Delta Lloyd Asset Management is one of the big players in the Netherlands in institutional asset management. The company is a division of the insurance company Delta Lloyd, which in itself is part of the UK Aviva Group. Delta Lloyd Asset Management offers traditional asset management plus various possibilities to reduce or take over the risks of the investment portfolios of their clients. We met Paul de Geus, Francis van Bergenhenegouwen and Maarten Weiss of Delta Lloyd Asset Management and discussed their new approach to provide pension plans more safety to cover their liabilities.
What is the idea behind this new approach?
“A growing number of companies considers the hedging of the risks they are running with their pension fund liabilities. This is a direct result of the extremely difficult investment period we have been going through and the consequential losses many plans have suffered. Moreover, in the near future the pension plan will become more linked to the balance sheet of the company. This is a result of the introduction of the new reporting requirements IAS 19 in 2005 and the new guidelines as from 2006 of the Dutch Pension and Insurance Chamber, the so-called Financieel Toetsingskader (“FTK”). These developments put a lot of strain on the solvency of the fund. Many companies are looking for opportunities to minimise the impact that the pension fund will have on the results of the sponsor too strongly. This implies hedging the risks or a shift of the risks of the liabilities to a third party. We have created this possibility in a very flexible and cost efficient manner. In our new approach we take the structure of the company and pension plan as a starting point and offer risk reduction where this is requested. For instance, we can fully or partly take over the risks of non-active participants, pensioners and even active participants of the fund. But all kinds of hedging percentages can be considered. This could offer room for the rest of the assets of the plan to implement traditional active management or alpha strategies.”
Which techniques are used?
“The essence of the structure is cash flow matching, where the projected cash flows are structured in a fixed income portfolio. The future cash flows are discounted and the higher the return on the fixed income structure, the lower the amount to be invested is. Here we have the advantage that we can offer better returns than in traditional ALM matching techniques and in some recent cases better returns than competitive offerings.
“The fixed income portfolio is constructed with synthetic exposure to about 100 corporate bonds. The cash flows of this portfolio are distributed over different tranches with different risk/return profiles. The lower the risk the higher the rating of the tranche. The client makes his choice in the preferred rating category, where the remaining layers are hedged in the market. Currently it is for instance possible to create an Aa3 tranche with a return of euribor + 275 bp with a maturity of 10 years.
“Ratings are based on the quality and diversity of names in portfolio. The expected loss is calculated with default and recovery statistics. First losses are absorbed by the equity and lower rated tranches. The extra return is amongst others a function of the difference between expected market defaults and the lower defaults of a managed credits portfolio.
“Finally a cash flow swap is used to let the paying cash flows exactly match the pension plan liability cash flows. ”
Why do you pick this moment to introduce cash flow matching?
“Traditional instruments which are used for cash flow matching, such as bonds, private loans and cash, can only be used to a certain limit. They do not offer enough insight into the risks that insurance companies take on to their books. These instruments are only limited available and take up extra solvency. Derivatives have made new techniques available and do not have the former disadvantages. Besides that, the sponsor did not have to worry. Nominal liabilities of the fund had to be taken into account at a fixed interest rate of 4%. Therefore there was no need to extend the duration of the assets. When the assets of the plan will be accounted at fair value and the pension plan will be consolidated with the sponsor, cfo’s will want to make the company independent of market influences caused by the plan. We insure the liabilities and make an agreement with the client about the level of insurance. That can be 100% including the risk of mortality, or 90% or any other required level. If for instance an 80% level of safety is chosen, that would imply that 20% can be invested in products which deliver outperformance. This could be used for indexing the pensions for inflation.”
How is this structure organised?
“We manage the portfolio of the underlying credits and take care of client contacts. We leave the structuring of the various components of the structure to large investment banks. The result is a structure with an attractive spread over swap and a different risk/return profile, which is not correlated to financial markets. For a client only the risk of default of Delta Lloyd remains. As Delta Lloyd has a AA rating this risk is very small. We can offer this product in close co-operation with Delta Lloyd Life insurance company. They take it on their balance sheet and provide solvency. Fast decision making and good communication with the insurance company are of the essence. When liabilities are fully hedged, the volatility of the return of the pension plan is zero!”
What is your target group?
“This approach is very useful for pension plans who wish to exchange future volatility (capital gains and losses) of investments for safety. It is estimated that the coverage ratio of about 150 Dutch pension plans is in the critical zone. These are plans that would prefer to get rid of the risks of for instance their sleepers and pensioners. Our proposition is much more interesting than that of industry wide pension plans who make a deal on the basis of a traditional ALM study. Besides, industry wide pension plans mostly do not want to take over plans that have difficulties within their solvency. This approach is not driven by product sales, but is fully demand based. For example, many asset managers and consultants nowadays propagate inflation linked bonds. But that does not solve the problem. These products are expensive and Dutch inflation linked bonds are not available. French bonds do not fully hedge Dutch inflation. Moreover, a cfo wants risk control and not market risk. This matching approach is designed on the basis of the balance sheet problems of both the pension plan and its sponsor. The market risk is being reduced or fully taken away. It is not the intention to replace the pension plan’s participants administration and asset management activities. Delta Lloyd Asset Management can grow its assets under management and the spin offs are interesting such as the knowledge and expertise we gain in this specific field. Besides, it confirms our capabilities as an innovative asset manager!”
Paul de Geus and Francis van Bergenhenegouwen have institutional client and sales responsibilities and Maarten Weiss is head of credit asset management of Delta Lloyd