Have falling interest rates over the last year finally persuaded trustees and sponsors that yields may not revert to the mean, or do they expose liability hedging as expensive flattery of scheme balance sheets? Axa Investment Managers' Jonathan Crowther, Barnett Waddingham's Sophia Heathcoat, Dalriada Trustees' Simon Cohen, Hymans Robertson's Alen Ong, Law Debenture's David Felder and Standard Life Investments' Mark Foster discuss.
David Felder: I think [there has been] more of the same, rather than much change. A minority of pension funds have reached their funding target, which is generally to hedge in line with their technical provisions, or solvency, funding ratios for both inflation and interest rates; they have finessed their strategies.
The majority of funds have some way to go, and some have a very long way to go before they reach those sorts of levels. And in the early months of last year, the focus was very much on whether to continue or build up the hedge against the backdrop of even lower real and nominal yields.
Triggers have not worked since this all started, as we know, so there has been a steady drive on a time-based approach to build up the hedging levels.
Mark Foster: I think you have seen some innovation over the last couple of years, particularly with integrated liability-driven investment solutions. Some of the small and medium-sized schemes may have felt they had missed the boat.
However, with that increased interest rate uncertainty and liabilities continuing to increase in the first three quarters of the year, you saw a few more of those schemes put at least some LDI protection in place.
Jonathan Crowther: The big theme is probably recognition of the fact that you cannot time or call these markets. We all sat around here 12 months ago and said, “You would not want to hedge at these levels”. And then, 12 months on, it is even more pricey.
I am not forecasting it will get more pricey, but I have been in the market for a long time and if I cannot say it is going to be one way or another, I think most people cannot.
I think there is a logic to the concept that these liabilities are more or less guaranteed and therefore need to be valued as if they are guaranteed
Alen Ong, Hymans Robertson
Pensions Expert: LDI has been said to prop up an unsuitable valuation system at a high cost. Do you see any merit to that argument or any prospect of regulatory change on this?
Felder: This is an approach that does the rounds from time to time. The last episode of that was three or four years ago, when the government consulted on the possibility of smoothing discount rates, and of course they backed off that.
For those that are hedged, saying, “Interest rates are not –1.5 per cent, they are really zero, for valuation purposes” does not do any good at all. It would provide some artificial support to those who are underhedged, but because of the split needs of those two groups, that idea developed no traction. Using funding around gilts plus discount rates ought to stay in place.
Foster: The interesting bit, I suppose, is if a lot of people are starting to use, say, private markets for cash flow-driven investment and some inflation protection. That could see people try and change the valuation basis. How do they take account of illiquidity premiums in their valuation basis?
Alen Ong: I think there is a logic to the concept that these liabilities are more or less guaranteed and therefore need to be valued as if they are guaranteed. Moving to something that is completely driven by risk premiums and things like that has a purpose, but it does not necessarily give you all the information you need to know about how you should manage your scheme.
Simon Cohen: I struggle a little bit with the assumption that the gilts plus basis is appropriate, because if you have a sponsor with a really strong covenant, why should their decisions about how they finance the business be driven by an assessment of the scheme’s liabilities on the basis that it is risk free, plus maybe a margin, when they could be running a higher equity allocation?
Crowther: I have been involved with a number of employers that have told me how rock solid their covenant was, only to discover some extraneous event occurs and that covenant is not as solid. We could all think of some household names where 10–15 years ago, covenant just would not be an issue.
There is no point in trustees spending a lot of time discussing their growth portfolio only to then take such a large unhedged position in rates or inflation
Sophia Heathcoat, Barnett Waddingham
If you go back to the fundamental point that pensions are there to pay built-up entitlements, and the trustees have a responsibility to try and make sure that those benefits are delivered as they have been set out, then I think that takes you back to a funding basis that is slightly more conservative than most sponsors might wish to run.
Sophia Heathcoat: I can see why some people disagree with the fact that LDI is just brought in to support this triennial valuation. But if you took that aspect out of it, we could still see support for inflation hedging, because that actually impacts the pound amount that you pay out to your pensioners. Interest rate hedging is just a valuation issue, but equally a necessary one.
Pensions Expert: Given that rates might start to rise, will well hedged schemes lower their hedge level?
Felder: I have a minority of schemes that have started that discussion with the sponsor. If you are well hedged and your overall value at risk is under control, there is a discussion to be had if a sponsor has, from this point, a strong view that rates are going to trend upwards, despite all the disappointments in that forecasting over the last few years.
If a sponsor comes along to a trustee meeting and says, “How about taking 10 per cent of the hedge off and we will give you some covenant enhancement instead in the form of escrow or guarantees or asset-backed arrangements?” there is a reasonable discussion to be had within the overall risk management framework, but that is for a minority of schemes.
Heathcoat: And I think the key point there is that we are looking at changing the hedge ratio by 10 per cent. It has to be proportionate with the other risks in the portfolio.
There is no point in trustees spending a lot of time discussing their growth portfolio only to then take such a large unhedged position in rates or inflation, such that any returns that could be made there are then wiped out by a fall in yields.
Foster: It is the sponsor’s ability and willingness to underwrite the risk as well. The trustee’s role in all that is to meet members’ benefits. Effectively re-risking the scheme is quite a brave decision, although if there is pressure from the sponsor that may be something you have to entertain. We have all seen that calling markets is really, really difficult.
