Going for the middle ground
For years, a typical allocation of 70% equities and 30% fixed income delivered double-digit equity returns. However, the fall in equity returns seen over the last five years has pushed many pension funds into deficit.
Pension funds can continue allocating 70% to equities and hope that they recover sufficiently to bridge the deficit. Or, they can disband the traditional allocation to equities and start structuring their assets to behave like the liabilities.
The assumption that equity markets will return to generating returns like the ‘good old days’ is unlikely, and in some respects immaterial to asset liability matching (ALM), as equity returns bear little correlation to liability profiles. However, the alternative may also have repercussions, as drawing a line in the sand may force sponsor companies to increase contributions in future years to ensure beneficiaries receive their expected pension. So, both options have implications for plan sponsors’ balance sheets.
However, for most pension funds and indeed the plan sponsor, it is managing and reducing balance sheet volatility that is key and ALM is a way to achieve this.
The intention behind accounting standards FRS17 and IAS19 is for pension fund liabilities to be treated like any other corporate liability on the balance sheet. Consequently, closer attention needs to be given to managing this risk. The 70:30 equities:fixed income mantra of the 1980s and 1990s makes even less sense when a closer look is taken at real pension fund liabilities.
A failure to properly hedge that risk, whether by cash flow matching or duration hedging, might lead to increased volatility on the plan sponsor’s balance sheet, which in turn may lead to lower than expected payouts for beneficiaries.
These issues have brought ALM back to the forefront as an optimal strategy for pension funds. I say back for a reason; ALM has been kicking around in insurance companies for decades. However, the concept has only recently been applied to pension funds, although essentially it has just been repackaged as a new concept.
One question pension funds should be asking themselves is whether repackaged old concepts should warrant premium fees.
This makes you ponder the motivation behind the provision of ALM solutions. Clearly ALM makes sense for pension funds, as it enables the hedging away of liability risk or duration risk. However, while pension funds gain by reducing the mismatch between assets and liabilities, attention should not be drawn away from the increased level of governance required to monitor such a structure.
Investment banks are also keen for pension funds to adopt interest rate swaps (IRS) as part of ALM solutions because increasing volumes is lucrative for the market maker. In addition, when cash collateral is pledged against IRS, similar to a margin payment on a futures contract, the interest rate received is in the region 25 bps below LIBOR. This cash collateral is subsequently invested at a rate closer to LIBOR and the difference booked as profit for the bank.
Although bid-offer spreads - the difference between the purchase and sale price - on IRS have eased, they are still on the expensive side when compared with their physical counterparts. The expense is tolerable within a buy-and-hold strategy but regular rebalancing will see this expense rise to a more uncomfortable level. Given that investment banks generate profits via volume of transactions, it should not be surprising that they might advocate regular rebalancing. The concern for pension funds is deciding on the lesser of two evils: rebalancing costs versus a mismatch between assets and liabilities.
Many investment managers have welcomed the repackaged ALM concept and invested heavily into the development of ALM solutions. Whether this investment can be recouped via higher fees is another matter. The high-fee protectionist approach has led to complex and arcane solutions involving portable alpha (adding outperformance blocks together) and removing beta (market risk) and tactical asset allocation. The key to success lies in getting basics right and following the founding principal of ALM, which is to match your liabilities. Once the basics have been mastered pension funds are in a stronger position to include higher alpha strategies as part of their overall strategy.
But does the solution need to be so complicated and expensive? There is a middle ground. The neutralisation of liability risk via IRS is straightforward enough to implement and so is the investment of cash to meet the floating leg obligation of the IRS.
IRS are essentially the exchange of fixed for floating interest rate payments. Under this arrangement a pension fund would receive a fixed interest payment to neutralise its cash outflow liability in return for making a floating interest payment. The floating interest payment is typically a money market rate, such as three-month LIBOR. Simplistically, a pension fund could therefore match its liabilities using IRS if its assets produced a return of three-month LIBOR.
The type of investment strategy linked with a three- or six-month LIBOR benchmark is an enhanced-cash strategy. It should be stressed that there are significant advantages to using an enhanced-cash strategy as part of an ALM solution:
q It is cost efficient;
q It is easier to understand;
q It requires less governance;
q It has a lower risk profile, and may result in less volatility on a plan sponsor’s balance sheet.
The temptation lies within solutions offering excess returns over
and above the liability match – for example, liabilities plus 2-3% where a multitude of high-risk, high-alpha strategies are adopted, most of which are generally uncorrelated with the liabilities. Pension funds should weigh up whether they are aiming to match or reduce the mismatch between their assets and liabilities, whether they are aiming to generate excess returns via absolute strategies, or whether they are aiming to achieve a combination of both approaches.
Excess returns are hard to achieve and, in an environment where growth and inflation are low and where equities and bonds are providing single-digit returns, expectations need to be
Pension funds should remember that the risk/reward payoff is much higher for ensuring that liabilities are matched than it is for picking the wrong strategies for generating excess returns. And trustees will probably sleep better at night too.
Many paths can be taken to arrive at ALM solutions and investment managers have a duty and responsibility to simplify the journey. This is a people business and these are real peoples’ pensions on the line. If meeting liabilities really is of paramount importance then one should remove liability risk and adopt a risk-adverse policy. One cannot deny that some asset classes, such as hedge funds, private equity and currency are attractive and may provide strong returns, but it is crucial that investment managers do not lose sight of ALM basics or they could be seen to be gambling on the future
economic wellbeing of millions of pensioners.
David Rothon is director fixed income product management at Northern Trust GI (Europe)