While some DB plans are faced with the need to sell other assets to fund these needs, there are others where inflation sensitivity has declined, meaning they may reduce coverage.
Closed DB plans protect against rising interest rates by investing in liability-driven investment strategies, which include interest rate swaps and gilt reverse repos. As interest rates rose, the value of these gilt portfolios fell.
Some LDI managers currently only provide monthly data on their LDI mutual funds, which, given the current market volatility, is insufficient
Hemal Popat, partner at Mercer, told MandateWire, “The mark-to-market loss on the plan’s gilt repo assets creates significant collateral management challenges for LDI portfolios.”
Plans will also find their gilt repos and interest rate swaps more expensive to fund as the cost of borrowing has risen, he notes.
“But the collapse in the value of gilt portfolios far offsets these cost increases,” adds Popat.
The annual funding cost of gilt repos has increased by more than 1% since the end of last year – due to rising interest rates – but the value of LDI wallets has fallen by 30% in many cases during this period.
Aon, head of LDI, Dilesh Shah, said: “In effect, DB schemes use unfunded hedging using gilt repos.”
The gilt is repoed by the pension plan which agrees to sell the gilt with an agreement to buy it back at a later date at a pre-agreed price.
As interest rates rose, the value of gilts fell, meaning a pension fund must make up the difference between what the plan borrowed and the value of the gilt by posting collateral, Shah says. .
For most systems, moving additional collateral into this portfolio will be a relatively straightforward exercise.
Popat notes, “Many systems have a ‘cascade’ to obtain additional collateral for the LDI portfolio, but some systems may find they need to sell stocks or credits to realize this capital.”
Shah adds: “Large schemes have the necessary governance structure and have sorted out the cascade of safeguards needed, as well as determining their levels of interest rate and inflation stress. Plus, they probably have a separate account that will give them more flexibility.
However, smaller systems might not have as strong a governance structure or the necessary cascades of safeguards in place.
“These plans will then have to realize cash from the growth portfolio at a time when the value of those assets declines,” Shah said.
Given the rapid evolution of the current situation, it would be useful for pension plans to receive more frequent data.
Willis Towers Watson, Investment Consultant, Frazer Morgan, said: “Some LDI managers currently only provide monthly data on their LDI mutual funds which, given the current volatility in the markets, is insufficient. Weekly information would be more useful, he notes.
It is also useful to provide this data in an Excel spreadsheet rather than a PDF so that the data can be manipulated, he adds.
It may seem counter-intuitive, but current levels of inflation have reduced – compared to 2020 – the need for inflation coverage for plans with a 5% cap on their benefits.
Indeed, the sensitivity of the value of the liabilities to inflation will vary depending on the position of the forecast prices in relation to the ceiling.
The Challenges of Inflation Hedging
Morgan says, “When long-term inflation is in the middle of the range defined by the floor and the ceiling, liabilities are generally treated as more inflation-sensitive.”
In other words, if, for example, you had an inflation-linked benefit payment capped at 5% to be made two decades from now, and the current 20-year inflation swap curve implied inflation of 2, 5%, you would want to hedge against inflation more than you would in recent market conditions where implied inflation was above 4%.
“In some cases, LDI’s managers perform analyzes on a plan’s underlying liabilities. If the LDI manager has the required data from the plan’s actuary, he could update his analysis of the impact of changes in inflation on liability sensitivity in light of current market conditions,” says Morgan.
TPR: ‘Keep asking questions’ about investment strategies
The current economic malaise, and in particular the impact on liability-driven investing now that interest rates are rising, proves that it is especially important for trustees to continue to ask questions about their investment strategies, even if they seem “silly,” says Fred Berry, the regulator’s senior investment consultant, Pensions.
This could help plans adjust their inflation hedge more quickly, he adds.
Additionally, IDL benchmarks are normally specified in terms of interest rate and inflation sensitivity.
“But it would be possible to set the benchmark on the LPI – the cap and floor version of the liability – meaning you could then give the LDI manager direction to act as inflation moves in and around the ceiling and floor rate”, he notes.
In other words, the LDI manager could then automatically add a hedge when inflation approaches the midpoint, and remove it when it hits the cap or floor levels, he adds.
This article originally appeared on MandateWire.com