Pensions World

Are your hedges as well trimmed as you think? asks Anthony Hilton, Evening Standard

The great shift in investment philosophy in recent years in defined benefit pensions has been the change in emphasis from a focus on growing the assets to matching the liabilities. The use of swaps to hedge inflation and interest rate risks has become commonplace.

It has been big business for the investment banks who are the counterparty to these swaps and lucrative, too, because trustees for the most part are not equipped to judge whether or not what is offered is value for money, and their advisers are also probably more in the dark than they like to let on. The rule of thumb which they should apply is that if the investment bank is selling it, then it is wise not to buy at the price offered, but the reality more often is that trustees feel they have little choice but to accept.

Unfortunately trustees, who swallowed hard and accepted the fees because at least they thought they had made their funds safe, may be in for an uncomfortable awakening. When there is no volatility it is impossible to know whether a hedge will work or not because it is not under any stress. This will not be the case much longer. Inflation is already picking up and sometime in the next couple of years interest rates will also begin to climb back to more normal levels. It is then that we will begin to discover whether funds are as well hedged as they thought.

Rooted in assumptions

There is reason to believe several are not and their trustees are in line for nasty and expensive surprises. The swap can only be as good as the data on which it is based. Unless the liability profile given to the swap providers accurately reflects the real liability profile of the scheme then there is a risk of a mismatch. If this data is wrong, the swap will be wrong. It may over-provide or under-provide, but it won’t match.

No fund would make such an elementary mistake you might think, but the truth is that many have. Though trustees may not always realise it, pension scheme data is notorious for being late, vague and rooted in assumptions which may or may not be valid. The typical actuarial fund valuation for example is built on anywhere between 60 and 100 assumptions, few of which the trustees are even aware of.

One has to doubt whether the full significance of even the key six to ten assumptions is fully appreciated even when they are spelled out and it is explained that they can make a material difference to the outcome.

When it comes to swaps, the cash flow data supplied to the counterparty tends to be what comes from applying actuarial tables to the technical provisions – so it too is a generalisation. Likewise probably the interest rate and inflation projection – which could often come through as a straight line not a curve. The gap between those generalisations and the underlying reality is what could turn into an expensive nightmare.

Interesting development

It is for all these reasons that perhaps the most interesting development of recent months is the arrival of technology developed by Pensions First which makes it possible for trustees to follow the movement of assets and liabilities in real time. Those using the service can know the actual rather than the assumed position of the scheme almost to the hour and this, in turn, should allow much more precise and targeted response to scheme risks.

It comes too late for those who may find their hedges are not as good as they thought they would be; but it comes in time to stop others making a similar mistake.