How Selex secured an £18.6m swaps boost

The £414m scheme holds a portfolio of swap and swaption contracts to protect members against the impact of changes in long-term interest rates and inflation.

"Our swaps portfolio has provided excellent protection, generating a significant mark-to-market valuation increase over the year and undergoing some restructuring," said a newsletter to members last month.

Swaps and swaptions are derivatives that can help defined benefit schemes to derisk, as part of their liability-driven investments, by guarding against uncertain market movements.

When a change in interest rates increases the value of schemes' liabilities, these assets also increase in value to offset the increase. 

Selex's interest rate hedging  

Selex explained it had entered into an agreement with a bank to pay or receive money depending on the movements in inflation and long-term interest rates, also known as a swap.

React fairly quickly to opportunities as they present themselves in the market

Dan Mikulskis, Redington

Members were informed that the scheme's liabilities would be "suitably matched" if long-term interest rates fell and the deficit of the scheme increased. 

The newsletter stated: "We regularly consider whether the swaps need refining in order to ensure the scheme's liabilities remain suitably matched."  

Beneficial interest rates in August 2011 accounted for a boost in the scheme's portfolio of swaptions, the scheme said. The scheme then refined the swap contracts in January to better match its liabilities. 

Selex's accounts, published earlier this month, stated: "The rise was necessary to offset the rise in value of the scheme's liabilities and so the impact of the rate changes on the scheme's finances will... have been broadly neutral."

Swaps are derivatives that can protect schemes against market fluctuations, for example interest rates.

The scheme can enter into a contract with a bank, mediated by a fund manager, over a fixed period.

The bank can provide a fixed rate for the scheme's liabilities in exchange for a cash rate, which is easier for the scheme to manage.

A swaption is the option to enter into a swap contract at a specified time in the future.

How to use swaptions effectively 

Dan Mikulskis, director of asset liability management and investment strategy at Redington, said schemes should ensure swaptions were appropriately sized, compared with other risks and liabilities in the scheme.

Do not just be bamboozled by advisers pushing a wonderful sales pitch

Richard Butcher, Pitmans

"I would never advocate a scheme doing 100 per cent of its interest rate hedging through swaptions. [The right size is arguably] 10 or 20 per cent of interest rate hedging through swaptions," Mikulskis said. 

He said schemes could benchmark a swaption against a straight swap, which would generally be the default option for trustees. 

He added: "Schemes we have implemented, where it has worked, have typically had a small, very knowledgeable trustee group set up to deal with investment issues.

"That group can meet frequently and has the power to implement and sign off on those swaptions." 

Schemes can make sure trustees are educated so any new investment strategy is understood. 

Richard Butcher, managing director at Pitmans Trustees, said: "Beware consultants that say they have the latest whizzy gadget and everybody must be buying it without a thought."

He urged schemes to understand the risks and ensure advisers properly explained the negative as well as positive aspects of investment choices.  

Butcher added: "Do not just be bamboozled by their advisers pushing a wonderful sales pitch. 

"Seek independent advice from another investment consultant or an independent trustee with experience, or a competent actuary."