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Investment Note July 2007
Developments in Fixed Interest Markets
The move to bonds
Recent years have seen a substantial increase in the proportion of pension scheme assets invested in fixed interest markets. This has been driven by trustees and sponsors wanting to limit their exposure to risk. Specific motivating factors for the shift in asset allocation have been:
- Pension schemes’ liabilities are maturing. Many UK schemes are now closed to new members (and a significant proportion are also closed to future accrual of benefits);
- “Shocks” such as volatility in equity markets and increases to life expectancy have brought risk management into focus;
- The accounting standard FRS17 (and its international equivalent IAS19) measures liabilities by reference to corporate bond yields. Investing in appropriate bonds can reduce volatility on the sponsor’s balance sheet;
- The new scheme funding regime and the ‘risk-focussed’ Pensions Regulator urge greater prudence by trustees in setting funding assumptions. This increased prudence is expected by many observers to lead to greater demand for bond-type investments;
- Uncertainty over future inflation has increased the attractiveness of index-linked bonds.
Many commentators expect equities to outperform bonds over the long term and hence would hope that future outperformance from a scheme’s equity holdings would reduce the financial support required from the sponsor. In the short term, however, the volatility of equity values can result in perceived deficits in schemes that need to be made up by increases to the sponsor’s contribution rate.
Fixed interest yields are currently at relatively low levels. Switching investments to bonds would lock in those returns, possibly in advance of an increase in yields later. Trustees (and sponsors) can therefore be concerned not to switch to bonds if yields are expected to rise. However, some commentators believe that increased demand from pension schemes for fixed interest investments will continue and result in higher prices and even lower yields. If this is correct it would not make sense to hold out for better buying opportunities.
Not all bonds are the same
A major consideration for trustees when switching to bonds is the characteristics of the actual bonds being purchased relative to their scheme’s liabilities. Trustees are ideally looking for bonds whose values behave in a similar way to their scheme’s liabilities when, for example, interest rates or inflation changes. However, for many schemes the duration of their liabilities is longer than the duration of the majority of the bonds available in the markets, i.e. the average time until the pension benefits are paid out is longer than they have to wait for receipt of income and capital from the bonds. This mismatching of durations means that payments received from the investments would have to be reinvested on terms that cannot be known in advance until they are needed. These future investment terms may be insufficient to discharge the liabilities. By switching into inappropriate bonds trustees could potentially be buying into a lower returning asset class without the advantage of reducing risk - possibly the worst of all worlds!
The main problem with buying longer-dated bonds to match long-dated liabilities has been that there are not enough to go around and those that are available are expensive. The Government helped relieve the short supply of longer-dated instruments in 2005 with the issue of a 50 year fixed interest gilt, followed later in the year by a 50 year index-linked gilt. These gilts proved popular but unfortunately the corporate sector has not, as some had predicted, followed suit by issuing long dated bonds in significant quantities.
Swaps
Typically, the conventional bonds held by a scheme produce a series of proceeds that do not exactly match its benefit outgo. This can be illustrated as shown below.
The banking sector has responded to the difficulties of finding bonds appropriate for matching liabilities by developing products that use derivatives (specifically swaps) to perform this task. Through the use of swaps investors are able to create investment portfolios with similar characteristics to their expected future cashflows.
Banks, who have sold these products to other investors for some time, have in recent years been actively marketing swap contracts to pension funds as a means of better matching liabilities. Both interest rate risk and inflation risk can potentially be managed by using such contracts and Barnett Waddingham has assisted several clients entering into these arrangements.
The chart below shows how a bond portfolio can be modified to more closely match the liabilities through the use of derivative instruments.
The cost of implementing bespoke arrangements can be high (due, for example, to the specific legal advice required) and therefore a liability driven solution has historically only been practical for larger funds.
Pooled Liability Driven Investment Funds
The market has developed recently and a number of investment managers have now launched funds designed to bring liability driven strategies within reach of smaller pension funds (those with assets of less than £50m). These pooled funds operate in a similar way to traditional pooled investment funds; investors purchase a number of units whose value depends on the performance of underlying assets.
The pooled funds are made up of holdings in fixed interest securities and swap contracts and are designed to act like a fixed interest bond with a specific duration. Each manager typically offers several pools, each targeting a range of maturity dates e.g. 2030 – 2034.
Pooled funds give a pension scheme the ability to join other investors in a collective vehicle and make more precise matching available with smaller sums.
As the pooled funds have target maturity dates covering a range of years, the matching would not be as accurate as with a bespoke swap arrangement. There is, however, a strong argument that given the uncertainty inherent in predicting the level and timing of future liability payments, the additional expense of using a bespoke arrangement is harder to justify.
Typical charges for these funds are in the range of 0.20- 0.25% per annum. This compares with typical fees of 0.10- 0.25% for a pooled bond fund.
Targeting Additional Returns
We highlighted earlier the problem of the lower yields on bonds leading to increased contribution requirements. Swap rates, while marginally higher than the yields on Government bonds, are generally below the expected longterm returns on other pension scheme assets and so this problem remains.
To counter this, many of the available pooled funds now incorporate some level of gearing. This means that only a proportion of the value of the underlying LDI asset has to be passed across leaving the balance to be used to gain exposure to “return-seeking” assets. For example, £50 could be invested to gain £100 worth of exposure to the LDI asset. The remaining £50 could then be invested in “returnseeking” assets with the objectives of achieving better returns and improving the funding position.
An increasingly popular approach has been for trustees to combine the use of LDI-type products with “absolute return” strategies. The fund manager has a fixed performance target that does not depend on the performance of financial markets. Typically an absolute return target would be set at a fixed level (say 2% p.a.) above Bank of England base rates.
It should be acknowledged that using geared LDI funds and investing a portion of the assets in other areas reintroduces some risk – although this is a different risk to that being hedged by the LDI fund. The hope is, however, that this new risk will be easier to manage than before. This is because most LDI funds require an objective return slightly in excess of cash rates to support the swap rather than having a liability-related benchmark. This is consistent with the capital protection objective of the absolute return manager.
Absolute return products may have a “dynamic asset allocation” and the manager may have few constraints on how funds can be invested. Managers generally follow strict risk-control procedures. Funds may be held in a wide range of asset classes, including equities, bonds, property, commodities, currencies and derivatives. Investors are effectively placing a heavy reliance on the manager’s skill in judging which individual stocks, sectors and asset classes to invest in, far greater than under traditional mandates. As such the manager may need to be monitored more closely than under a traditional investment structure. Due to the capital protection objective of these funds they tend to be more cautious in nature than a typical equity fund. For example, in times of uncertainty the managers may ‘retreat’ into cash investments to protect against potential market falls. This may result in a lower long-term expected return on the fund than for a conventional equity fund; in effect some of the upside of investing in equities is being given up in an attempt to protect the downside. In addition, management and compliance costs are also likely to be higher than for a traditional equity fund.
One challenge with equity investment for pension schemes has always been the lack of correlation with movements in liability values. In particular, sharp falls in equity markets have not necessarily coincided with a reduction in liabilities. The use of an LDI approach combined with return-seeking assets potentially allows schemes to reduce funding volatility while still targeting some outperformance.
Investment advice
The suitability of various investment strategies will depend heavily on scheme-specific conditions. In particular trustees should consider the funding level, their own risk tolerance, the sponsor’s ability (and willingness) to contribute and the nature of the scheme benefits. Trustees should receive investment advice before making any significant changes to their investment strategy.
Barnett Waddingham runs one day investment seminars for trustees - please visit our website for details of other forthcoming trustee training events.
For specific advice on pension investment issues please speak to your usual contact at Barnett Waddingham LLP.
Barnett Waddingham LLP, June 2007Related DocumentsInvestment Note (438.33 KB, .pdf)