Perspectives: Rising rates pose questions
The anticipated rise in interest rates urges pension funds to review their liability-management strategies
• Rising interest rates are generally good news for defined benefit (DB) pension funds
• The outlook is uncertain and volatility is to be expected
• Pension funds will tend to maintain or raise their hedging levels
• Allocations to non-traditional matching assets are increasing
Interest rates are finally rising in Europe, after an unprecedented decline that lasted for nearly three decades. In September of 2016 the yield on German 10-year government bonds bottomed out in July 2016, and now stands at around 40bps. European markets are pricing in a rise in policy rates of 41bps over the next two years, according to one estimate by Aviva Investors. In the UK, markets expect rate rises of 48bps over the same period.
This is mostly good news for Europe’s defined benefit pension funds, which held €3.2trn of assets at the end of 2017, according to PensionsEurope, the organisation representing Europe’s national pension fund associations. Rising rates mean the value of liabilities will fall too, driving funding levels upwards, thus reducing the risk that pension funds will not meet benefit payments.
Is this a time to review liability-driven investment (LDI) strategies? A country-by-country snapshot of trends in LDI shows that the shift towards a rising rate environment, although apparently a benign factor, requires thoughtful consideration.
UK: more volatility on the horizon
• DB assets: £1.58trn (€1.78trn)
• Aggregate funding level: 93.8% (Data as of October 2018, source: Pension Protection Fund)
• Discount rate: 2.5% (median discount rate as of end 2017, source: KPMG Pensions Accounting Survey 2018)
Pension funds have benefited from the bull market in risk assets of the past decade. Furthermore, a recent improvement in mortality assumptions has boosted funding levels. However, the country is dealing with a difficult divorce from the EU which could put pressure on its economy and generally determines a ‘risk off’ behaviour from investors. Gilt yields, and in turn DB funding levels, have been extremely volatile since the Brexit referendum. The aggregate funding level of UK DB pension schemes has ranged from a high of about 105% in early 2010 to below 80% in 2011, 2014 and 2016, according to the Pension Protection Fund (PPF), the UK’s lifeboat fund for DB schemes. It fell from 97.7% to 93.6% at the end of October 2018.
In such context, LDI consultants and managers overwhelmingly agree that pension schemes should raise, or at least maintain, their hedging levels. The argument is that even if interest rates rise, there is no incentive to take advantage of higher funding levels by increasing risks on the asset side. Therefore, the path for schemes should be towards fully hedging, whatever their risk tolerance may be.
Simon Bentley, head of LDI client portfolio management at BMO Global Asset Management, says: “With Brexit around the corner, you can see a lot of uncertainty over whether rates travel up or down. From a risk perspective, we would always advocate hedging more rather than less. Also, whether one think rates are going to go up or down is slightly immaterial, because if they are going to be volatile, that will be a good rationale for doing more hedging.”
There are ways pension schemes could benefit from a rising-rate environment, at least to an extent.
Robert Gall, head of market strategy within Insight Investment’s financial solutions group, says pension schemes using asymmetric hedging techniques may benefit from rising rates. “Strategies using swaptions or similar instruments protect pension schemes on the downside, but allow them to participate in the upside when yields rise,” says Gall.
The Netherlands: risk-off behaviour prevails
• DB assets: €1.37bn
• Aggregate funding level: 109% (Data as of September 2018. Source: Dutch Central Bank)
• Discount rate (ultimate forward rate): 2.3% (Data as of October 2018, source: KPMG)
“In the Netherlands, an important driving factor for many interest rate-hedging decisions is regulation,” says Remmert Koekkoek, head of matching and overlay strategies at Robeco. That is not to suggest pension funds have no say in how much risk they hedge. But the regulatory framework, known as FTK, requires pension funds to keep total risk below a certain level. Under the FTK framework, pension funds must value liabilities using a swap curve, something which has naturally led to a significant use of swaps. “The majority of pension funds have hedged partially or fully using swaps and, as such, they will only benefit to a certain extent from interest rate rises,” says Rik Klerkx, head of portfolio and treasury management at Cardano.
“We see different responses from our clients to the prospect of rising interest rates,” says Klerkx. “Those who structurally seek a lower hedge ratio are a minority. Many actually prefer to adopt a dynamic hedging strategy, whereby they will raise hedging when rates rise.”
Pension funds have long been discussing whether it makes sense to hedge further at such low levels, but Koekkoek advises them to look at the carry aspect. “If rates stay at the same level, pension funds with low hedging ratios will see their solvency ratio decline every year. Over time, that can be quite a loss,” he says.
The regulator will offer pension funds with improving solvency levels opportunities to raise risk in the portfolio and lower the hedge ratio, but not all pension funds will take advantage of that. In any event, the general trend will be to reduce risk. Cardano’s Klerkx says: “If rates rise more than expected, and solvency ratios increase, funds should take risk off the table to lock in gains, but that has yet to happen.”
Despite the stringent regulatory environment, LDI strategies have evolved significantly over a relatively short time, says Koekkoek. Pension funds have diversified their portfolios of matching assets by allocating to domestic mortgages, which now can take up as much as 15% of overall assets . “Now the conversation has turned towards diversification from European credit to global credit,” adds Koekkoek.
Germany: shifting out of corporate bonds
• DB assets: €256.5bn
• Aggregate funding level: 67.5%
• Discount rate: 1.96% (data refers to DAX plans, as of Q3 2018. Source: Willis Towers Watson)
German DB pensions funds tend to be underfunded, perhaps more so than in other countries. Tobias Bockholt, senior investment consultant at Willis Towers Watson, points out that the average funding ratio for companies on the DAX index is 67.5%. As such, pension funds stand to benefit significantly from rising rates, according to Bockholt. He explains: “In Germany, pension funds discount liabilities using a benchmark of AA-rated corporate bonds. Their liabilities are long-term, but there aren’t enough long-term corporate bonds to match those liabilities. As a result, pension funds are maturity short. Therefore, as interest rates rise, whatever they lose on the asset side, they more than gain on the liability side.” This is, of course, assuming that interest rates rise smoothly as they have been.
Allocations to corporate bonds are significant but German pension funds are clearly diversifying their portfolios, says Bockholt. A recent study from Willis Towers Watson indicated that, over the past year, both regulated and unregulated pension funds raised their allocation to alternative assets. Regulated funds now allocate 9% to alternative assets while unregulated ones are at 6%. Both categories were allocating 5% as of last year.
“Investors are diversifying into illiquid assets. We see high increases in allocations to real estate, infrastructure debt and private debt strategies, including real estate debt. Pension funds need to reduce their allocation to corporate bonds, as they are no longer being compensated for the risk they take,” says Bockholt.
Switzerland: shackled by pension system
• DB assets: CHF994.5bn (€850.2bn) (Data as of end 2017, source: OECD Pension Markets in Focus)
• Aggregate funding level: 87.2% (includes public pension funds)
• Discount rate: 2% (median) (Data as of end 2017, source: PPCmetrics)
Pension funds in Switzerland are somewhat stuck. Interest rates have fallen dramatically in recent years, but the structure of the pension system gives pension funds little chance to offset the negative impact. Pension fund boards autonomously decide the discount rate for the liabilities relating to existing pensions owed to retirees.
At the same time, they have to guarantee a 1% return on the capital received from active employees.
Stephan Skaanes, partner and member of the executive board of PPCmetrics, the Swiss consultancy, points out that the average discount rate used by Swiss pension funds is about 2%, while the yield on long-term Swiss government bonds is at zero. “If rates start rising, pension funds will most likely suffer losses on the asset side, but they will not make any significant gains on the liability side. Only if rates were to rise above, say, 2%, then the benefits on the liability side would materialise,” says Skaanes.
While technically, from a balance-sheet perspective, pension funds are relatively well-funded, the real funding ratio using market rates as a discount rate would be significantly lower. “This is a huge challenge for the future,” Skaanes says.
Funds are taking tentative steps to address the situation by investing in higher-yielding illiquid assets, Skaanes says. “They are looking at investments like loans, mortgages and other assets. There is also a need to invest globally, as the supply of investment opportunities in Switzerland is limited, particularly when it comes to real estate, which has been a favourite in recent years. However, investing abroad can be costly and operationally complicated, therefore the allocations so far have been small,” he says.