The pension fund of Boots, a UK pharmaceuticals retailer, put liabilities management on the map when it moved its entire portfolio into fixed income securities in 2001.
The aim was to achieve closer match between assets and liabilities, thereby removing risk from the sponsoring company’s balance sheet.
Few UK pension funds have taken as bold a step as Boots in the management of their liabilities. Yet a number of developments have forced an increasing number of pension funds, in the UK and elsewhere in Europe, to look at their liabilities more closely.
Among these developments is the odd behaviour of the equities market, with equity prices falling in tandem with interest rates. Normally, equity prices tend to rise when interest rates fall. This uncharacteristic market behaviour has affected pension funds’ net asset liability positions – that is, the extent to which their assets cover their liabilities.
Meanwhile, international accounting standards such as IAS19, and national solvency regulations such as the new FTK in the Netherlands, have encouraged pension schemes to reduce the volatility of both their assets and liabilities.
Finally, mortality rates have fallen and longevity has increased, putting additional pressure on pension funds’ liabilities.
All these developments have drawn attention to the mismatch that exists in many pension funds between their liabilities - what they have to pay out in pensions payments - and their assets, and what they have to pay these with.
Bernd Scherer, the head of Deutsche Asset Management’s solutions and overlay management group in Frankfurt, drew attention to this mismatch in his paper for the European Asset Management Association ‘Re-thinking asset management: Consequences from the Pension Crisis’.
Scherer argued that the crux of the pension crisis was not that the value of pension fund assets had fallen but the fact that these assets often bore little relationship to liabilities.
He blamed consultants who took “a too actuarial view” of long-term asset management, and he predicted that pension funds would switch many of their assets from equities to fixed income: “In future consultants will need to take more care to establish the relative riskiness versus the long run liabilities for a given asset mix, rather than focusing on asset-only solutions. As a direct consequence we will see a permanent reduction in equities by institutional investors in exchange for fixed income investments.”
Scherer also blamed asset managers, who, he said, had managed pension fund assets against the wrong benchmarks. “What are needed are liability benchmarks and not broad-based market benchmarks. It is not good enough to invest against a broad market fixed income index when client’s liabilities show interest rate exposure equivalent to 25 years’ duration or more.”
The poor match between pension assets and liabilities, combined with the new demands of accountancy bodies and pensions regulators to mark assets and liabilities to market, has created volatility on company balance sheets.

The current interest in liabilities management is driven by the need to reduce this volatility, says Paul Bourdon, director investor solutions at Threadneedle Investments in London: “Any movement in the net asset/liability position of a company pension scheme on the company’s balance sheet introduces quite a lot of volatility.”
Equities have something between 15-20% volatility as an asset class so a company is likely to see some very big movements in assets if they’re invested heavily in equities.
“The volatility of liabilities and assets is now an issue and the pension funds and insurance companies have to look to reduce that volatility.”
In an effort to match their assets to their liabilities more closely, pension funds are beginning to move away from traditional benchmarks, says Bourdon. “In the past they may have included equity indices in the benchmark, but there isn’t a great deal of matching between an equity index and a pension fund’s liability profile. If they want to reduce volatility they have to look more closely at how their assets match their liabilities profile.”
The priority is to hedge the two risks within the liability stream: interest rate risk and inflation risk. Traditionally, pension funds have used government bonds to hedge against interest rate risk. However, Bourdon says that government bonds available to pension funds may not be sufficiently long-dated to provide the necessary duration.
There is a similar problem using index-linked gilts to hedge inflation risk, although the UK’s Debt Management Office’s first ever 50-year inflation linked bond, was launched in September specifically to remedy this.
An alternative to government bonds is credit bonds, which provide pension funds with a larger universe and better returns. Yet the problem with using either credits or government bonds to match pension fund liabilities is that it ties up assets, which could be working more effectively elsewhere, says Bourdon. “Both government bonds and credit bonds are using up some of a pension fund’s asset pool. You’re hedging interest rates and inflation but at the same time you’re producing a return, which equates to the government yield or the yield on the credit bonds.”
Derivatives offer a better solution. “Using derivatives, like a swap, a pension fund is able to separate out the hedging of interest risk or inflation risk from how it wants to invest its assets.
“The swap exchanges the interest rate risk for a floating risk. When the pension fund has done the swap it needs to invest the assets in a way, which matches the floating liability. How it does this will depend the amount of risk it is prepared to take. But the investment decision is separated from the hedging decision.”
Derivatives provide the duration match pension funds want, he says “If a pension fund has a 30-year liability in interest rate risk, it can match that exactly with a zero coupon swap. The duration of a 30-year zero coupon swap is 30 years.”
Liquidity is also not a problem, he adds, since swaps are still relatively liquid beyond 30, 40 or even to 50 years.
Using derivatives to hedge interest rate risk opens the way to absolute returns, says Bourdon. “Once you’ve used derivatives to hedge interest rate or inflation risk then you’ve ended up with what is in effect a floating liability. This is one of the reasons why we’re hearing so much about absolute return funds. An absolute return fund is trying to beat LIBOR by a margin. The margin is the alpha generated by the fund manager. So the best asset to match a floating liability is an asset targeting cash plus returns.”
A pension fund has to decide how much of its liabilities it wants to hedge. How much will depend on the scheme’s funding position, the size of the scheme relative to the corporate balance sheet, the ability of the company to pay increased contributions, among other factors. In other word , its appetite for risk to achieve full funding.

A pension fund’s appetite for risk can be plotted against a simple
liability curve, Bourdon suggests. The scheme’s risk increases the further away in time the liabilities are due. Assuming the scheme hedges liabilities with swaps, the assets for early year liabilities - the number of years depends on the scheme’s risk appetite - should be invested in money funds yielding cash plus 15 to 25 basis points. Assets for the the next 15 to 20 years’ liabilities - again dependent on risk budget - might look to increase risk and invest in absolute return funds targeting cash plis 1 to 3% . For long liabilities, funds would invest assets in equity type investments.”
However, investing in equities would mean volatility levels of 15 to 20% – precisely what pension funds wish to avoid. The answer, says Bourdon, is to invest in a broader range of assets, which would include alternative investments such as hedge funds, commodities and private equity, as well as traditional assets: “Hedge funds and commodities generally have a low correlation with equities. Regulators are asking pension funds to maintain long-term returns but reduce the volatility around those returns. By using a range of uncorrelated assets, pension funds can produce an equity type return over the long term but reduce the volatility of the overall portfolio by half.”
One way to produce equity-type returns with low volatility is to use portable alpha. Portable alpha was developed to provide the consistent outperformance that traditional asset managers have failed to provide.
Essentially it involves separating alpha from beta - that is, excess returns from market return - and transferring the excess return to a chosen benchmark.
Portable alpha can be used as part of an enhanced liability driven investment strategy, says John Wilkinson, senior manager at Man Investments.
‘It is a simple structure. You create a portable alpha fund, which the investor buys into. This fund then enters into swap agreements with investment banks to get the index exposure, whatever that index may be. That frees cash to be invested into a fund of hedge funds. It is the objective of this fund to outperform the cost of the swap.”

Man uses a conservative fund of hedge funds for the purpose, with a bias towards market neutral strategies and away from directional strategies. “We’re looking for a conservative mix which is consistently outperforming LIBOR on a short term basis, because inherent in the structure is the return hurdle of LIBOR plus the spread – what the fund has to pay a bank to obtain that market or beta exposure.”
The size of the spread will depend on the benchmark, says Wilkinson. “The return hurdle of the fund of hedge funds is the cost of the swap contract with the bank and this is very much index or benchmark specific. So if you specify a benchmark like the FTSE 100, S&P 500 or Eurostoxx 50, it’s relatively easy for the bank to hedge out those particular exposures because futures contracts are available on those indices.
“But if an investor picks some of the more exotic, highly diversified benchmarks it is going to be that much more difficult for the bank to hedge out the risk. Hence the higher spread.
“So we would encourage investors to implement this kind of strategy in the more liquid, efficient markets, which almost by definition you can have derivatives contracts on.”
Credit risk could pose problems, because as soon as the fund enters into a swap agreement with the bank, there is inherent credit risk between the two counterparties. If the value of the specified index were to rise, the bank would owe the fund money. If the value were to fall, the fund would owe the bank money.
The solution is to fully collateralise the contract with gilts UK government_securities, says Wilkinson. “As soon as the contract is ‘in the money’, in other words the bank owes the fund money because the value of the underlying index has risen, the bank transfers gilts to the fund’s custodian, removing the credit risk.”
Man has now extended its portable alpha concept to liability driven investments. The objective here is to reduce one ofthe biggest risk pension funds currently face - possible changes in real interest rates.
“Pension funds liabilities are calculated by compounding up with inflation expectations, and discounting using a long-term fixed interest rate. This means that liabilities are highly sensitive to changes in real interest rates,” says Wilkinson.
National and international accounting standards, in particular the requirement to mark to market pension funds’ assets and liabilities, have greatly increased this sensitivity. “Movements in real interest rates are the major risk for pension funds at the moment because they have relatively short time horizons with FRS17 accounting methods. They have liabilities, which are very sensitive to changes in long-term interest rates and long-term inflation expectations. And they have assets, which are still heavily invested in equities.
“If real interest rates were to compress dramatically, the value of the liabilities would rise quite dramatically as well. If real interest rates were to compress by 1% in a 20-year duration structure it would mean a 20% gain in the value of the liabilities.”
Man’s liability-driven investment product uses the same concept as the portable alpha product, but instead of the fund entering into swaps on the leading UK and US indices, it enters into swaps on interest rates and inflation.
It is important to use swaps to strip out both kinds of risk, Wilkinson says “Inflation swaps protect the investor against inflation but not against falling real interest rates, while interest rate swaps give you exposure to a fixed long-term interest rate but don’t protect you against inflation.”
Two types of swap – interest rate and inflation – are used. Inflation swaps are traded at fixed interest rates. So, for a 20-year inflation swap fixed at 3% a fund would receive the UK Retail Price Index (RPI) over 20 years. In an interest rate swap, the fund pays LIBOR and agrees to receive the rate fixed at that time, for example, 4.5%.
When the two swaps are combined, the fund is paying LIBOR and receiving RPI plus 1.5% for the next 20 years.
This combination is achieved with a zero coupon bullet structure, says Wilkinson. “This means we have a pre-determined notional amount today and we agree to pay the bank LIBOR compounded up for the next 20 years. In exchange we’ll receive RPI, whatever that is, plus a real yield of 1.5% compounded up for the next 20 years.
“At the end of the 20th year we just net off, and exchange the difference in the cash flows. With these two swaps it means the funds is locking in a real yield of 1.5% and it is hedged against RPI for this entire period, because that is what the bank has committed to pay.”

The value of the two will, of course, move in line with interest rates. But as long as the fund is investing in a product, which is achieving a return of LIBOR, then it will receive inflation, plus that real yield.
In a portable alpha structure, as long as the fund of hedge fund portfolio outperforms the cost of the swaps (typically a small spread over LIBOR) the investor receives the return determined by the swap contracts plus the value added of the hedge fund portfolio. This excess return can also help cushion the pension fund against any unforeseen risks, such as increasing longevity.
“So we have what is, in effect, a zero coupon inflation-linked security, protecting the investor against compressions in real yields. And that is what has been driving up the values of the liabilities over the last 12 to 36 months.”
This solution has been developed
for the UK market, but could be rolled out into the rest of Europe, says Wilkinson. The key issue is the derivative instruments that may or may not be available.
“When you move from country to country you need to understand how the liabilities are valued and what’s driving the change in the value of those liabilities. You then have to assess whether you can gain that sort of exposure via derivatives at a competitive price from the investments banks. Because if there’s a particular measure of inflation in the country that’s driving the value of the liabilities but you can’t enter into that exposure via a swap with the bank, then this sort of structure just cannot be implemented.”

Other structures may be necessary. Andrew Dyson, head of institutional business at Merrill Lynch Investment Managers in Europe believes that asset managers must design their liabilities management solutions to order.
“We don’t think it’s just a question of saying here’s the answer and trying to squeeze everybody into that. We think it’s much more about listening to what the client needs and designing the right solution.
“Certainly some of the building blocks are consistent from country to country. Applying a swap is one of the building blocks. But there is a need to design the right solution as well, and that will vary from client to client.
What the management of pension fund liabilities across Europe does share is a number of common principles; he suggests. “They are all trending towards this situation where the liabilities are being viewed as bond-like in nature, and as the price of bonds changes the value of the liabilities changes.”
However, Dyson does not see a common liabilities management product emerging. Instead he detects three broad strands of development. The first is pure bond mandates. The second is target return mandates. “This is multi-asset, and much more absolute return in nature. It incorporates a lot of liabilities driven principles into a bundled approach, and in some cases it can be combined with a swap.” he says.
The third strand is unconstrained equity mandates. “This is where people are completely re-thinking equity mandates and moving them away from indices, and there are very good liability reasons why you would do that.
Demand is greatest for target return products, he notes. This fits in with what consultants have noted in the growing popularity of liabilities management. Looking at the cash flows of a pension fund though time, they see bonds as the natural choice for shorter-term investment and equities as the preferred choice in the very long term, offering a hedge against inflation and capturing the equity risk premium.
But in the space in between there is room for liability-driven investment, and that space is filling up rapidly.