Axa IM's Jonathan Crowther gives a ground-up description of the derivatives that liability-driven investment managers use to mitigate against key funding risks, in the latest edition of Technical Comment.
Risks are ultimately taken versus liabilities – which are promised payments, or cash flows, to current and future pensioners.
The timing and amount of these cash flows depends primarily on how long members live, and what inflation turns out to be in the period to retirement and beyond. Actuaries predict them using assumptions for these variables.
Key points
Understand risks versus liabilities and how these risks can be mitigated
Decide on whether to hedge and by how much
Start enabling the scheme to use the full risk management toolkit now
Pension scheme liability cash flows stretch out many years and resemble long-dated bonds – and just like bonds, the value of liabilities will rise if interest rates fall, and vice versa.
When inflation expectations rise, the value of liabilities also increases as more is expected to be paid out. Investing in assets whose value has the same sensitivity to interest rates and inflation protects a scheme.
Most UK pension schemes are in deficit. This means that they must take some investment risk to reduce this deficit, and investing all their assets to match liabilities is not usually a viable option.
Swaps can offer schemes a way to better tailor their matching assets to their liabilities – and due to their unfunded nature schemes are able to hedge risk while keeping return-seeking assets to reduce deficits over time.
The basics
Interest rate swaps involve one party agreeing to pay fixed cash flows in exchange for the other party paying floating cash flows that are linked to short-term interest rates – typically six-month Libor.
At inception, the payments made on each leg of the swap are expected to be of the same value and therefore the contract will be of zero value to both parties. As interest rates change, the expected floating payments will change and this means the value will no longer be zero – it will have positive value to one party and a corresponding negative value to the other.
Schemes will typically go into interest rate swaps with a bank to receive the fixed payments and pay the floating leg.
The fixed payments would be constructed to capture the long-dated nature of the scheme’s pension payments to members. In this way the scheme has an asset whose value moves in line with liabilities as interest rates change.
An inflation swap also involves the exchange of cash flows; this time the payments made on the floating leg increase with inflation, typically the retail price index. The fixed leg payments are agreed at inception based on the expected inflation at that time. Again, the contract has zero value at inception.
Schemes will look to receive the floating inflation-linked payments on inflation swaps to reflect the inflation sensitivities of their pension payments, thereby holding an asset that reduces the scheme’s inflation risk.
A swap option
A 'swaption' is an option on an interest rate swap. It gives the buyer the right but not the obligation to enter into a swap contract at a future date at a rate agreed now.
At contract expiry, the buyer will enter into the interest rate swap if the interest rate agreed is better than prevailing interest rates. If not, the buyer will not exercise the option.
Schemes can use swaptions to protect against interest rates falling below the agreed rate.
However, if interest rates do not fall to this level at the swaption expiry date then the scheme maintains an unhedged position.
Swaptions are typically used by schemes that may not want to hedge at current interest rates, but are concerned about rates falling beyond a threshold level. This threshold represents their views or deficit tolerance levels.
Jonathan Crowther is head of UK LDI at asset manager Axa Investment Managers
