They all understood the challenges of balancing investment risk and return to meet their life insurance policy holders’ expectations. On Tuesday 2nd December 2003 they hedged the interest rate and inflation risk in their pension fund liabilities using derivatives in the form of a long dated interest rate and inflation swap.
Writing this blog now, in 2013, the idea of hedging liabilities is commonplace and many pension funds now use Liability Driven Investing (LDI) as a tool to invest and manage risk in their Defined Benefit pension funds.
Ten years ago, though, this was the financial equivalent of the Olympic high-jumper Dick Fosbury winning the High Jump Gold Medal with his “Fosbury Flop” technique at the Mexico 1968 Olympic Games . It was an unconventional, innovative and game-changing approach to managing investment risk between assets and liabilities in a pension fund.
Back in 2003, pension funds were open to new members and therefore flush with annual contributions; measurement of liabilities was opaque both from an accounting perspective on the corporate balance sheet and from an actuarial funding perspective. Remember, the accounting standard, UK FRS 17, which was a significant improvement on SSAP24, had only been introduced in 2001 but not fully implemented until 2005. Likewise, the Pension Regulator “tPR” had not yet been created. It was only set-up under the Pension Act 2004 and launched on the 6th April 2005.
Things were different
A decade ago conventional investment strategy design was focused on the asset side. The practice of Asset & Liability Modelling, and Management “ALM” was not widely used or well understood by the wider industry. Investment strategy wasn’t balanced. It was mostly focused on investing in equities with most strategic asset allocations based on a two-thirds investment in equities and one-third investment in bonds. However, many pension funds had allowed their investment in equities to grow to over 85% and just a small investment in gilts and corporate bonds (see Towers Watson Global Asset Study 2013 for a history of changes in asset allocation over the past decade). These gilts and corporate bonds were typically earmarked to back the pensions in payment
At the time, pension fund governance and investment committee time was focused on active management and the search for fund managers who could outperform their equity benchmarks; not on ALM or the overall investment strategy mix and its risks. This was because performance of pension funds was not focused based on the value of their assets and their relative investment performance. As most pension funds had similar strategic asset mixes, the difference in performance was often down to which fund managers were selected and performing well. In order to compare performance, and measure progress every year pension funds compared their relative investment performance using the WM Company data and index.
Friends Provident pension fund was one of the first to ask, what did it want?
“We want to protect ourselves against a fall in our funding position, due to a rise in our liabilities as a result of a fall in the real yield.”
This clear statement of their desired outcome led them to plan the design of a solution specifically for their pension fund.
Against this backdrop, Paul, Philip, Graham and the trustees decided to do the impossible and immunise the interest rate and inflation risk in the liabilities using derivatives. They were simply following Frank Redington’s advice from the 1950s:
“Frank Redington’s Immunisation Theory states that duration matching of assets and liabilities is the best way to protect against changes in interest rates.”
(Note thanks to Paul Cooper we learnt a lot about Frank Redington, arguably the UK’s greatest actuary, and inspired by his progressive and creative approach decided to name Redington Limited, in Frank Redington’s honour).
What would it mean if you could hedge your liabilities using derivatives?
The challenge at the time was that conventional wisdom was not to hedge. Below are three views widely held at the time:
“Everyone knows equities are the biggest risk”
“Why hedge at these levels? Both history and economical fundamentals suggest that the real yield will rise from here and is unlikely to fall below 2.0%.”
“Pension funds shouldn’t be using derivatives”
However, on Tuesday 2nd December 2003, the Friends Provident pension fund executed a thirty-year swap linked to the real yield (the difference between nominal interest rates and inflation). The purpose of the swap was to protect the pension fund against further falls in the real yield. The value of the swap was linked to a combination of long-dated interest rates and inflation rates.
The swap was designed specifically for the pension fund. The sensitivity of the swap to interest rates and inflation was measured to exactly mirror the mismatch between their assets and liabilities. Therefore, as long-dated interest rates fell and long-dated break-even inflation rose, the value of the swap rose in value.
The result was to stabilise the pension funding level with respect to changes in the real yield. Over the twelve months, as the real yield fell from just over 2.10% to 1.75%, the pension fund liabilities rose from £600 million to £635 million. Offsetting this rise the swap which had no value at the outset rose in value from £0 to £35 million. That’s because both the liabilities and the swap had an equal but offsetting sensitivity of £1million per a 0.01% change in the real yield.
The swap was executed between Merrill Lynch and the Friends Provident pension fund. The transaction was designed and implemented by Dawid Konotey-Ahulu and Philip Rose working very closely with Paul at Friends Provident. The trustees were advised by Mark Duke of Towers Perrin (now Towers Watson) and overseen by Richard Boardman who was working for Friends Ivory & Sime asset management (now F&C).
Then & Now
|LDI Managers||1||17 (in the UK)|
|LDI Mandates||1||Over 686|
|Total LDI mandate size||£0.6 billion||over £446 billion|
|Total Interest Rate Sensitivity (PV01)||£1 million||over £627 million|
|Total Inflation Sensitivity (IE01)||£1 million||Over £439 million|
“We always over estimate the change that occurs in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into in action.”
It will be interesting to see where real yields are in the next ten years. Will defined benefit pension funds be fully funded and fully immunised to changes in the real yield? Will individuals have access to LDI investment solutions, on their Defined Contribution platform, to help manage their income in retirement?
Reflection: On LDI’s 10th Birthday it is important to reflect on the lessons learned.
- Understand where you are and where you want to get to.
Friends Provident sponsor and trustees wanted to protect the pension fund from the risk of falling interest rates and inflation.
- Evaluate what might happen.
By measuring both the assets and liabilities sensitivity to changes in interest rates and inflation they were able make quantitative as well as qualitative judgements.
- Analyse the impact.
Using this information they were able to examine, discuss, debate the impact of hedging or not hedging the risks.
- Create a solution.
This then allowed them to plan and design a solution created to remove the risk without having to sell their equities and buy index linked-gilts, which is what Boots Pension Fund did two years earlier.
- Apply and implement.
The pension fund was only protected once the swap had been implemented.
- Share and remember.
Make sure this knowledge and understanding is shared and understood with all key stakeholders. For example, the company board and all the trustees and their advisors.