Pension scheme liabilities are as volatile as portfolio assets and should be managed accordingly ahead of Basel III regulation, State Street Global Advisors (SSgA) said.
According to the asset management firm, for a theoretical scheme with a classic 60% equity/40% gilt portfolio and liabilities discounted at 30-year gilt yields, 46% of risk came from the liabilities, compared with 39% from the assets and 15% from the sponsor – the latter based on an annualised default rate (B-rated) over five years.
SSgA head of European liability driven investment (LDI) Raymond Haines said a combination of risk factors including low gilt yields, low interest rates, high inflation, increasing longevity and regulatory pressure had pushed up liabilities creating a “perfect storm” for investors as asset values have simultaneously dropped.
“We have been in the longest bull market in bonds with 20 years of rates going down… there is the same amount of volatility from liabilities as there is from assets,” he added. Haines explained inflation has exacerbated the problem as year-on-year RPI has been volatile in comparison with 10 and 30-year inflation swaps ,which represent the market’s expectation of inflation. Therefore, he said investors looking at the long-term inflation picture need to consider the liability risk to their portfolios because on the nominal side rates are at all time lows but inflation expectations have not come down nearly as far and have not been volatile.
From a regulatory perspective, the legal documentation for trading over-the-counter (OTC) derivatives under Basel III is evolving so schemes will have to increase the capital requirements for counterparty credit risk. SSgA said under the changes pension funds will have to manage collateral and post a variation margin which will change how they manage their LDI portfolios, which often use derivative instruments.
Pension funds do not usually hold a lot of cash in their portfolio as the return on cash is not comparative to other asset classes and so use other assets to post as collateral. They will also have to manage collateral and the variation margin, which will add to costs and complexity, said SSgA.
It added while banks will be the biggest beneficiaries from this by charging clients to manage assets, leverage will be reduced by the requirement for initial margin on centrally cleared contracts and pension funds will have to post more collateral.
However, this could create better liquidity, in the market according to SSgA senior LDI portfolio manager Ben Clissold, but there is no guarantee of this and schemes might have to enter into repurchase – or repo – arrangements for cash.
Comments