United Utilities ups interest rate hedge after hitting trigger

The DB schemes – United Utilities Pension Scheme and the United Utilities PLC Group of the Electricity Supply Pension Scheme – increased their interest rate hedge by around 4 percentage points in November, from its previous 88 per cent level. Employer contributions have also been linked to inflation to further protect the scheme from inflation rises.

Market-based triggers have been put in place so when the pricing of interest rate hedging improves, the schemes increase their protection. Schemes with such triggers have faced a difficult few years as rates have stayed low, but value has begun to improve.

This was a preferable way of reducing volatility within the schemes, rather than increasing employer contributions to handle fluctuations in interest rates, said scheme manager Steven Robson.

“We didn’t have the ability to put additional contributions in and we didn’t want to fund it that way so we set triggers on different things we wanted to do, [which wouldn’t] affect our funding level,” said Robson.

A joint working group, comprised of three company representatives and three trustees, has been looking at how inflation, interest, investment and longevity risk can be removed from the schemes, over the past few years.

Hedging triggers are increasingly used by schemes looking to reduce volatility. There are three main ways schemes put triggers in place – market-based, time-based and funding-based.

Schemes have historically used market-based triggers to decide when to increase their interest rate hedge, said John Towner, director in Redington’s investment consulting team.

“The problem we have when we’ve had an interest rate market like we had over the past few years – more schemes have found themselves in a position where [these targets] have never been hit,” he said.

A funding-based trigger where schemes take into account the flight path of their assets and liabilities over a certain time period can be a better way to decide when to hedge.

“If assets outperform liabilities or underperform then these may be certain trigger points where you take rerisking or derisking,” said Towner.

The extent to which an employer is willing to hedge depends on the strength of the employer’s covenant, according to Clay Lambiotte, partner at consultancy LCP.

“There’s an issue around risk appetite and the strength of the employer covenant to the extent [that] it’s the employer that underwrites that risk,” he said.

United Utilities has also linked employer contributions with inflation rates.

“We have done a deal directly with the trustees that we will put more money into the scheme for inflation [hedging] as inflation goes up,” said Robson.

He said if there comes a time when the schemes can buy inflation-hedging products where they do not have to pay a premium in the market then they will probably look to do so.

Schemes linking employer contributions to rising rates of inflation is not common, but is usually carried out by utility companies and employers that benefit from increased inflation rates.

“It could have very difficult and unexpected consequences for the employer’s cash flow,” Lambiotte said.

Schemes can hedge against fluctuating inflation through buying inflation swaps, inflation-linked corporate bonds as well infrastructure debt and long-lease property.