Pensions Newsletter - Spring 2015
At a time when funding is already under pressure, the general election has added a new risk for many defined benefit pension schemes. There are a number of techniques pension schemes and plan sponsors can consider when trying to preserve the value of their equity investments.
The general election raises the stakes for many pension funds
At a time when funding is already under pressure, the general election has added a new risk for many defined benefit pension schemes. Sterling has already been hit by fears that a hung parliament may create political uncertainty. Although the currency has since recovered, there are signs that volatility has spread to the equity market as investors’ fears grow that the election will give no clear winner.
Protecting the value of pension schemes’ equity investments has always been important, but it assumes greater significance during such times of market uncertainty or volatility. There are a number of techniques pension schemes and plan sponsors can consider when trying to preserve the value of their equity investments.
Some of these can be employed on an opportunistic basis. However many schemes are also now considering putting in place more formal mechanisms. The ideal for many would be one that allowed them to participate in equity market rises but not to be overly exposed when they start to fall. Structures are now available which can provide such protection, while retaining participation in the long-term growth of the portfolio.
It is possible to create a structure that can provide assurance that the value of an equity fund will not fall by more than a predetermined amount. This should give the investor confidence that any equity losses will be limited to a level of their choosing. Significantly though, the structure still allows a level of participation in equity rises when markets are doing well.
The implicit cost of the protection provided by this “collar” structure, which uses derivatives, is met by sacrificing potential gains above a certain capped level. Trustees might consider such a technique when there is a specific time period over which they would like to protect their equity portfolio, such as a valuation period, or a known event that might trigger volatility in equity markets, such as a general election.
Another strategy that could be put in place aims to provide protection during short, but severe, market downturns, whilst still aiming to capture growth over the medium term. Known as a volatility cap, in its simplest form it seeks to limit volatility in a portfolio of risky assets, such as equities, to a maximum level, e.g. 15% a year. The prevailing volatility is regularly monitored and whenever it exceeds the “cap”, risky assets are sold for cash until the portfolio volatility falls back to the 15% level again. Once the volatility has subsided, cash can be reinvested in the risky assets to participate in any market recovery. By following this simple, systematic rule, the portfolio volatility should be effectively limited to 15% per annum.
A new cap to help protect against electoral squalls
For illustration only. The above results are based on a back test. The strategies trade once daily at the close of business. Indices used are the S&P 500 [Div Adjusted] (1928–1988), S&P 500 Total Return (1988–2012). Observations are for 12-month returns measured on a daily basis. These charts show the returns of the strategies applied to the S&P index.
An observation of –10% indicates the return was between –10% and –19%. Source: Bloomberg. Federal Reserve Bank of St. Louis and Schroders. As of 31 December 2013.
For schemes which require a higher level of protection, say to prevent losses of more than a fixed percentage, a variable volatility cap can be used. This works by automatically lowering the level of the volatility cap as losses rise, thus accelerating the move out of risk assets until the portfolio stabilises. Once the market starts to recover, the cap can be gradually lifted back to its original level, allowing the portfolio to participate in the recovery.
These are just two of a number of different approaches that may be taken to reduce the impact of short term market corrections, depending on what the scheme is trying to achieve, and for how long. We believe that, as the UK enters a period of political uncertainty, now may be a good moment for trustees to consider using one or more of them to help reduce their equity risk.
Betting the house on red: why doing nothing may be the biggest risk any pension scheme can take
The paramount risk faced by most trustees is not being able to fund their members’ pension payments. While many trustees want to reduce this risk by hedging their liabilities, it is easy to feel that there could be a more opportune moment than now. Speculation that rates may rise has caused some to put off the decision in the belief that both liability values and scheme deficits will fall as rates increase. The election may also be encouraging some trustees to wait for more political certainty before making liability hedging commitments. However, the decision to delay is a risky one.
Figure 1 shows the breakdown of a typical pension scheme’s funding level risk, measured by Value at Risk (VaR: see chart for definition). The key bar is the first one, which shows the total risk from changes in the value of the liabilities of the typical scheme and the reduction in risk likely to be achieved by the bonds and LDI assets held by the typical scheme to match those liabilities.
Figure 1: Not hedging is the average scheme's top risk
Example for illustration only. We have used VaR 95, a measure of risk which estimates the least by which a scheme’s deficit could increase in one year out of every 20. Average pension scheme asset allocation taken from Pension Protection Fund’s 2014 “Purple Book” and average level of liability coverage derived from KMPG LDI survey 2014. Total risk is lower than the sum of the individual risks due to the effect of diversification. Source: Bloomberg, KPMG, PPF and Schroders. As at 31 December 2014.
The chart demonstrates that the unhedged liability risk for a typical pension scheme is larger than all the other investment risks - from the growth assets such as equities and alternatives – added together. So, while most trustees recognise the need to diversify investment risk across a range of different assets, many may not be aware that they could be running a much bigger risk with their unhedged liability values. Essentially, these latter are a big bet on interest rates going up.
But even a rate rise may provide a false sense of security. Many schemes are under the impression that an increase in yields will automatically reduce liability values. Sadly, it is not that simple. The current interest rate curve slopes upwards for the next 10 years. This means that the market already expects rates to rise and has priced that expectation into the future cost of borrowing.
The implication for scheme funding is that interest rates must not only increase, but increase above market expectations in order to reduce liability values (red area in Figure 2). If rates remain at low levels or merely rise in line with expectations, funding levels will not improve, as illustrated by the grey area in Figure 2. In other words, remaining unhedged will only be beneficial if rates rise above market expectations.
Figure 2: What do interest rates price in over the next three years?
Source: Bank of England. As at 27 April 2015
So, by leaving their liabilities unhedged, schemes are making a large one-way bet on interest rates. They could lose out if rates do not rise as quickly as has already been priced in by the market. Adopting such a position might be compared to betting the house on a single turn of the roulette wheel.
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