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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions: Best of both worlds

Looking at the last 10 calendar years’ performance of UK equities and gilts, a pension scheme with a 60% allocation to the FTSE All-Share and the rest invested in gilts would have yielded a total return of about 3% pa versus an expected return of 7% pa. This implies that schemes that would have used a prudent estimate of the expected return, say 5.5% pa 10 years ago, in their liability valuations would have seen their funding ratios drop by almost 30-40% by the end of 2009.

What would have happened if the scheme had invested 100% in gilts instead? In this scenario, the funding ratio would have still dropped by about 15-25%. The reason for this is the duration mismatch of the underlying gilts compared to the liabilities. A fairly broad selection of gilts would have a typical duration of 10 years, whereas pension liabilities are usually much longer with a duration of over 20 years. As a broad rule of thumb, a 1% fall in the valuation rate of interest would lead to a 20% increase in the value of the liabilities versus a 10% increase in the value of gilts.

Duration is commonly used to provide an estimate of the sensitivity of the underlying asset or liability to changes in interest rates. Therefore, we would expect a scheme that has its liability cashflows matched exactly with its asset cashflows to have no duration mismatch risk. However, it is generally not possible to obtain very long-dated fixed income assets in abundance, which provide a smooth cashflow profile matching the liability cashflow profile.

Currently, most defined benefit (DB) schemes are closed to new members and/or future accrual. Any deficits in their funding ratios have to be repaired by increased sponsor contributions and higher returns from growth assets such as equities, property, and so on. Unlike an open scheme, which can fund outflows using its incoming member contributions, a closed scheme needs money to pay its pensioners as and when their liabilities fall due. Hence, it is important that closed schemes have a specific investment plan in mind to ensure that they run a very low risk of not being able to meet these payments in the future.

Therefore, two main themes are very important for schemes in the current market environment:
1. Increasing the duration matching of assets and liabilities without having to reduce the allocation to growth assets

2. Monitoring and implementing a de-risking strategy to move out of growth assets into fixed income assets so as to meet the liability payments as they fall due.

So, how can we increase the duration of the assets without having to sell equities and buy gilts? The answer is by using synthetic equity. By synthetic equity, we imply a combination of assets/derivatives that could replicate the performance on physical equities. Examples of synthetic equities include:
>> Equity total return swaps (TRSs) — an over-the-counter (OTC) swap in which one party (the total return payer) makes floating payments to the other party (the total return receiver) equal to the total return on an equity index (including dividend payments and net price appreciation) in exchange for floating payments linked to LIBOR (London Interbank Offered Rate)
>> Stock index equity futures — a stock index equity futures contract is an exchange traded derivative whereby the contract parties commit to buy or sell a specified amount of an equity index at an agreed contract price on a specified date.

Equity TRSs are mainly used by large schemes that have relevant legal documents in place for OTC derivatives and would like the flexibility of using an equity index that is not available for trading in the futures market. TRSs also have the added benefit of investing collateral funds in assets other than cash.

Stock index futures, on the other hand, are simple low-governance structures, which can be used for small- to medium-sized pension schemes that would like to replicate the equity performance of common indices such as FTSE 100, S&P 500, and so on. Futures are highly liquid, do not require legal documentation related to OTC derivatives and involve very low credit risk to the London Clearing House. Costs involved in investing in stock index futures and rolling them forward at expiry is relatively low and does not involve stamp duty, which is incurred while using physical equity.

Therefore, a scheme could pretty much replicate the performance of the FTSE 100 index by investing in cash, for example, and have a FTSE 100 stock index futures overlay to provide exposure to equity. The cash provides liquidity for variation margin calls as the equity market moves over time. However, can something better be done with this cash? As all the cash on day one is not required for any expected variation margin payments in the future, a large proportion of it can be invested in fixed income assets such as gilts or index-linked gilts, as shown in Figure 1 (below).

The gilts and index-linked gilts provide a better match (relative to equities) for underlying nominal and inflation-linked liabilities respectively. So, such a structure has achieved better duration matching of liabilities without having the need to forego exposure to equity markets. Table 1 (below) looks at a scheme’s overall duration exposure before and after investment in an equity future structure described above.

For a scheme with a duration of 20 years, the asset allocation strategy that includes use of equity futures provides a duration match to the liabilities of almost 57% versus 25% (before use of equity futures). The most attractive part of this strategy is that market risk in relation to asset liability matching has been reduced without reducing the expected return on the total assets. So, a low risk and high expected return is definitely possible after all.

Many large schemes have bought billions of pounds of equity exposure using equity TRSs in the last few years. Smaller schemes that cannot use such TRS structures due to cost reasons have found UK asset managers mainly offering swap-based liability-driven investment (LDI) pooled funds as the main alternative. Only one or two UK asset managers provide a pooled fund solution with a synthetic equity structure.

Let us now focus on the second theme, the monitoring and implementation of a de-risking strategy. Every scheme should devise a de-risking plan that, as the funding ratio improves, exposure to equities is reduced by investing more heavily in fixed income assets. Figure 2 (below) shows how a typical pension scheme could have reached 100% funding ratio over time by de-risking at appropriate levels.

The scheme in Figure 2 started at an 83% funding level with an 80% allocation to equities. By transferring all of this equity allocation to an equity futures fund and implementing funding ratio triggers over time, this would lead to a path followed by the red line above. This path reduces the volatility of the funding ratio considerably as opposed to the orange line, which consists of 80% of equity allocation throughout. It also smoothly achieves a 100% funding ratio in five years’ time as a result of gradually reducing the equity allocation from 80% to 5%.

LDI has typically involved swap-based solutions, but synthetic equity products provide an alternate LDI solution for schemes wanting increased matching of assets and liabilities without having to forego growth assets.

A combination of synthetic equity products and a de-risking implementation plan can provide schemes with a robust plan to filling any funding gap and meeting the liability payments due, as and when required.


Nisha Khiroya works for F&C Asset Management in the LDI team