Analysis: The LDI analogy of pensions and airlines

EUROPE - The move to liability-driven investment strategies has been a hot topic over the last two years. But discussion with consultants has revealed pension funds are still not adopting the strategy's full process, even though the break-even rate on 40-year inflation has now hit a new high of over 4% and the liability risk for schemes is continuing to rise.

Whereas pension funds have been willing to adopt strategies which hedge long-term interest rate risk through the application of interest rate swaps, consultants say only the larger UK funds feel they are in a position to tactically apply the three elements of LDI diversification: interest rate risk, the use of alternatives, and inflation rate risk.

Robert Gardner, a founding partner at Redington Partners, says discussions with pension funds leads him to believe many trustees are either still not fully aware of the increasing risk creeping inflation rates could have on a scheme's liabilities, or they are choosing not to act because they consider the hedge "too expensive". Within the last year, he notes, long-term inflation expectations have increased by 70 basis points - the 30-year inflation rate has risen from 3.2% to over 3.78% in that time and the break-even rate of 40-year inflation has now topped 4.02%, according to Gardner.

More worryingly, he suggests, this has added approximately £56bn (€70.6bn) to the value of the liabilities of the aggregated pension schemes of the FTSE100, but many pension funds made a tactical decision not to act in 2007 because they believed the price of hedging through inflation risk swaps was already too high.

"In the last few weeks the problem has been exacerbated as the capital markets have become more constrained and volatile. Even the short end of the Euro swap market - which is usually highly liquid - has experienced much greater volatility than usual and the inflation market has suffered from the same effects of constraint and uncertainty," said Gardner.

"Inflation is expensive but the market was wrong at 3.00%, 3.20%, 3.50%, 3.70% and now 4.00. The risk is there for both interest rate risk and inflation risk. The mistake is to confuse strategy i.e. risk reduction with tactics i.e market timing," added Gardner.

Redington Partners uses the analogy of airlines to try and explain why many pension funds ought to hedge risks even where they themselves might consider them expensive or consider certain assets to be unrealistically priced. Florida-based Southwest Airlines announced last year it owned "long-term contracts to buy most of its fuel through 2009 for what it would cost if oil were $51 a barrel". The result at that time was to deliver hedges worth more than £2bn in November 2007 when the price of oil was around $90 a barrel, giving Southwest a comfortable cushion for its business liabilities. In contrast, other airlines - such Silverjet which is now reopening under new management but was in administration - have struggled to manage increasing liabilities on their operations and still continue to do so because of the rising price of fuel among other things, and yet the markets anticipates oil is unlikely to fall back to the $51 per barrel hedged by Southwest.

According to Gardner, this analogy is no different to the dilemma of pension funds as officials are also holding back from applying the strategies they believe should be applied for tactical pricing reasons.

Andrew Firth, investment principal at Aon Consulting, believes many pension fund trustees are aware of the risk they take in waiting for inflation pricing to fall. But they do so, he suggests, because many strongly believe the lack of day-to-day volatility means there is less immediate risk and the cost of hedging through 30-year swaps appears high when it has moved by over 53 basis in one year, from 3.34% to 3.87%.

"That is the reason pension funds are hanging back. They think the price is overdone and would rather wait for it to come back. However, many were arguing the same at much lower levels and there is ongoing debate as to whether long-term inflation will indeed fall markedly," said Firth.

"The problem stems largely from the supply-demand imbalance, with few natural payers of inflation to offset the receiving interest of pension funds, but many schemes are maintaining a watching brief and implementing triggers and will implement these if inflation drops.

"Because inflation is less volatile, there is not a desperate hurry for trustees to act. But if there are continually high inflation rates and it continues to move higher they may well reassess. Although you could argue that schemes have lost some ground since last year, interest rate risk is often a greater issue with higher volatility than inflation so they have tended to act on that first," he added.

Marcus Whitehead, head of investment services at Barnett Waddingham, notes part of the complication is many of its clients are schemes with £250m or less, so those managing the assets are more likely to be lay people who still face a huge education challenge to understand the complexities of LDI strategies and offerings on the market.

"It is a case of one step at a time, so some people dive straight in and fully hedge their fixed interest risk, but delay hedging their inflation risk. But for many trustees that was too much to comprehend. A large majority of trustees - albeit with requirements for knowledge and understanding - are altruistic lay people. Because of their role as investors, they have to ensure they understand and comprehend what they put in place," said Whitehead.

"There is a strong theoretical argument that if short-term volatility and funding stability are key for the employer, hedges should be put in place. Somewhere within this, [pension funds] have just focused on the fixed interest side, and taken the view that the worst that can happen is the inflation-linked increases on pensions get capped at 5% pa.

"If we see high inflation we could, under certain inflation scenarios, also see high asset returns. The small to medium-sized schemes are saying they are not going to this extra expense of hedging inflation risk because of the cap at 5% on inflation-linked pension increases and in their minds if they have growth assets that rise with inflation, they should benefit."

Firth's suggestion if employers are concerned about seeking liability hedge is pension funds might look to hedge 50-year inflation as the price on 5.65% inflation break-even effectively looks cheaper than the 30-year rate. But with fewer new buying opportunities accessible on the markets in recent months, pension funds have again found the tactics of doing so could be expensive.

The difficulty is, according to Whitehead, is many trustees are perhaps also eyeing the gains enjoyed during the 1980s when inflation rose but the value of assets went with it, when what the UK economy at least could face ‘stagflation' of high inflation and poor asset return.

"The finance director will often be the person who is looking at the big picture implications and trying to understand the behavioural issues. The 5% cap is less important to them," said Whitehead.

"Those not reading history will forget there is every chance if we go through high inflation and possible stagflation in the economy, it could be difficult. There is a chance, although this is my personal expectation, we could get that very high inflation situation but we have trustees who may not have that experience of the situation.

"People are trying to bank future income returns, but no-one can guarantee that return. As consultants, we can put forward that and options for dealing with it, we can give views and opinions and guidance, but at the end of the day it is the trustees who make the decision," he continued.

Redington's recommendation is clients ought to be applying some inflation hedge, whether it matches 25%, 50% or 75% of the risk, or at least apply at 2:1 ratio on nominal rate and RPI hedging.

But the experience at Aon Consulting, according to Marcus Hurd, senior consultant and actuary, is not only are trustees perhaps preferring to tackle interest rates first, but he has so far seen little evidence of inflation risk hedging becoming widely adopted.

"Some companies are doing a bit of both interest rate risk and inflation risk. What the actual proportions are as to how much are going on the full interest swaps and inflation swaps is not clear. But there is not a huge amount of experience of companies doing this. It is claimed over £1trn in business has been done, but I would be surprised if it anymore than £10bn," said Hurd.

"Given they are often lay trustees looking after the fund, they tend to hedge out their interest rate risk and a year ago [inflation] was perhaps not that big an issue for them. Very few trustees are prepared to go the full LDI. But it is a developmental market. They are looking for a comfort zone. They probably head in one direction and they perhaps look at alternative asset classes, rather than look at inflation rate risk.

"And the question of whether it is expensive should be changed to whether many will want to sell it. Not many suppliers are doing so," added Hurd.

His view is especially interesting because it differs from the experience of consultants at Watson Wyatt. Nick Horsfall, senior investment consultant, said nearly all of its clients - who are largely officials looking after schemes with more than £2bn in assets - now apply the full LDI strategy even though there have been supply issues because firms consider it important.

"Our view would be that unless we have got a real view of inflation falling, why wouldn't you hedge," said Horsfall.

"If you take 30-year inflation, the headline price might be 3.8%. But one way of looking at it is it really will be 3.8% and the market is pricing in the risk premium.

"The choice for trustees is do they accept the risk premium or not hedge it and accept the risk? Our generic view is take interest rate and inflation risk might be a rewarded risk, but less well-rewarded than other risks.

But given what is happening globally we are finding it harder to find swaps and having to do a lot more work through the primary market. When Network Rail did its recent issue, our clients bought more than half the issue. We are having to work hard to get the inflation hedge. Clients are still buying index-linked bonds and inflation swaps, but the market has gone down, the decision cost has gone up and the number of attempts to trade are reducing. Corporate supply from property and utility companies has not been there for the last 3-6 months.

"We used to get utility inflation but no-one is willing to issue. Banks and suppliers are still looking to package some of that inflation risk swap. But we do not expect quite as much supply this year as there was last year's £35bn," added Horsfall.

With the yield on long-dated bonds dropping again and the risk of ‘break-even inflation' rates widening further, the evidence being presented by consultants suggests although many smaller pension funds have delayed tactical decisions on managing inflation, there may now be increased need to do so, even if hedging supply has yet to reveal innovations to widen liquidity.

More information about how European pension funds view inflation is available in a special report of IPE's June edition.

If you have any comments you would like to add to this or any other story, contact Julie Henderson on + 44 (0)20 7261 4602 or email julie.henderson@ipe.com