Special Report - Pensions Risk Management: Bull, horns, grab – getting a grip on pensions risk

“Trustees know that they have to get the scheme to a fully-funded position and there are only two sources of funds for this. Either they get the funds through growth in the asset base, or the company puts the money in,” says Mercer’s MacLaughlin. It follows that if trustees want to reduce the proportion of equities in the scheme from 50%, which is the proportion followed by many schemes today, to just 30%, they know they are going to have a very difficult conversation with the FD.

“FDs are all for reducing risk in their pension scheme, but they cannot endure the additional funding costs of moving out of growth assets, such as equities, to that extent,” says MacLaughlin.

Floored thinking
One way around this might be for the FD to persuade the trustees to give away some of the anticipated growth in return for putting a ‘floor’ on some of the downside. The way this works, MacLaughlin explains, is that a fund provider might agree to indemnify the scheme against losses of, say, more than 10%. The scheme then agrees to limit its share of any market gain to, say, 6% per annum, with the rest going to the provider.

That way, the FD and the trustees neutralise some of the downside risk, while retaining the chance of gaining 6% per annum growth. It is worth pointing out that many of these kinds of deals will only offer a limited floor. This means the scheme would bear, say, the first 5% of any downward movement in the market. The provider would bear the next 20%, but if the market fell more than 25%, then the scheme takes the rest of the loss. The attraction of this kind of arrangement is no upfront costs to the scheme ­ and it is protected as soon as the deal is signed.

Another approach to retaining growth assets, but trying to de-risk equities, is to move at least part of the fund to a more sophisticated “total return” strategy that is not wholly predicated on global growth. As Christopher Nicols, a member of the Global Absolute Return Strategy fund team at Standard Life Investments explains, what the recent crash showed was that when market conditions become extreme, many of the usual approaches to de-risking an investment portfolio through diversification techniques simply fail.
A good part of the reason for this failure was that so many of the strategies being deployed in these so-called diversified portfolios were all dependent on the world continuing to grow at a reasonable rate. As soon as global growth crashed, the correlation between all the strategies became obvious.
Part of a new modus operandi with this lesson in mind, Nicols says, is for pension fund managers to look to funds that find investment strategies based on underlying patterns, such as the relative volatility of two markets, the German DAX and the FTSE indices being two examples. The DAX has fewer stocks than the FTSE, so is typically more volatile.

However, there are occasions when the reverse is true. Structurally, this has to happen again over time, so using derivatives to exploit these anomalies generates strong returns for the fund whatever global growth happens to be doing.

That is just one strategy among many. The point is that this kind of fund does worse than a pure buy-and-hold equity fund when markets are rising strongly, but outperforms strongly when equity markets crash. Nicols says that since the crash, the fund has seen very strong inflows from pension funds, with many funds choosing to invest between 5% and 10% of their portfolio with the fund in the first instance. Again, an FD has to have an excellent relationship with the trustee body, and be able to make the case in some detail, to push through this kind of de-risking shift in the fund’s investment strategy.

Turning to interest rate risk, Punter Southall principal Danny Vassiliades points out that trustees and pension funds generally like rising interest rates, as when interest rates rise the discount rate rises too, so the scheme’s liabilities are discounted to a greater extent. One of the advantages of the LDI strategy, Vassiliades points out, is that if a trustee body was lucky enough to have a fully-funded scheme that was wholly matched, bonds to liabilities, then although a rise in interest rates would hurt returns from bonds it would diminish the liabilities by a matching amount: the effect would be neutral.

However, since we know most schemes are far from having a perfect LDI plan implemented, if the company and the trustees want to take interest rate risk off the table, they have the choice of either looking to be 100% hedged against falling rates, which is expensive, or simply taking a view on interest rates. The former costs money and only time can tell if it turns out to be a good or a bad move, but it will remove the risk. The latter approach is to accept the risk and for the trustees and the company and their advisors to form a view of where in the yield curve they expect interest rates to move. “This is a perfectly legitimate approach but it is an investment approach, taking a position on interest rate movements, rather than being about removing risk,” says Vassiliades.

If the FD and the trustees are not going to remove all risk absolutely by going for a buyout, then each chunk of risk you remove from the scheme will cost you money. “You can go in for a range of swaps, including interest rate swaps, inflation swaps and life insurance swaps, but you have to bear in mind that swaps always have a counterparty and that counterparty is someone who is taking a diametrically opposite point of view from the one you are taking,” says Vassiliades.

Take a punt
But this does not mean swaps are pure punts. Take inflation rate swaps. Pension funds have inflation rate exposure so they want assets that are fully exposed to inflation and increase in value along with inflation. Vassiliades points out that there are organisations that already have lots of inflation exposure and want to sell it to diversify their risk. Banks sit in the middle and arrange a deal between the parties on either side of the swap.

The one risk Vassiliades says funds are struggling to dispose of is longevity risk. “The problem here is that it is very difficult to find natural counterparties for a longevity swap. It comes down to some hedge funds and private investors deciding they are happy to write these contracts at a price where they think they can see a return.”

Vassiliades points out that another dilemma currently bedevilling the pensions market is an anomaly around risk and the strength of the employer covenant. “As an FD, you have to balance the fact that you want your fund to generate a return, against the fact that return-seeking assets can also go backwards and worsen your funding position. If the company is weak and could not cope with a poor scenario of very negative returns, then the trustees should not allow the employer to set out a high returns strategy,” he says.

However ­ and this is the anomaly ­ if the employer is wobbly and it looks like it will take many years to get fully funded even to the level of the Pension Protection Fund (which provides reduced benefits to members), then trustees might be tempted to say: “The only way we can do better for the members in this situation is to be very aggressive in our return-seeking strategy and hope it pays off.” So, in a perverse way, the existence of the PPF can mean that the weakest and worst pension schemes are incentivised to take maximum risks with their investment policy. Only politicians can create this kind of scintillating unintended consequence.