Triggers can help pension schemes lock in their funding position and move closer to de-risking. Will these triggers play a role as QE starts to unwind? George Mitton reports.
Picture this: A defined benefit pension scheme is keen to sell its growth assets and de-risk – if the price is right. One day, the markets move in the scheme’s favour, and an insurance company offers an affordable quote for an annuity package.
A trader might seize the opportunity and sign the deal right then. But this scheme, like many others, must gain approval from its trustees, and their meeting isn’t for two months. The scheme waits,
and, in the meantime, the markets move against it. The insurance company’s quote is no longer affordable, and a crucial opportunity to de-risk is missed.
This is an all-too-familiar story for many defined benefit schemes, but there is a remedy. By deciding in advance the level at which the scheme will buy the liability matching assets it needs to “lock in” its funding position, the scheme can ensure it is ready to act quickly when it gets the chance.
The technique is called setting “triggers”, and their use has spread in recent years. But are triggers always a good thing, and can they play a role as schemes prepare for the potential winding down of quantitative easing?
Charles Cowling, managing director at consultancy JLT Employee Benefits, says triggers are necessary to help schemes make quick decisions. “Over the past four years, there have been a few times when pension schemes nearly locked in gains through buying annuities or matching bonds. Ideas were discussed, proposals were discussed, but by the time it had been through two trustee meetings and everyone was happy with the idea, the opportunity had been missed.”
Triggers are particularly useful in dealing with insurance companies. Annuity pricing is less transparent than bond and equity pricing. Insurers may be able to offer a good deal on an annuity if assets become available to them – but this good deal may only be available for a short period of time.
“Triggers make sense because they allow trustees to think about things in advance, and move quickly when market opportunities arise,” says Cowling.
Triggers can also help schemes decide when to buy inflation or interest rate hedging. At what price it is sensible to buy inflation-linked bonds, and on what terms should a scheme enter into an interest rate swap? Schemes can decide affordable levels in advance and set triggers accordingly.
These “market level” triggers can be useful in forward planning, though schemes should be wary of setting too many triggers, says Mike Walsh, head of solutions distribution and management, Legal & General Investment Management. “You could argue some people go too far and start to overcomplicate the triggers, and end up with maybe 40 of them,” he says.
“By doing that you're adding complexity almost for the sake of it. We generally work on the basis of six triggers. Short, medium and long inflation protection, and the same for interest rates.”
It is most common for pension schemes to set a funding level trigger. This will advise the scheme to buy liability matching assets once it reaches a certain funding level. In essence, the trigger tells a scheme when it can afford to de-risk.
Yet in recent years, schemes have found their funding levels going in the opposite direction to their triggers. A prime cause is quantitative easing, which has pushed down interest rates. Pension scheme liabilities rise when interest rates fall, meaning funding levels have declined.
Triggers have sometimes been counter-productive during these difficult years, says Marius Penderis, senior liability driven investment structurer, F&C Investments.
“Sometimes these triggers have been detrimental. In the last two years, we've seen falling rates, which have been moving against schemes. Triggers have been, to some extent, an excuse not to do anything.”
Penderis suggests some schemes did not set their triggers at the right levels.
“In the past few years, some schemes have set triggers too high, never de-risked and therefore been hurt, it has been a constant story.”
This may be changing, however. Faced with continued low interest rates, some schemes are taking steps to de-risk even at what Penderis calls “unpalatable” levels.
“It’s because the pain of things getting worse is greater than the pleasure of things getting better,” he says.
But what if Ben Bernanke, chairman, US Federal Reserve, follows through with its plans to taper bond purchases, and ushers in the end of quantitative easing? Investors in equities and bonds – pension schemes included – would suffer from an expected fall in asset prices. But on balance, the end of QE would almost certainly be good for pension schemes. It would be likely to lead to a rise in interest rates and a corresponding fall in schemes’ liabilities. Pension schemes may see their funding triggers hit even as equity and bond prices fell.
If QE were to end, there would be many effects on the market, and amid such turmoil, schemes ought to be ready to adjust their triggers, says Lucy Barron, LDI solutions strategist at Axa Investment Managers.
“You can't set them and just leave them for ever more. If you’ve got a trigger strategy in place, have your objectives changed, in which case you will want to refresh your triggers as a result? “Second, is the market going to do something that means your triggers will be hit in the future even without a fundamental change in the market price of these instruments?”
Barron says schemes must hold regular meetings to assess their trigger strategy in light of market movements.
“The key thing is monitoring,” she says.
Funding triggers are for now limited to defined benefit pension schemes, but in future, defined contribution schemes could employ similar techniques. Target-date funds are one example from the defined contribution world that could make use of funding triggers. As defined contribution scheme members, who are today mainly young, get closer to retirement, there will be more demand for inflation and interest rate hedging, though this will be done on a personal level rather than by scheme.
The need for funding triggers varies across Europe’s pensions market. In the UK, the use of funding triggers is rising as the country's many small schemes attempt to de-risk. Yet in the Netherlands, pension schemes have employed liability driven investment for 15 years or more.
“The Dutch central bank was closely involved with setting the Basel solvency rules,” says Jacqueline Lommen, head of European pensions at Robeco. “The people involved in this risk-based banking solvency system implemented the same principles from Basel to pension funds in the Netherlands. We have used asset liability management and liability driven investment solutions for a long time already.”
You could say the Dutch are already far ahead.
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