By Colette Christiansen
For some time now there has been an expectation that base rates will rise, at least a little. The fact that this hasn’t happened and is now expected to be delayed further is good news for those of us with variable rate mortgages but bad news for pension schemes, very few of whom have fully hedged out interest rate risk.
The longer rates remain low and the slower they eventually rise, the pension scheme deficits that UK plc needs to make good on will only continue to increase. This clearly presents a challenge; with many plausible reasons why UK long-term interest rates could either rise, remain at current levels, or go lower, how can trustees best prepare for an uncertain future?
The good news is that they don’t have to suffer at the mercy of interest rate changes. The growth and advancement of liability driven investment (“LDI”) products over recent years provides a solution that can help create more stability for schemes, regardless of which direction interest rates go.
Historically most schemes held a proportion of their assets in gilts and bonds and this helped to form a partial hedge against interest rate risk. As schemes switched out of equities they increased their allocation to bonds. Such an approach makes it possible to create more interest rate hedging by investing in more bonds, but it is relatively capital inefficient: every £1 invested in a bond gives £1 of interest rate and inflation protection. Therefore, to increase the level of hedging, a scheme would most likely have to exchange some of its return seeking assets for bonds. This, in turn, had an overall impact on their predicted future investment returns.
However, over the past five years or so there have been significant increases in the number of pension schemes investing in more sophisticated LDI solutions. This comes as their need to stabilise funding levels in a low interest rate environment has become increasingly important.
Financial leverage sometimes has a stigma attached to it, but in this context the leverage is being used entirely for risk-reduction purposes. By moving from a traditional bond investment to a leveraged LDI solution, it is possible to increase the level of protection against interest rate and inflation risks without sacrificing return seeking assets.
Leveraged LDI solutions can typically provide around three times the amount of protection against changes in interest rates and inflation compared to traditional bond investments, through the use of derivatives, and consequently are a more efficient risk-reduction tool.
That’s not to say that hedging has to be an all or nothing decision though and many trustees are already hedging a proportion of their risk. Part-hedging in this way can arguably provide a good balance between risk management and choosing to hedge all your risks now only to find out you would have been better off waiting.
However, with much uncertainty still in the market, and given that removing volatility is now a priority for many corporate sponsors, hedging through leveraged LDI provides a welcome third way for schemes who previously were faced with one of two options: sacrifice potential returns or do nothing and be a hostage to rate rise decisions.
Colette Christiansen is head of de-risking at Punter Southall
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