Handling the mismatches
Matching of assets to liabilities should be the pension fund’s prime concern. For deferred liabilities and pensioners the matching asset class is evidently bonds, but few schemes own bonds with a maturity profile that matches the probable outflows of cash. At the long end there are few bonds available in sufficient size to fulfil pension funds’ requirements. Also the payment schedule of longer maturity bonds does not match the payment profile of liabilities, which peaks and then tails off over time. Hence the average duration of bond portfolios is well below the average duration of liabilities.
This is a major and understated source of risk that has for many years been masked by the negative correlation of bond yields to equity markets. Improving equity assets have historically compensated for falling yields, which increase the value of liabilities. The market since 2000 has disproved this hypothesis, leaving funds exposed and requiring cash injections from plan sponsors.
To give an idea of the scale of the problem, consider the approximately £800bn (E1,200bn) invested by UK pension funds. Assuming an average duration of liabilities of 15 years, an interest rates fall of 1% increases the value of the total liability of UK schemes by some £120bn. If the average bond holding is 25%, and average duration six years, UK pension scheme assets will only rise £10-15bn in value, a differential of over £100bn overall. Morgan Stanley has estimated this risk as analogous to an additional 30% exposure to equities.
Interest rate swaps offer a flexible and liquid method of lengthening the duration of the bond portfolio, according to executive director in Morgan Stanley’s European pensions group, Gareth Derbyshire. Comments Derbyshire: “A pension fund could increase its average duration by buying very long duration swaps. This addresses the overall duration mismatch, but would leave the fund exposed to changes in the shape of the yield curve especially at the very long and short ends. This approach has the benefit of simplicity; that aside, going one stage further and trying to match out the cash flows is no more expensive.”
Hugh Cutler, strategic account director at Barclays Global Investors concurs, saying: “The swap market is sufficiently flexible that there is little advantage to standardised products. The specific cash flows over the next 30 years can be hedged at no additional cost.” According to Cutler, BGI is already transacting several billions of euros worth of swaps for European clients, and Cutler anticipates this rising into tens of billions by the end of 2005. Cutler sees this as part of a trend by funds not to want to take risks for which they are not being compensated. Says Cutler: “The decision to hold shorter-dated government bonds than the liability schedule, just because that is what the benchmark index contains, is not the same as deciding to invest in equities, where the risk is anticipated to generate excess return.”
The strict cash flow matching approach is of particular appeal to mature schemes, with pensioners and deferred 70-80% of liabilities. Comments Derbyshire: “These types of schemes are typically more risk averse, as any mismatch is more likely to lead to a deficit that may be large relative to the size of the sponsoring company.”
Derbyshire continues: “In the mid range, say 50% split of actives to deferred and pensioners, broad duration matching is worthwhile. Less mature schemes will have less confidence in the liability schedule and so have less to gain from precise duration hedging. Besides they often have large equity exposures, implying a higher risk tolerance.”
Consultants Watson Wyatt advises both duration and inflation hedging for schemes with high bonds weightings, usually over 50%. For pensioners and deferred the cash flows are known and the inflation exposure readily calculated. Nick Horsfall, consulting actuary, explains: “Mortality and inflation are the key drivers of the cash paid to those in payment or deferred, and not hedging inflation is taking unrewarded risk.”
Hedging the active side of the pension fund against inflation was always supposed to be the role of equities, but disappointing performance and high volatility has undermined perceptions of its fitness for the job. However, the real exposure here is to wage price inflation, not the CPI, to which wage inflation is 0.8 correlated, and because the eventual pension payment is unknown, there is additional uncertainty in the cash flows. To hedge inflation in the active part, a probability needs to be attached to each payment, expressed in real terms, to gauge the precise amount of swap to transact. However, materiality needs to be considered, before engaging in such an exercise, as Horsfall asserts: “Inflation for the active part of the liabilities is just one of the many uncertainties of these payments.”
Changing the basis on which liabilities are valued can also create a need for duration modification. The fund may still own the matching asset under the old system, and so have a mismatch with the new. In 2001, Denmark announced a change in the discount rate for liabilities, from a fixed rate to one based on long bond yields. This was enacted in 2003 (optional in 2002). The small size of the Danish bond market meant that mainly transacting euro market swaps, and hedging back into Danish kroner was the best way to lengthen portfolio duration.
The PVK, the regulator for pensions and insurance in the Netherlands, is formulating a framework based on yield curve rather than a fixed rate liability valuation, to be enacted in 2006. Once the new formula is announced, funds will have to restructure ready for computation under the new approach, whilst still having to demonstrate solvency under the old system. Whereas in the past the E400bn of Dutch pension liabilities were immune to interest rate changes, now a fall in euro rates of 1% would create a funding gap of approximately E50bn. A derivative that can address this problem is called a swaption. Funds that continue to hold short duration assets could buy a receiver swaption to have the option to receive the returns on long-dated assets. Dutch pension funds are known to be actively investigating derivatives to deal with the possible consequences. Banks are able to offer these products, firstly, because the swap market can be a far greater size than the underlying cash market, and secondly, because they have access to forms of interest rate and inflation exposure that pension funds are not allowed to, nor would they want to buy and manage directly. Interest rate swap prices are made in upwards of £1bn, although the index-linked swap market is somewhat smaller, at $25-50m for a typical transaction. Banks will build up positions in inflation exposure by transacting with companies who already have inflation exposure, such as PFI projects and utilities, in order to fulfil customer demand in larger size.
Only the internally managed pension funds, where there is a closer link with the corporate treasury department, would transact swaps directly. Most externally managed funds would delegate this responsibility to a fixed income manager, usually one who already manages some or all of the bond exposure. Says Cutler: “If BGI has control over the bond portfolio, it can bring the portfolio cash flow and inflation exposures into line with the liabilities by the use of swaps, and any mismatch would be an explicit yield curve play. If the swap portfolio is being run as an overlay, BGI will transact swaps to bring the benchmark of the external manager into line with the liability schedule.”
Given that interest rates appear to be on the rise, tactically this may not be the best time to engage in duration hedging. Some might suggest that the UK and European yields at the long end are currently unnaturally low. Derbyshire reiterates: “ A yield of 4.8% at the long end might seem low by historical comparisons but we are now in a low inflation environment. Real yields are under 2% and either real yields or inflation need to rise for absolute yields to go up. If either real yields or inflation fell, the funding position would worsen further.”