FTfm article on swaps and liability matching
by Dr. Ros Altmann
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Trustees are being encouraged to switch into bonds, as a way of reducing ‘risk’, on the premise that pension liabilities are more like bonds than equities. The traditional over-reliance on equity returns has failed, largely because trustees were aiming to ‘manage returns’ and ‘take risk’ rather than actually ‘managing’ risk. Trustees ignored the fact that equities carry two kinds of risk, but they can only expect to be rewarded for one of them. The ‘risk premium’ for volatility should be rewarded, but the risk of equity returns not actually matching pension liabilities was not explicitly recognised.
Switching to bonds in an effort to match liabilities more closely could be compounding past mistakes. Although pension liabilities may be bond-like, they are not bonds. Conventional fixed income markets cannot properly match the pension liability risks of duration, mortality, credit, salary inflation and limited price inflation (lpi). Increasing bond weightings and chasing the scarce supply of gilts could even make deficits worse over time. Trustees must find more sensible liability-driven investment approaches.
Using swaps and derivatives can help trustees control returns, control downside risk and explicitly consider liabilities when setting investment strategy. Swaps are far more liquid than bonds and, if implemented correctly, are probably the best way to reduce many of the specific risks faced by pension funds. Trustees need to understand how to use them successfully to immunise pension fund portfolios against interest movements and specific inflation risks. Of course, swaps can help, but they are complex and costly and there is still a need for additional returns, to cover mortality, salary inflation, and perhaps to plug a deficit, if the sponsor is weak.
Incorporating swaps into a structured approach could ensure pension assets grow in line with lpi-linked pension obligations and also deliver significant extra expected returns, to help repair deficits and cope with rising longevity.
Structures can be designed so that the very worst outcome would be the full return of the initial investment adjusted for accumulated lpi. Thus, after 15 years (or other duration of the structure) trustees will have enough money to meet the pension increases – and hopefully much more. This would be a three-stage strategy:
- lpi swap
- Zero coupon bond
- High return alpha generating investments (possibly leveraged)
Assume the pension fund invests £100million in this structure.
1. SWAP AGREEMENT:
An lpi swap agreement is signed, which will deliver £100million adjusted for limited price inflation on maturity (e.g. 15 years). Current market inflation expectations for the next 15 years are around 3%. This means that, on maturity, the trustees must pay 155million in exchange for £100million adjusted by lpi. Effectively, the trustees are swapping a fixed 3% per annum interest rate payment in exchange for the annual lpi increase over the next 15 years, whatever that turns out to be. It is the counterparty that takes the risk of lpi being greater or less than 3%. The trustees no longer carry that risk.
If inflation is above 3%, a counterparty may lose money on this deal, but if inflation is below 3% over the 25 years, the counterparty makes money on the swap (depending on how much is hedged out elsewhere in the market). Trustees, however, do not mind what the inflation rate is, they just need to be sure they can pay members’ lpi-indexed pensions and the swap ensures they should be able to do this.
2. 25-YEAR BOND:
The trustees need £155m, to pay for the lpi swap on maturity. With long rates around 4.3%, discounting £155million by 4.3% over 15 years, gives a cost of around £82million today. So trustees could buy a zero coupon bond now for £82m, which will deliver the required £155million.
3. HIGH RETURN ASSETS:
Having used £82million of the original £100million to secure return of initial capital plus lpi, there is still £18 million left over. This £18million can be invested in ‘riskier’ assets, aiming to deliver high returns. The trustees will only be taking risks they expect to be rewarded for, and these ‘risky’ investments could also be leveraged to provide added performance potential.
Unlike when buying index-linked gilts, trustees have the prospect of much higher investment returns from ‘risky’ assets (for example small cap equities, hedge funds, currency, absolute return) and can also receive the lpi they need (index-linked gilts only deliver rpi). All they have given up, in exchange for this, is the real yield on a 15-year gilt. As real yields have plunged below 1%, the opportunity cost is very low.
The main problems with swaps are their cost and complexity. However, if a structured product handles the administration, ISDA agreements, collateral posting, monitoring and execution, trustees would not need to be concerned with these issues. The crucial element will be to find reliable, experienced providers to handle the investments and structure.
It is vital that trustees start to consider these modern investment approaches, rather than simply trying to reduce risk by switching to bonds, which entails an enormous reduction in expected return and still cannot match liabilities properly anyway.
Modern money management has enormous potential to help trustees manage their assets in a much more controlled manner, focussing on actually paying the pensions. Just switching to bonds is not the answer.