 By Jay Tikam, MD, Vedanvi Business & Risk Consulting
Banks and asset managers are playing an increasingly greater role in the de-risking of pension schemes. However, both industries are facing stringent regulation aimed at making them more resilient and systemically stronger. How will the role of these institutions change in the context of pension schemes and what are the likely implications for the pension fund trustees?
Many pension schemes are facing a shortfall because of falling equity values, lower interest rates and higher inflation prospects. Low interest rates increase the present value of pension liabilities and falling equity values reduce the value of the pension plan assets. With mortality improvements especially in Europe, longevity risk is a growing cause for concern for many of these pension plans as they may need to continue paying annuities beyond the plan assets being depleted.
Particularly for Defined Benefit Schemes, a complete de-risking in the form of a “buy-out” is potentially the best solution for the Trustees. A buy-out involves the transfer of all risks; however it’s also one of the most expensive ways to de-risk and remains unaffordable under current economic conditions. Pension schemes are therefore left only with the option to hedge the risks they face.
Liability Driven Investment Solutions
For investment risk hedging, the latest and most popular developments point to Liability Driven Investments (LDI). This is an investment strategy which not only ensures that assets grow sufficiently to meet liabilities, but dynamically links the assets to liabilities. Investment banks were instrumental in promoting LDI strategies and pension fund investment managers now offer dedicated LDI products.
LDI involves the hedging of interest rate and inflation risk in part or in full. The main objective of an LDI strategy is simply to meet or outperform liability streams. In essence, the liabilities of the defined benefit or other scheme become the very benchmark for outperformance instead of the more traditional asset based benchmark.
These strategies use sophisticated instruments such as swaps and derivatives to reduce balance sheet risk and improve capital efficiency. These instruments are typically over the counter (OTC) contracts making them flexible and easier to develop bespoke solutions. However, sweeping regulatory reforms proposed by regulators suggest that the financial crisis could not only dissuade pension fund trustees from using LDI solutions but may drive away the very creators of these innovative hedging solutions – the banks. Both regulations have the potential to increase the cost of derivative transactions but this will also mean higher capital requirements, demanding some operational changes to the banks’ business model.
Regulatory Reform and Impact on LDI Market
The European Market Infrastructure Regulation (EMIR) Directive which comes into force towards the end of this year, signals a move away from OTC to Central Counterparty Clearing Houses (CCP), mirroring the Dodd-Frank Act in the US. The rules are far from being finalised, but are aimed at reducing exposure to counterparty credit risk through inadequate collateralisation of trades. Counterparties will usually be required to post higher levels of collateral (initial or by variation margin) which will be held by the CCP. OTC derivatives that are not suitable for CCP clearing will continue to trade under bilateral agreements. However, they will be subject to more stringent reporting and prudential requirements. Such OTC trades will be required to be reported to electronic trade repositories.
Mandating central clearing could give rise to unintended systemic risk, so regulators have put in place more robust risk management and governance requirements that CCPs must demonstrably adhere to. This will increase their cost of operation, which they may well pass onto their clients.
Overall, EMIR is likely to increase the cost of LDI transactions and raise margin requirements (quantum and quality) which may make them uneconomical. Clearly, regulators are moving the industry towards standardisation, which is a positive move under current market volatility. However greater standardisation may mean that more complex pension schemes are harder to hedge exactly, leaving them open to some residual risk and making the LDI solution ineffective.
Basel III, being adoped in Europe through the Capital Requirements Directive (CRD IV), will impose higher capital requirements to non-cleared (OTC) derivatives transactions or derivatives with uncollateralised counterparties. This more stringent regulatory stance and a move by regulators to improve the liquidity and quality of capital may well dissuade banks from trading in this market.
Longevity Hedging
Pre-financial crisis, banks were taking an active interest in longevity as an alternate asset class, and many set up dedicated longevity desks to actively focus on this market. Especially for deferred annuities, the long duration of the liability payments meant that assets could be “sweated” to achieve far greater returns compared with liability payments, implying a healthy return for the banks.
Given the looming Basel III regulatory reform, many banks have been exiting this market due to stricter liquidity and funding requirements. However, this could bode well for some global insurers who would benefit their overall risk profile by taking on more longevity risk.
Although there is still a great deal of uncertainty regarding Basel III and EMIR, both are likely to impose challenges but also offer opportunities that could change the market for pension fund hedging.
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