UK retailer Boots’ pension fund’s switch to bonds from a traditional equity driven asset allocation won many plaudits, if only for impeccable timing. While the equally strong financial economics arguments put forward at the time did not trigger an industry-wide shift, last month’s disclosure of an equally groundbreaking transition by another UK retailer WH Smith may be the silver bullet sponsors and trustees have been seeking.
So what did they do and, more importantly, why? The trust’s deficit was several times larger than company profits. Pension deficits are effectively unsecured loans to sponsors on beneficial terms (so much for self-investment restrictions). Although superficially attractive to companies, these debts have very variable nominal values that are incredibly sensitive to changes in already low real interest rates. As investment analysts get to grips with the role of pension funding in companies’ capital structures, fixing the value of the debt becomes ever more important, especially when risk-based payments to the Pension Protection Fund are introduced.
Trustees would, of course, prefer deficits to be eliminated. Funding can come from only two sources - contributions and/or investment return and WH Smith, like most companies, has only a finite ability to make additional contributions.
With bond-based investment strategies, expected company contributions are higher (because the expected return from investments is lower), but there is lower volatility in the actual contributions. Equity-based investment strategies result in lower expected contributions, but invite greater volatility over actual future payments, with a significant risk that poor market returns will result in very high contributions being required at some time in the future.
This would be fine if pension funds were genuinely investing for the long-term with a secure and equally long-term company commitment behind them – but often they’re not.
Given full funding, trustees would aim to ‘match’ the future cash-flow liabilities by nature, term and currency. These cash-flows can encompass administration and management costs as well as expected benefit payments. Typically, this means investing in government bonds.
However, achieving an investment strategy that is fully matched at all times is impossible using physical assets. Future experience is very unlikely to replicate the financial and demographic assumptions adopted and, in the UK at least, appropriate government bonds do not exist that would generate the required income streams - even with the recent 50-year inflation-linked bond issue.
The existence of deficits requires an element of risk-taking anyway to reduce shortfalls and this means investment in return-enhancing (as opposed to risk reducing) asset classes such as equities.
Generally there are only three ways to manage a deficit: matching all cash flows from the front end, matching all cash flows from the back end and optimising the cash-flow match based on expected future contributions.
The first has low cash-flow risk, as all the short-term liabilities are covered. The residual deficit in the tail is completely unfunded though and, being so long-term, is highly sensitive to changes in interest rates and inflation. Such an approach is also the least altruistic, clearly making the problem of today one for the ‘management of tomorrow’.
Matching all the future cash flows from a certain date leaves near-term liabilities unfunded and thus reliant on company contributions to make good the shortfall. However, the long term interest rate and inflation risks are minimised.
In between these two extremes are a wide range of alternatives, the optimum of which balances liability-matching with expected additional company contributions and an agreeable level of equity-type investment.
Using derivatives is becoming increasingly popular among UK pension funds although they have been used by insurance companies and European pension funds for much longer to manage exposures. Institutions have bought ‘put options’ (the right to sell your equity portfolio to another investor at a predetermined price) to protect against future market falls. It is easy to see how this reduces the risk of holding equities.
However, there is increasing interest in holding bonds to mirror the liabilities and buying “call options” (the right to buy equity markets at a future date at a certain price) to participate in any future equity market growth. Logic dictates that holding bonds plus call options should have similar payoff and risk profiles as equities plus put options.
Setting up a bespoke sub-fund with an established insurance company avoids trustees having the trading, settlement and compliance challenges that the pension fund acting as principal would entail (a bar that has held back many trustee groups)
Crucial cashflows
Deciding what cash-flows to match and being able to model them accurately is crucial for any scheme, particularly smaller ones considering using pooled funds made up of investments with single year durations. WH Smith developed a cash-flow matching strategy that met benefit and administration costs and minimised unrewarded interest rate and inflation risks (although mortality improvements are still uncovered). Liabilities beyond 50 years are also fully covered, but subject to a small reinvestment risk.
To counter the now fixed deficit, a basket of global equity call options was purchased with a variety of payoffs over several years into the future. This gives the trust the same exposure to equity markets in the event of strong future performance as they had before, thus removing any “regret risk”, but limits the downside from a sustained fall to just the premium spent.
Most transitioned funds were put in a facility whereby the actual total return on the investments held is swapped with a bank for a guaranteed return of Libor (the inter bank borrowing rate) plus a variable premium dependent on certain terms of the facility. The balance is held as cash targeting Libor, net of management fees.
The insurance company swaps both the guaranteed and targeted Libor returns for guaranteed long-dated fixed income returns and these are swapped for guaranteed inflation-linked cashflows to meet future trust expenditure.
There is no reason why the theory and practice of this strategy, suitably tailored, could not apply to any scheme in deficit although the ramifications for the asset management (and consulting) industry are enormous.
Tony Osborn-Barker is a director in consulting at Deloitte.
