By John Belgrove
For some time, trustees have been aware of the significant equity and interest rate risk within their schemes having witnessed an ever-increasing level of volatility in their funding levels these past 10 years.
Many schemes have taken, and continue to take, measures to protect against equity market risk by diversifying their growth assets and acting more nimbly. However, taking action to build or extend interest rate protection has often stalled in the education, the planning or even the implementation stages.
Interest rate risk is one of a pension scheme’s biggest risks. It refers to changes in a scheme’s funding position due to an adjustment in the level of long-term interest rates. Hedging this risk, by investing in assets or instruments that move in the same way as liabilities allows trustees to manage this risk.
However, even for those pension schemes that have taken action, the level of hedge is usually somewhat below their strategic long-term targets. Individual considerations for schemes are of course important, but on average, we think closed and frozen schemes should be hedging at least 70% of their interest rate risk.
Yet, still the vast majority of schemes have not taken sufficient measures to adequately address this risk. Why?
There are many different reasons for pension schemes not hedging interest rate risk, some common barriers being:
– Scheme size and the complexity of the investment tools
– Affordability and the need to invest in return-seeking assets; and
– Historic low interest rate levels.
Over the last decade the market has changed considerably with regard to liability-driven products. It used to be the case that only the largest schemes were able to access the investment tools necessary to efficiently hedge key financial risks. Nowadays the widespread availability of first class pooled solutions give any size scheme access to the required investment tools. Complexity can be easily overcome with the right support and training.
Also increasing hedging does not have to mean reducing return expectations. This is one of the most significant misconceptions. By improving the capital efficiency of the scheme’s matching portfolio you can comfortably simultaneously increase your hedge ratio and maintain the same growth portfolio allocation or indeed even increase it.
This leaves us with the thorniest of the three barriers mentioned – historically low yields.
Over a number of years we have seen gilt yields fall to record lows. During this time it was a popularly held view that waiting for gilt yields to rise would be the catalyst to extend hedging and on this basis, many trustee boards frequently concluded that any significant hedging activity should be delayed.
The market consensus is for a gradual rise in base rates as the economy gradually improves and short term rates gradually rise but it is long-term rates that matter to pension schemes. Last year saw a significant rise in long gilt yields or, more importantly, a significant rise in future interest rate expectations.
When a pension scheme de-risks and hedges out some of its interest rate-linked liabilities, it effectively locks into a certain interest rate, typically that on gilts or swaps. For trustees that have been holding off putting in place interest rate protection until rates rise, they may now consider value to be more reasonable. This wasn’t the case a year ago but by not acting now, schemes remain vulnerable to yields falling, staying flat or rising by less than the market expects.
Trustees would be well served by looking again at their exposure to interest rate risk and asking what is preventing them increasing their hedging levels now.
John Belgrove is senior partner in the Global Investment Practice at Aon Hewitt
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