March 2011

DEFINE YOUR LIABILITIES: splitting the portfolio

Define_your_liabilitiesLiability-hedging portfolios are poorly defined at nearly half of pension funds, and many have not defined their liabilities precisely, finds Samuel Sender of the Edhec-Risk Institute There is widespread recognition of the importance of asset allocation to investment returns and thus to pension fund performance. Since a 1986 study by Brinson, Hood and Beebower, asset management and asset/liability management (ALM) practices have undergone marked changes as many institutions now allocate significant shares of their portfolios to alternative assets such as listed and unlisted real estate, commodities, infrastructure and hedge funds. The recognition that pension funds seek first to cover their liabilities and then to generate performance has led to formalisation of financial techniques for their asset and liability management: portfolios are constructed with a liability-hedging portfolio to cover liabilities and a performance-seeking portfolio to generate performance. In addition to financial risk, pension funds are subject to non-hedgeable risks, usually biometric risks mainly longevity risk). Tentative steps to create a market for the transfer of these risks, in the form of  catastrophe bonds, longevity swaps, or securitisation, have also been taken. Recovery plans
Since the 1990s, pension fund regulation has grown considerably stricter. The 2003 European directive, the Institutions for Occupational Retirement Provision (IORP) allows underfunding for an undefined limited period of time” and in the main requires a realisable recovery plan. Some countries, such as the Netherlands, adopted a risk-based prudential framework inspired by Solvency II, the prudential regulation of insurance companies. The Dutch FTK requires a minimum funding ratio of 105% plus buffers against market risks. Although regulation was temporarily relaxed after the 2008 crisis, the overall trend has been towards tightening prudential regulations; at the same time, stricter accounting standards have made an impact on the accounts of sponsors of corporate pension funds. Stricter regulations have led to the development of risk-insurance techniques that focus on risk control through state-dependent asset allocation to ensure that minimum funding constraints are respected. However, no representative overview of the ALM practices of pension funds is readily available, since most surveys merely review the asset holdings of pension funds. A recent survey by Edhec-Risk Institute – EDHEC Survey of the Asset and Liability Management Practices of European Pension Funds taken as part of the Regulation and Institutional Investment research chair in partnership with Axa Investment Managers – examines the ways ALM at pension funds makes use of modern investment management techniques. In short, we assess the ways European pension funds define investment policy, how they implement it, and how its performance is analysed. We thus shed light not only on the conception of the ALM strategy but also on the way it is implemented. The survey of pension funds, their advisers, regulators and fund managers elicited responses from 129 of these ALM specialists, representing assets under management of around €3trn. Pension funds and their sponsors account for approximately €0.9trn. Pension fund stakeholders (trustees, pension funds, their sponsors and fiduciary managers) work, in the main, in ALM, risk management or investing. Analysis of the ALM practices of European pension funds spans three geographies: the United Kingdom, with its mix of traditional defined-benefit (DB) and full defined-contribution (DC) schemes; Northern European countries, including the Netherlands, characterised by hybrid pension schemes and regulations inspired by Solvency II and economic capital models – often referred to as traffic-light systems; and core European countries, such as Germany and Switzerland, with somewhat more traditional pension regulation. Hedging risk
Respondents in continental Europe generally have hybrid liabilities (28% in core Europe and 71% in Northern Europe), a reflection of the shift from traditional defined benefits to more hybrid forms such as funds with conditional indexation liability (some form of guarantee is almost always required). Hybrid schemes do not exist in the UK and many DB pension funds have been closed. The first challenge for pension funds involves covering their liability by hedging it away. Hedging liabilities away requires that a liability-hedging portfolio, a liability benchmark whose focus is on replication and which takes the definition and the characteristics of the liability as the main input, be defined. Deterministic cash flows or cash flows indexed to inflation can be hedged perfectly, but hedging more generally involves matching the sensitivity exposure of liabilities to traded risk factors such as interest rates and inflation. As it happens, the liability-hedging portfolio is poorly defined at 45% of pension funds, 25% of pension funds have not defined their liabilities precisely (they assert that their liabilities are not defined even though they are not full DC plans), and more than 30% do not define a liability-hedging portfolio at all. In addition, 60% of pension funds include hedge funds in this type of portfolio, which seems inconsistent with the very notion of portfolios designed to hedge liabilities. Reasons for failure
A reason for the failure to define a liability-hedging portfolio formally (45% of respondents do not fully identify one) and for the incorporation of hedge funds into them lies in the use of portfolio optimisation techniques such as economic capital (used by 30% of respondents) and surplus optimisation (used by 21% of respondents). These techniques do not require the identification of a liability-hedging portfolio and of a performance-seeking portfolio. Edhec argues that optimisation techniques that do not identify a liability-hedging portfolio run the risk of unintentional imperfect liability hedging. When pension funds do define a liability-hedging portfolio, the instruments it contains vary from one country to another. In the UK, formal indexation to inflation is the standard, and inflation-linked assets account for more than 20% of the portfolios of 64% of UK respondents; because there are caps and floors in the indexation formula – indexation to inflation in the UK, capped to between 2.5% and 5%, depending on the year of service of liabilities – inflation derivatives are the easiest way to replicate this non-linear indexation, and inflation derivatives account for 20% of the liability-hedging portfolios of 40% of respondents from the UK but for only 12% of those from continental Europe. Non-linear indexation to inflation is far less frequent in the rest of Europe than in the UK. Respondents from Northern European countries and from the UK rely heavily on swaps to manage their interest rate duration exposure: 54% of respondents from Northern European countries invest more than 20% of their liability-hedging portfolios in swaps, and 60% do so in the UK. The flexibility of swaps accounts for their popularity: in the UK they make possible accurate replication of a fully defined liability and in Northern Europe the matching of very long-term cash flows. In core European countries, Germany and Switzerland in particular, regulatory provisions bias pension funds towards lower interest rate duration on the asset side than on the liability side, a bias that may account for the lower popularity of swaps (33% of respondents from core European countries invest more than 20% of their liability-hedging portfolios in swaps). ©2011 funds europe

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