Following closure to future benefit accrual, trustees at the University of Leicester Pension and Assurance Scheme have decided to double its hedge, as experts emphasise the importance of keeping an eye on triggers and cash flow.
In spite of declining interest rates and uncertainty over whether they will rise again anytime soon, many schemes are continuing to adopt liability-driven hedging strategies to reduce risk.
Closing to future accrual means you really have to start thinking about your cash flows
John Walbaum, Hymans Robertson
Deputy director of finance Gary Hague said the university and the trustees of the £141.8m scheme, which closed to future accrual in March 2016, “have been working closely together over the past few years with their advisers to review the overall level of risk within the pension scheme”.
He added: “As part of this, it was decided to gradually reduce the exposure to the largest risks facing the scheme – gilt yields and inflation – by the development of an LDI aspect as a key part of the scheme’s investment strategy.”
Previously the pension fund hedged about 15 per cent of the exposure of the fund’s liabilities to both interest rates and inflation.
In June 2016, the trustees agreed to increase the level of interest rate and inflation hedging through the corporate bond and LDI allocation with Axa Investment Managers.
Hague said the first stage was completed in January 2017, which achieved a hedging level of 30 per cent of the scheme’s technical provisions.
Meanwhile, the trustees and university are considering the timing of further increases to the amount allocated to LDI, said Hague.
This was implemented through monthly switches from a smart beta credit fund run by Axa into the LDI portfolio.
Further increases in hedging are dependent on improvements in the scheme’s funding position, and the trustees have implemented a trigger mechanism to manage this process.
Triggers or time-based approach?
John Walbaum, head of investment consultancy at Hymans Robertson, said many schemes have had triggers in place for a long time. However, the problem has been that a lot of schemes have never met the triggers and “as interest rates have fallen, the triggers have tended to get further and further away”.
“So what a lot of people are thinking about doing is reviewing their triggers and deciding if they’re set at the right level, based on the environment that we’re currently in,” said Walbaum.
He argued that triggers should be reviewed as part of an ongoing strategy and discussion.
LDI: Should schemes hedge now or ride it out?
Pension schemes wanting to derisk through liability-driven investment are faced with the conundrum of whether to hedge now or hope for rates to finally rise.
“There’s still fear that… rates could not rise as fast as the market’s predicting, in which case people are thinking that maybe there is merit in doing something that’s more time-based rather than trigger-based,” explained Walbaum.
Cash flow moves to centre stage
A growing number of schemes are getting to the point where they need to generate cash. Walbaum noted that “closing to future accrual means future service contributions stop, so you’ve got less money coming in from the company… and that means you really have to start thinking about your cash flows”.
Thames Water pours money into LDI
Trustees of Thames Water’s two defined benefit pension schemes have been focusing on risk reduction over the past year, introducing a new liability-driven portfolio for both funds.
Walbaum said: “LDI programmes are very, very helpful in meeting cash flows, if they’re structured properly.” Schemes need to think ahead and plan for at least three to five years to make sure that they remain in control of cash flow, he said.
One solution is for a scheme to take income from the assets it holds. For example, “if you’re holding bonds you can take the coupons, if you’re holding equities you can take the dividends, if you’re holding property you can take the rental income”.
A fund can also invest in contractual cash flow assets, which are typically bonds that “have cash coming back to you either through a coupon and also through a redemption”, he added.
And it is possible within LDI to use leverage to “increase your exposure but deploy less capital”, Walbaum said.
Robert Gall, head of market strategy at Insight Investment Management, agreed that cash flow has “become a much bigger focus now because many schemes are maturing… and have to pay out more than they’re receiving”.
To prevent becoming a forced seller of assets, “the idea really is to try and protect yourself… have some sort of cash flow buffer which enables you to be able to pay out those cash flows as and when they’re due”, advised Gall.
He said that this sort of cash flow planning is something many schemes are working on, and it sits alongside an LDI mandate. The “LDI mandate is dropping down the risks of those longer-term cash flows... and then you have a shorter-term pot that deals with the physical cash flows that you actually need to deliver”, Gall explained.
It is about an “integrated solution of dealing with all the risks a pension fund faces, rather than just looking at the interest rate and inflation risk”, he added.
