The driving force behind these developments has been the need to ensure a clearer linkage between assets and liabilities and greater transparency over the risks being taken to get a return.
The major asset classes can be divided into two separate camps: risk-reducing and return-enhancing.
A defined benefit pension scheme will use government and corporate bonds to match its expected cash flows (benefit payments) as part of its risk-reducing portfolio. The remaining investment universe will constitute the return enhancing portfolio.
The longest dated government bond is due to be redeemed in 2038. Pension scheme liabilities stretch much further into the future. A matched portfolio of assets will inevitably be overweight cashflows at the short end and underweight cashflow at the long end.
Pension funds are taking large, often unacknowledged, strategic bets on interest rates. Falling rates coupled with crippling equity market returns have served to reduce funding levels, on average, by 30 per cent. With up to 30 per cent of the liability without asset backing, the importance of placing greater onus on the issue of risk management is clear.
A 1 per cent fall in yields for a scheme with a straightforward 60/40 equity/bond split can lead to a decrease in the funding level of over 10 per cent. Successive changes in gilt yields have seen rates fall from over 8 per cent 10 years ago to around 4.5 per cent today.
The adroit investor can look beyond the tool kit provided by fund managers to include other financial instruments in order to better manage their risks. Interest rate risk has negative expected value for a pension scheme and it therefore seems intuitive to seek methods by which this risk can be controlled.
Enter the swap market
The swap market dwarfs the government and corporate bond markets. The International Swap Dealers Association estimates place the notional value of the swap market was in excess of £70,000bn (e100,000bn) at the end of 2003. Even allowing for the effects of double counting, the government bond market looks feeble at £50bn.
A swap is an agreement to exchange two sets of cashflows; the values of which will be equal at the outset. The net present value of the contract is therefore zero, ignoring transaction costs. The scheme can pay away the excess cashflows arising from the spikes of redemption payments from its bond portfolio plus its expected future contribution inflow and receive cash flows in the future to match its liabilities, even beyond the maturity date of the longest dated bond. The scheme can substantially reduce its sensitivity to interest rate risk.
Next stop – inflation. We can use similar techniques to reduce inflation risks. With the exception of index-linked bonds the traditional asset space does not offer strong inflation hedges.
Based on the behaviour of the equity market over the last 100 years, a a holding period of 20 years is required to serve as an adequate inflation hedge, so not an ideal solution as part of a risk-reducing portfolio.
In addition, the index-linked bond market is small. With nine index-linked issues currently outstanding, of which only four are of durations longer than 10 years, the need to seek alternative methods of hedging inflation is apparent. Index-linked bonds are very tightly held by pension funds and are a costly way of matching inflation risk.
Why take a chance?
The downside to removing such risks is that the scheme will not benefit from favourable changes in interest rates or inflation rates. But should pension schemes be taking strategic bets in such areas? Taking these risks out of the equation leaves the scheme to focus on the more manageable risks within asset allocation decisions and the level of active risk adopted. The costs involved in establishing the swaps contract mean that a bespoke product is likely to be possible only for large funds.
The major remaining risk (other than salary risk) that the scheme will face is mortality improvement. We have just seen the launch of another mortality bond, so the future may well offer a product to match every risk in the pension scheme. Trustees might then be able to put their feet up and look forward to a happy, risk-free retirement.
Bill Sharp, director and chief actuary, Gissings
