Liability management of defined benefit funds
The below chart shows the estimated funding level of a sample DB scheme. We observe that despite poor equity market performance, funding levels are up by 12 to 18 percentage points in FY 2021-22. The reason is liabilities dropping by more than asset values due to higher discount rates. With DB funding at levels not seen since 2008, some DB managers may wonder how to “lock it in” by putting in place a sound liability management framework.
For a DB scheme that is fully- or more-than-fully funded, the obvious answer is to implement a fully funded liability-driven investment (LDI) program. Simplistically, that means investing 100% in assets – usually nominal and inflation-linked bonds – whose duration matches the duration of the scheme’s liabilities. In practice that may not be exactly achievable due to a shortage of assets with the appropriate profile, and derivatives and/or proxy investments may be required. The important thing is that the LDI hedges are funded. This means dispensing with the traditional asset allocation approach to investing, and only investing with a view to matching the liability profile of the scheme. The result should be that the assets and liabilities of DB scheme move in tandem. In the case of a derivative hedge, 100% of the exposure could be set aside in a cash fund, for example, so as to have a ready source of liquidity in the event of mark-to-market collateral calls. Recent events in the UK, outlined below, highlight the benefit of this.
For a DB scheme that is underfunded, a common approach has been to adopt unfunded hedges such as interest rate swaps and repo’d bonds to manage the liability exposures, while investing the assets of the scheme in higher returning assets such as credit and equities in an attempt to ‘earn’ its way back to a fully funded position. The main pitfall of this approach is that unfunded hedges need to be collateralised with cold, hard cash in the event of mark-to-market losses. In theory those losses are offset by an equivalent reduction in the calculated liabilities, but unfortunately that ‘gain’ on the liability side doesn’t produce any cash.
Events in the UK highlight the risks to unfunded LDI hedging. DB schemes in the UK have typically been under-funded, but regulatory pressures have nonetheless required them to hedge their liabilities. Since typically they hadn’t held enough assets to fully cover their liabilities, the only option was to hold large unfunded LDI hedges in the form of received nominal and real rate interest rate swap positions as well as long long-end gilts bought on repo1. However, higher yields lead to mark-to-market losses on those hedges and those losses need to be funded. While most funds hold sufficient reserves to withstand some movement higher in yield, the sudden lurch higher in yields on the back of the new government’s first mini-budget was the final straw. 30y gilts had already sold off around 260bp over the previous 9 months, an additional 150bp in 3 days(!) resulted in a system-wide liquidation of assets (for example the gilts that were causing the mark-to-market pain) as DB schemes scrambled to raise cash to meet margin calls, and forced the Bank of England to step in restore market order by committing to buy large quantities of long end gilts.
For a sponsor of a DB scheme there is a final alternative to embarking on a full-scale LDI program, and that is to “sell” the pension liabilities to an external party, who then takes all responsibility for the future pension obligations. Typically, the buyer of the liabilities will require the seller to transfer sufficient assets to cover the liabilities, so the scheme needs to be fully funded, and if not the sponsor of the scheme would be required to top-up the assets. For a corporate sponsor that approach may nevertheless be appealing since the DB scheme itself can be an unwanted source of earnings volatility, and it is unlikely that the company’s core competency is managing pension liabilities. Moreover, as demonstrated above, a typical DB scheme is likely to be in the best position it has been for many years, so even if a top-up is required, it is likely to be lower than it was previously.
Despite the UK experience, we think there is still merit in an LDI approach to managing defined benefit pension schemes, particularly for schemes where recent moves in interest rates are depressing liabilities to such an extent that schemes have reached more-than-fully-funded status. Even for under-funded schemes, LDI can be a viable strategy provided potential liquidity needs are adequately taken into account. Alternatively, moves in interest rates may finally put schemes into a position where they can “sell” their pension liability without having to top up the assets. Challenger Solutions Group offers advice and execution covering the full spectrum from direct LDI hedging to DB scheme buy-in/buy-outs, in addition to our more common defined contribution services.
The Solutions Team
The Solutions team provides derivative overlay and risk management fiduciary services to Asset Owners and Managers in Australia. Our goal is to provide asset owners and managers with an experienced overlay advisory and execution service to improve portfolio outcomes and cost efficiency.
1 Here a DB scheme effectively buys £100 worth of bonds and simultaneously borrow £100 using the purchased bonds as collateral.
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