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Match of the day

Lower projected returns from equities and increased awareness of the potential frailties of defined-benefit pension schemes is leading many fund managers to place greater emphasis on liability management when considering their investment strategies.

The heady days of the 1980s’ and 1990s’ bull runs in the equity markets ground to a halt at the turn of the century and three years of negative returns preceded a period of poor performance from fixed interest that helped to drive many schemes into deficit.

On top of this, globally falling interest rates and inflation mean double-digit returns are widely considered a thing of the past.

The difficulty in holding sufficient lower-volatility assets to help match liabilities yet still provide decent asset growth is leading pension fund managers to focus more strongly on matching their liabilities by using derivatives and other tools to hedge out inflation risk.

Newton head of institutional business Mark Scott says the current situation was last seen in the early 1980s when interest rates were in the mid-teens and scheme managers were looking to lock in gains as opposed to today’s emphasis on avoiding deficit.

Scott says: “Locking in gains is an important part of liability matching but it is an easier decision if returns are high. Today, funds are only locking in fairly low gains.”

He says the key to liability matching has to be delivering returns that consistently beat inflation.

Hargreaves Lansdown head of pension research Tom McPhail says with most defined-benefit schemes sitting on 20 to 25 per cent deficits, a decision has to be taken whether to go 100 per cent down the liability matching route, thereby locking in that deficit, or to hope that equities save the day. Not an easy decision.

McPhail says: “If you match assets too closely, you lock in any deficit. The alternative is you stay overexposed to equities and hope the stockmarket rides to the rescue.”

Looking at the extent of the problem, McPhail points out only four companies in the FTSE 100 have defined-benefit schemes not in deficit.

The asset allocation strategy also has to take inflation into account.

Britannic Asset Management fixed-interest fund manager Eddie Middleton says: “Inflation risk is an important component of pension management. The traditional approach has been to invest in equities because they should have some correlation to inflation but the problem is you get a lot of volatility. We see a structural shift where in the current environment equity returns look less tenable.”

He says Britannic has reviewed and discussed the investment strategy of several of its pension funds with its clients. However, fund managers should not look at this as a replacement for asset allocation but a strategy that supports it and meets client needs.

Scott says Newton has held similar discussions recently and both Scott and Middleton have increasingly been using derivatives to hedge out inflation risk.

Scott says: “Schemes have liabilities with a duration of 40 years or so, so they require some fixed-interest holdings and a derivative overlay structure. Unless pension funds are in a critical state, though, you do not want to do that with 100 per cent of the assets because you will never be able to close that gap.

“If you can stay ahead of deflation, you are going to do pretty well at eating into any deficit and we are working on this through a couple of threads using multi-asset portfolios that target returns at least 4 per cent in excess of Libor.”

Given the length of the liabilities’ duration, there are no gilts sufficiently long-dated to match them so fund managers must dip into the swaps market.

Scott says: “Using derivatives is quite a steep learning curve that a lot of funds have to go through and take-up has been slower than the investment and brokerage community thought.”

Swaps are traditionally the exchange of one security for another to change the maturities of a bond portfolio or the quality of the issues in a stock or bond portfolio.

Middleton says using the swaps market can typically add several years to a portfolio’s duration exposure while keeping the assets in liquid parts of the market. “We are increasingly being asked to have input on how we structure a portfolio around liabilities and we find swaps up to 30 to 40 years’ duration are quite liquid and if anything add to rather than detract from the portfolio’s liquidity,” says Middleton.

He also emphasises the importance of getting the short-term positioning right as if managers lose sight of this because they are focusing on the longer-term picture, the latter projection can be rendered almost irrelevant.

Middleton says: “The 25-year assumption is fine but you need to look out over one or two years. If performance in the short term is poor then your long-term assumptions are less meaningful.”

However, Britannic Asset Management is not taking a view on interest rates although Middleton says the current asset allocation implies by default that rates are going to rise or at least not fall further as they are well supported at current levels.

A rise in rates could potentially be the saving of many pension schemes, Scott says, and should they go up by just 1 per cent this would have a sufficient knock-on effect on returns to lift many schemes out of their deficits.

He also believes a shift away from the industry’s historic UK bias to take advantage of global opportunities would help many schemes. High alpha, more concentrated mandates are also growing in popularity, says Scott.

Whatever strategies are chosen, difficult decisions lie ahead – the choice between sticking with equities or locking in a deficit is not a happy one to have to make.


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