Michael Sher looks at the potential benefits of hedging strategies in controlling risks
When it comes to defined benefit (DB) pensions, companies like BMW and Rolls Royce are driven to do similar things to Diageo and Coca Cola. British Gas and BP are similarly switched on. And along with BT too, all of them have received the same message.
That message is: increasing pension deficits can turn the lights out on growth; they can shrink the dividends that investors thirst for; and they can lead to trustee involvement in the execution of company strategies.
Liability hedging is the 'art' of mitigating these unwelcome issues. It uses assets and/or derivatives to compensate for changes in liabilities. As a result deficits become more stable, enabling trustees, CEOs and CFOs to sleep better.
How is it done?
Pension liabilities are typically exposed to a wide range of different risks, including: changes in nominal interest and inflation rates, equity volatility, changes in average member longevity, and changes in credit spreads. Liability hedging offsets these exposures by utilising a wide range of tools.
A short list of some of the tools available and how they are used in practice is shown in the table below.

Hedging has costs
A well-tailored hedging strategy can provide mitigate the mismatch between assets and liabilities; however, there is no such thing as a free lunch.
A pension fund selling equities and buying gilts will reduce both its market risk and its nominal rate risk. However, expected returns from its asset portfolio will go down, leading to higher contribution requirements. Such a strategy can only be considered a success if the increased contributions are agreed to by the sponsor.
In practice, it is often the case that the hedging tools chosen will interact with each other and with valuation parameters. In best-case scenarios, these will all act together to reinforce the desired effects, though it is common that not all do.
Hedging in practice
Market conditions will affect the price of, availability of, and perceived need for, different hedging tools. As a result, the optimal strategy will vary with market conditions.
When conditions are favourable, trustees may choose to quickly execute simple derivative overlays and asset switches. When conditions are unfavourable, trustees can adopt other strategies to achieve the desired degree of hedging at an acceptable cost. Asset switches commonly result from a decision to accept lower expected returns in exchange for lower market risk.
Other strategies available include complex derivative strategies - which may quickly achieve a lesser measure of hedging at a lower cost - and simpler rule-based strategies that can achieve hedge aims over a period of time.
In this article we discuss rule-based hedging in more detail. The concepts of this approach are outlined below and include practical illustrations of the strategy.
Rule-based hedging
Rule-based strategies are commonly opportunistic in nature. They have three components:
1. An overall target for the exposure to be hedged. This avoids over-hedging, which would introduce a risk that is the inverse of the original risk.
2. A trigger level, or a series of trigger levels, governing when hedge execution can begin. This is set so that the ultimate cost of hedging, once the overall target is reached, is acceptable.
3. A limit on the volume of hedging that is permitted in a week or other pre-defined period.
Having several trigger levels allows the hedging to be accelerated when market conditions turn more favourable. In contrast to this, having weekly limits causes the hedging to take place at a slower pace than it would otherwise.
The imposition of weekly limits affords stakeholders the breathing space to consider developing market conditions and make timely changes to the hedging strategy.
As an example, we will consider the rule-based hedging of nominal interest rates. The example fund has a liability valuation discount rate of 4.5% and liabilities with an average duration of 20 years. It has therefore chosen 20-year nominal rate swaps and asset switches as its hedging tools. It also has sponsor approval to do some hedging when rates are at least 4%.
The diagram below shows the fund's implementation of opportunistic rule-based hedging. The rates are monitored continuously and hedging is executed whenever trigger levels are reached, at the discretion of the asset manager, subject to the overall notional limit described, which is higher for the higher trigger level. The fund also has overall limits on the notional hedging when no further hedging or asset switches will be carried out
RULE-BASED HEDGING

If nominal rates exceed the valuation discount rate, the pension fund is in a good position. It can afford to 'lock in' those rates by hedging, with no impact on contribution rates. This is a specific case of a useful general principle: when returns on hedging instruments exceed the valuation rate, the fund can de-risk at no extra funding cost. It no longer needs the higher returns from riskier assets to meet its long-term growth requirements.
Other considerations
In practice, external advice on hedging often adds value and can be readily obtained from potential swap counterparties, asset managers and consultants. A sponsor or trustee with an in-house understanding of the risks and costs of hedging is well-placed to derive its own hedging strategy. Alternatively, they may invite external parties to make suggestions and decide upon which is best for its scheme and sponsor.
Finally, it is worth noting that hedging can be of benefit to all entities with long-term financial risks, both inside the UK and beyond. Other entities that commonly use hedging include banks - both retail and investment banks - insurance companies, and companies that manage infrastructure under contracts from governments.
Summary
Hedging is a powerful way of controlling risk and several tools are available. Be aware that even simple hedging strategies can give rise to material costs, so the decision to hedge - or to change one's existing hedges needs to be a considered one.
In formulating the strategy that optimises the potential benefits for all parties, it is valuable to consider combining both internal and external experience and expertise.
Michael Sher leads the capital and risk strategy team at Kol Tov Consulting