Nationwide builds inflation hedge, ups matching assets to derisk

Employers in the sector are renewing efforts to control volatility in their schemes after Basel III regulations required scheme deficits to be factored into calculations of their capital base, effective from the end of last year. 

One of Lloyds Bank's defined benefit pension funds, for example, has also increased its allocation to bonds in a bid to boost stability.

The £3.6bn Nationwide scheme put in place inflation swaps – rather than the index-linked gilts it usually uses – with a notional value of £314m to hedge inflation over five, 10 and 15 years.

The scheme also increased its liability-matching assets to 41 per cent at March 31 2014, from 31 per cent the previous year, according to its 2014 annual report and accounts. 

A spokesperson for the scheme said: “This is all part of the active management of Nationwide’s pension fund and represents a response to current and expected future market conditions, aimed at ensuring the fund is able to meet its future obligations.”

The Nationwide section of the scheme had a funding level of 85 per cent at the time of its 2013 valuation, while its C&D section – containing members from its Cheshire and Derbyshire divisions – was 106 per cent funded.

Over the next two years the scheme will seek to establish a 50/50 split between matching and return-seeking assets by investing in alternatives such as long-lease property and ground rents.

The scheme is also considering increasing its exposure to private equity and real estate. The pension fund – which has a 75/25 per cent split between developed and emerging market equities – will move solely to passive management for the former.

A spokesperson for the scheme said: “The switch out of active management in developed equities was based on a number of reasons including performance and levels of return, but also our view that the opportunity to generate outperformance from these stocks is negligible at the current time.”

The Basel III effect

The introduction of the Basel III regulations in 2013 has meant sponsors are more keen to reduce the volatility within their schemes.

Scheme deficits are now knocked off the calculation of a bank’s tier-one capital, where previously only the next five years of contributions needed to be deducted.

This not only erodes the sponsor’s capital base, said John O’Brien, a partner in the financial strategy group at consultancy Mercer, but introduces a greater degree of volatility into capital held on an accounting basis.

“Probably more importantly the way banks were [previously] thinking about this, it [helped] stabilise the capital base; the contributions are going to be fairly stable,” he said.

In order to reduce the level of mismatch between their assets and liabilities, more schemes are pursuing lower-risk investments.

Simon Taylor, partner at consultancy Barnett Waddingham, said banks employ a balancing act when deciding whether to make contributions to their schemes.

“If they derisk their scheme or they start pumping money into their pension scheme to finance it better, theoretically it’s better funded … you can release some of the regulatory capital that you hold,” Taylor said. However, this money could generate greater profit in the business through loaning it out, he added.

Nationwide made an interim contribution of £60m by March and a £90m payment was made by July this year.

Further annual contributions of £49m will be made from July 2015 until 2020, however those due in 2015 and 2016 will be dependent on the funding position of the scheme at the time.

The employer contribution rate for the Nationwide section increased to 22.1 per cent of pensionable salaries from July 2014, up from 15.9 per cent from April 2014.