hybrid structure improved our overall funding ratios." The money raised was paid to Henkel's contractual trust arrangement (CTA), which has overall control of the scheme's current €1.65bn in assets.
Goldman Sachs Asset Management (GSAM), acting as fiduciary consultants to Henkel, completed an asset liability study in 2006. "We went into this process knowing that we could not eliminate all risk from the scheme, but with very clear ideas about how much risk we would accept on a forward basis," continues Hagen.
At present, 54% of Henkel's CTA assets are invested in liability-driven investments, comprising high grade corporate bonds, cash collateral and interest rate swaps. The duration of this portfolio is 15 years, close to the average duration of scheme liabilities. The goal of this portfolio is to reduce interest rate risk, and only a very small risk budget has been allocated to this half of the overall portfolio. Accordingly, the strategy for managing bonds, cash and swaps is passive, or buy and hold.
The remaining 46% of the portfolio is invested in the return seeking side of the portfolio. At present, this is 32.5% in US equities, 27% in Europe (including the UK), Asia-Pacific 8.5%, emerging market equities 10%, emerging debt 6% hedge strategies 10% and the balance held as collateral. This side of the portfolio is actively managed and re-balanced at each month end against a weighted benchmark derived from the MSCI World index.
"The first target of our strategy is to reduce the interest rate risk to company equity values," continues Hagen. If interest rates fluctuate over time this has an effect on the cost of liabilities under IRS accounting standards. "Falling interest rates will lead to an increased volume of liabilities. If nothing else happens then the amount of equity in the company will decrease." A second target is to get higher returns from the overall portfolio than the cost of financing this portfolio via the 2005 bond issue. "We used this to fund 90% of liabilities with the hope that we can close the 10% funding gap over time through excess portfolio returns," adds Hagen.
Henkel is not currently trying to hedge inflation risks. There are two important reasons for this, says Hagen. Firstly, there is an inadequate supply of liquid swaps to hedge German inflation. "This is a key point. German and euro-zone price inflation are not the same thing and most of our pensioners live here in Germany." The lack of German inflation rate swaps means that if Henkel used euro-zone inflation swaps they would open a new source of risk on the matching side of the portfolio. "You can say German and euro-zone inflation are related but still not identical," he adds.
A deeper concern lies in the choice of the measure of price inflation used for hedging. "The definition of retail price inflation is essentially a political decision. It does not necessarily equal the actual price inflation faced by our pensioners," says Hagen. As a consequence, any pension scheme using retail price indices as a benchmark is accepting political risk in its risk budget and asset allocation. "This could be very dangerous. What if the definition is changed at some future time?" asks Hagen.
Henkel has directly implemented its swap programme with the ongoing services of GSAM. "We manage our agreements with the banks we use, we retain control of the collateral and we manage the resulting cash flows," explains Hagen.
Henkel's swap programme uses so-called ‘receiver swaps'. These have two legs; the purchaser receives a rate fixed at the time or purchase, paying a variable rate based on Euribor 3-6 month rates. "We should be able to meet this fluctuating cost from our cash collateral which is held in short-term instruments," adds Hagen, pointing out that the net result is that the receiver swaps are cost neutral.
Unlike many swap programmes, Henkel's is not leveraged. "We think we have found a good solution for the company balance sheet and the pension scheme," concludes Hagen. "Use of interest rate swaps has been crucial to this."
PME: conservative approach
Approximately 75% of the PME Dutch metal and electrical industry fund's interest rate risk is hedged, according to Roland Van den Brink, CIO at Mn Services. Since May 2007, Mn Services has played the role of fiduciary manager for PME's asset portfolio after PME took a stake in the firm, which is owned by its sister metal pension fund PMT. Mn Services also manages assets for other major Dutch pension schemes including PMT.
The PME scheme is large with assets under management of approximately €22bn. However, the scheme's current asset allocation is fairly conservative. Some 32% of assets are in equities, against 36% in investment grade fixed interest securities, and 13% in high-yield fixed interest securities. A further 8% is invested in commodities and 7% in directly held real estate, with 4% in cash.
"Interest rate hedging starts with the overall construction of an investment portfolio," says Van den Brink. And this cannot be seen in isolation from other sources of risk. "Many schemes are running as much or more currency risk as they are interest rate risk," he adds. Because of the overall asset allocation in the PME portfolio, only around 30% of the portfolio, €6bn, needs to be hedged. The objective of hedging needs to be clearly established before it is undertaken. "Do you want to try to eliminate or diversify this risk within the portfolio?" asks Van den Brink. "But our approach is to view interest rate risk among a basket of other risks and try to adjust this basket to a more optimal portfolio for the funding position of the scheme," he adds.
PME has reached an agreement with its labour unions that will give a relatively stable framework for portfolio management until 2010. Salaries have been fixed over this period. PME's strategic plan is to be sufficiently well funded by 2010 to give some payments to early retirees over the following decade, and the scheme's funding ratio is currently in excess of 128%. Over the past 10 years the scheme has achieved returns of 8.3% per annum, but despite this the funding ratio remains lower than the board would like.
From last year the scheme's liabilities were valued at their market value, according to the FTK funding regime. One immediate effect of this was to increase interest rate risk in the portfolio. Consequently, the scheme's portfolio risk is now measured by the degree of investment risk the funding ratio can bear. PME's new policy framework specifies the degree of investment risk that is acceptable within this ratio. Risk is dealt with not only by spreading scheme capital over asset classes but also taking account of risks arising from interest rates, currency exposure, tactical asset allocation, and exposure to active manager styles.
"Given that this is the goal, the question arises as to what is the best route to achieve it," says Van den Brink. In 2004, PME identified interest rate risk as the major risk it faced. It had already received the maximum permitted premium and could not ask for a further increase. Other funds might have had the leeway to ask for higher contributions, but given this constraint, the fund had no obligation to look at reducing its interest rate risk. By the end of the year PME decided to implement a programme of swaps to hedge this risk.
At that time the availability of pooled funds hedging this risk was limited and PME chose to deal directly with an investment bank. Given PME's size it held some strong cards in negotiation with the bank and was able to reach an exclusive agreement; the bank does not manage swaps for any other pension fund.
The programme is managed on a weekly basis, with PME/Mn Services providing collateral to the bank on a direct basis. Forward duration on the swap programme is 30 years. "This is the furthest out we can go. Our research says that 40-year swaps are priced against the 30-year ones, so there is little point in buying them," says Van den Brink.
Van den Brink does not rule out the use of bucket funds but considers it unlikely. "We have the scale and expertise to deal with governance issues. Smaller schemes may not, and they might be better to go to a fund manager," he concludes.