The investment landscape has changed dramatically over the past few years, forcing pension schemes to look at their long-term investment strategies in a different light. What may be surprising, however, is that performance does not have to play the sacrificial lamb in this changing environment. Fixed-income mandates and liability-matching solutions (LDS) are fulfilling crucial roles in performance and risk management.
Pension schemes are moving away from the “one size fits all” approach to benchmarking and asset allocation, where only two asset classes (equities and government bonds) were used to achieve a target return, relative to a market index. Portfolios were not designed to match a scheme’s liabilities or guard against the biggest danger – falling interest rates. An adverse change in rates could equity investments. New accounting rules are making the volatility associated with this strategy unpalatable.
Investment philosophy has since progressed and today’s mandates are being tailored to meet schemes’ particular objectives and profiles. Many schemes are now diversifying into a variety of non-correlated asset classes to attain the most return potential for the amount of risk they are willing to take.
In addition, traditional market benchmarks are being abandoned in favour of ones that reflect the true nature of the fund’s underlying objective: to meet the scheme’s pension obligations (i.e. match its liabilities). One of the key functions of LDS is to make a fund’s assets more bond-like in nature, so they are similar to its liabilities. A well-implemented LDS ensures that assets move in the same direction and magnitude as its liabilities, given changes in interest rates.
A common misunderstanding, however, is that LDS is an “all or nothing” proposal – that it would require changing a traditional asset-allocation method (with a split of, say, 70/30 equities/bonds) to 100% bonds. The fear is that doing so would effectively lock in existing deficits, offering no hope of future recovery.
To the contrary, a successful LDS would provide a framework for managers to invest without fear that an adverse change in interest rates or inflation could wipe out years of hard-earned returns. The truth is that suitable matching strategies rarely require moving entirely into bonds.
In practice, LDS should include three steps:
q Analyse the portfolio’s risks / create a risk budget,
q Allocate the portfolio’s assets optimally and
q Hedge the liabilities.

Step 1: Analysing the portfolio’s risk
Traditional asset allocation was once quite straightforward: a manager simply selected how much of the portfolio to invest in equities, and which equity markets and managers were most appropriate. Consensus has always been that equities will outperform bonds over the long term, by a margin generally considered to be around 3.5% per annum. Evidence shows this may be overstated.
Historical annualised SPX returns over the last 30, 20 and 10 year periods suggests that, due to structural changes in the equity market in the 1990s, the expected equity premium (over bonds) is in the 2-3% range*. Combine this lower relative return with much higher equity volatility (approximately 17-20%) and the rationale behind equity investment is less clear.
Looking at the flip-side, even if bonds return 2-3% less than equities, as suggested above, many bond mandates are now targeting 1-2% outperformance. Combine this with bond volatility generally in the range of 4-5% and the argument for increasing bond allocations is quite compelling. We are seeing evidence that fixed-income components are increasing in terms of allocation, expectations and attention. To generate excess returns and increased diversification, bond mandates are becoming more flexible and now often include credit, high yield, structured credit and credit derivatives.
Thinking logically, why invest in an asset with 17-20% volatility to make 3%, when an asset with 4-5% volatility can make you 2%? Pension funds need to question whether they are being compensated for the risk they are taking.

Step 2: Investing in an optimal manner
Once the risks and acceptable risk budget are determined, the portfolio’s assets should be invested in an optimal manner. This step involves picking assets and running simulations to attain the best risk-return profile: highest return for a given level of risk. An optimal portfolio mix will almost certainly result in investing outside the two main asset classes (equities and government bonds).
A more detailed analysis generally indicates that the efficiency frontier can be improved by including such diverse assets as property, private equities, emerging markets and hedge funds. Uncorrelated asset classes such as these can add significant value, often without exceeding the portfolio’s overall risk budget. The objective is to generate the largest expected return at the risk level that is appropriate for the scheme (as determined previously).

Step 3: Hedging the liabilities
Once the portfolio is invested optimally, risks to the scheme’s liabilities can be hedged appropriately. The two biggest risks facing pension funds are equity and interest-rate risks. The surprise for many managers is that these two risks are often almost in equal proportion. Falls in either can have devastating impacts on a scheme’s solvency.
By increasing allocation away from equities (into either fixed-income or uncorrelated assets), a portfolio can reduce its equity risk. For hedging interest-rate (and inflation) risks, we find the swap market tends to offer the best solution for most schemes. An overlay of interest-rate swaps can increase the duration of a portfolio’s assets to match that of its liabilities more closely than bonds and leaves the assets available for active management. In this way, the portfolio is immunised against interest rates, as the value of its assets and liabilities will move in the same direction and magnitude with any change in rates.
Depending on the scheme’s particular circumstances and requirements, strategies can either match liabilities exactly or as closely as desired. Cash-flow matching involves investing in a basket of fixed-income assets with coupons that mirror the liability payments as they fall due. This is normally only appropriate for a mature scheme that is fully funded. There is little opportunity for manager skill to achieve outperformance in this strategy. For most schemes, a duration-matching strategy is more appropriate, which involves investing in assets (bonds and swaps) that match the duration of liabilities more closely.
The use of swaps offers the benefit of flexibility: it matches liabilities without disturbing the assets. In other words, assets can be selected purely to generate performance, while the swaps act independently to achieve the liability matching. Also, swaps can be re-structured relatively quickly and cost effectively when the scheme’s requirements change materially. The strategy evolves with the fund. In contrast, a portfolio comprised only of bonds would require physically selling the existing assets and then buying assets to reflect the new liability profile. Swaps enable the manager to concentrate on managing the “best” assets, rather than worrying about the liabilities.
In summary, pension schemes, together with their advisors, need to look at their long-term strategies differently. The investment world has changed and managers need to consider all of the tools available to them. Enhanced fixed-income mandates and LDS make a great partnership, providing an effective framework for managers to generate performance in a risk-controlled environment.
Kathleen Currie
Director, Stuctured Solutions
+44 207 003 2155
* Source: Bloomberg 30/4/04. Comparison of last 30, 20 and 10 years of equity returns, broken down by Dividends, Earnings growth and P/E Growth. Demonstrates a shift in last 10 years towards single-digit equity returns in the range of 7.5-8.5%. It may be argued that P/E multiple expansion, as seen in the 1990s, will not likely be repeated.