The Royal Mail Pension Plan has extended liability hedging in its portfolio by substantially boosting its use of swaps and gilt repurchase agreements, as it seeks to reduce risk in the scheme.
Liability hedging is now common among schemes looking to reduce the risks posed by their liabilities, but it may limit the potential upside from improving interest rates.
Royal Mail's asset mix 2014 v 2013
Global unconstrained equities: 7.9% (8.6%)
Global emerging markets equities: 1.5% (2%)
Alternatives: 2.8% (2.4%)
Private equity: 2.2% (2.7%)
Real estate: 6.5% (6.1%)
High-yield bonds: 4.7% (3.5%)
Corporate bonds: 11.9% (9.1%)
Index-linked bonds 53.8% (45.9%)
Cash investments 8.7% (19.7%)
Source: Annual report 2014
Royal Mail's scheme is using swaps and total return swaps to cover 56.7 per cent of its portfolio, with repo agreements covering a further 21.8 per cent.
This is increased from 24.5 per cent coverage using swaps in 2013, according to the scheme’s most recent annual report and accounts.
The annual report stated the extended hedge is the result of development in its investment strategy, which also includes the diversification of its return-seeking assets.
Ian McKnight, chief investment officer of the Royal Mail Pension Plan, said the diversified return-seeking pool would have a lower allocation to equities, coupled with increased investment in alternatives such as private market debt, emerging market debt and a slight increase to property.
"The plan's strategy from time to time depends on a number of factors, including actual experience over time, notably the changing values of the plan's assets and liabilities," McKnight said.
The Royal Mail Pension Plan is divided into two sections: the £2.96bn section for principal employer Royal Mail Group, and the £233m Post Office Limited section. Both have separate funding and investment arrangements within the plan.
The annual report and accounts stated: “The overriding principle of the strategy is twofold; just over half of the assets (55 per cent for RMG section and 52 per cent for POL section) are now allocated to liability hedging and the remainder are allocated to return-seeking assets."
Simeon Willis, principal consultant at KPMG, said the use of derivatives to hedge liabilities is common among pension schemes, with a recent survey by KPMG indicating over £500bn of UK pension scheme liabilities are being hedged.
Gilt repo agreements have become more commonly used since swap yields fell below gilt yields in 2009, Willis said. Falling gilt yields meant the hedging strategy would likely have performed well over the past few months.
“It’s only after the last two or so months that gilt yields have fallen, so they’re probably feeling very pleased with themselves,” Willis said.
Nicola Ralston, director at PiRho Investment Consulting, noted the unusually large increase in hedging from the scheme.
“In our experience, to be as hedged as that and to increase the hedge by that amount is relatively unusual, but that’s not to suggest it’s in any way inappropriate,” she said.
She added schemes expecting interest rates to rise may decide against hedging in the hope of reaping the benefits of a jump in rates.
“Many schemes are unwilling to increase their hedge at the moment because they’ve suffered the negatives [of low interest rates]” said Ralston. "If you hedge you won’t lose if rates go down, but you won’t gain either.”
Larger schemes typically have access to more options when hedging, whereas smaller schemes may be forced to rely on pooled funds to access derivatives.
