• Two of the biggest risks affecting schemes’ funding levels are interest rate and inflation risk
• Punter Southall Investment Consulting urges smaller schemes to understand the benefits of Liability Driven Investment (“LDI”)
Despite sustained low long-term interest rates, the firm is urging schemes of all sizes not to overlook the importance of hedging against further falls, given the huge demand for long-dated gilts and bonds from both pension schemes and insurance companies, which could exert downward pressure on rates. Further quantitative easing or market shocks, such as Greece having to leave the euro, could also affect long-term interest rates.
Pension schemes have found their deficits soar in recent years, in particular owing to falling long-term interest rates. A sustained programme of quantitative easing across the world has helped push government bond yields in the UK down, leading to rises in pension scheme liability values. Over the same period, pension scheme assets have not been able to keep pace with this increase in the value of schemes’ liabilities.
According to Punter Southall Investment Consulting, there has been a significant increase in the number of pension schemes using Liability Driven Investment solutions (portfolios tailored to protect pension schemes against rising inflation and/or falling interest rates) over the last five years to stabilise funding levels, whilst supporting the expectation of further investment returns.
However, even with this growth, the number of schemes hedging these risks as a proportion of the UK market is still relatively low and it is likely that less than 50% of UK Defined Benefit pension scheme liabilities are currently hedged. The proportion is far less for many small and medium sized schemes.
Yet the development of pooled products and increased implementation efficiency now makes LDI much more accessible for smaller schemes. The investment consultancy believes that LDI should form an integral part of the investment strategy of a pension scheme wishing to manage these key risks, irrespective of market conditions.
Nick Harvey, Investment Consultant at Punter Southall Investment Consulting, said:
“It’s very difficult to predict a change in long-term interest rates, but whilst many pension schemes may be hoping for a material rise, this is unlikely in the short term. Furthermore, what is perhaps not always well understood is that when a scheme puts in place an LDI solution at the current time they are locking in to the market’s prediction of future rises.
“We currently recommend that schemes of all sizes consider hedging at least 50% of their interest rate and inflation risk, in the absence of any scheme specific circumstances that might oppose that view, to reflect the current environment. LDI is a very valuable tool for schemes and more trustees and sponsors could benefit from engaging with this kind of solution. Schemes need a clear picture of the level of risk they currently face to weigh this against the level of risk they are prepared to hold. Engaging with LDI can have clear advantages to schemes, helping to control some of the key risks they are exposed to and managing the volatility of their funding levels.”
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