The UK pension world has been shaken up by several high impact developments recently. New regulations and accounting standards have quite drastically changed the way pension funds perceive their risks. This has motivated many parties to look for an advanced and solid risk management strategy.

The introduction of the financial reporting standard FRS17 has sharpened the accounting requirements for pension schemes. Since 2005, this standard requires the deficit of single-employer schemes to be included in the sponsor’s balance sheet. An important element of the standard is that pension scheme assets and liabilities are to be valued using market rates. Due to this element of FRS17, which is in line with IFRS and similar standards in other European countries, the focus of pension funds has widened from assets only to the entire balance sheet, ie including the liabilities. Broadly speaking, before FRS17 was introduced, a pension fund reported a strong performance when the assets did well.

The liabilities, being valued using a fixed interest rate, did not contribute to the interest rate risk. Under the new reporting standard, however, the liabilities are highly sensitive to changes in the yield curve. In general, the volume and the duration of the liabilities are that large that interest rate risk and inflation risk make up for a substantial part of the scheme’s total market risk.

Another crucial development has been the introduction of the Pension Protection Fund (PPF) in April 2005. The main function of the PPF is to provide compensation to members of eligible defined benefit (DB) pension schemes in case of a joint default of the pension scheme and the sponsoring employer. In a way, the PPF can be regarded as a collective protection of existing pension plans, funded by compulsory levies on all schemes eligible for protection. These levies are risk based. In other words, the higher the risks a pension funds takes the higher the contribution to the PPF. Therefore risk reduction will be rewarded from a PPF perspective.

The new perception of market risk obviously triggers new strategies to reduce risk on a balance sheet level. In the past years, we have witnessed several parties reducing the interest rate risk and inflation risk by narrowing the duration gap between assets and liabilities. Some reduced the allocation to equity in favour of the allocation in long duration bonds, while others decided for derivatives strategies involving nominal and inflation-linked swaps. These so-called liability driven solutions are not unique to the UK, but are also applied by pension funds in countries like Denmark, the Netherlands and, more recently, Sweden.

Simply switching into bonds at the expense of the equity allocation is synonymous to abandoning the equity risk premium. Since the majority of the UK pension schemes are currently underfunded, keeping the equity risk premium is vital to fully grant the pensions in the future. For this reason, liability driven overlay strategies are often applied. Such strategies enable a large or full reduction of the exposure to interest rate and inflation risk without an adjustment in the assets. The advantages of a derivatives overlay are clear. Not only can the risk premium on risky asset be maintained. It also provides flexibility, liquidity and the possibility of tailoring the strategy to the specific characteristics of a pension scheme with only a limited number of transactions. Strategies involving derivatives, however, need attention when it comes to implementation.

Points of attention range from adequate ISDA documentation, a robust execution procedure and independently running valuation models to back office procedures including operational collateral management. Yet, in practice, medium-sized and large pension funds favour derivatives-based overlay strategies over other liability driven solutions such as pooled LDI solutions. Apart from the reasons mentioned above, this choice is also motivated by lower costs and higher transparency.

While liability driven solutions have received much attention in recent years, the focus of UK pension schemes is now starting to turn to equity. Traditionally, equity allocations in the UK are high and the resulting equity risk is often at least as large as the schemes’ interest rate risk. A straightforward way to reduce this risk is lowering the equity allocation. However, as stated earlier, it is widely accepted that the risk premium on equity is vital for pension funds in the long run. Since the liquidity of both plain vanilla and structured equity option markets is high and still growing, equity options offer a suitable alternative to reduce risk while the expected risk premium is largely maintained. A put option typically increases in value when the underlying equity index level drops. When a put is combined with the equity portfolio, the total sensitivity for negative equity returns is effectively reduced. The put option protects in those scenarios where protection is required, while it leaves the upside open in all other scenarios.

This is illustrated in the following stylised case for a British pension fund. The pension fund currently has a funding ratio of 93%. In the base case, fifty percent of the assets are invested in equity, the remaining fifty percent in bonds. An advanced ALM study is performed to assess the risks and associated returns for different equity allocations. With respect to the modelling of economic variables, ALM captures all relevant statistical characteristics, reflecting both historical market behaviour and recent market expectations. The model is tailor-made, implying that the specific balance sheet composition and application of policy rules are included. Furthermore, a hedge strategy using structured equity options is designed to improve the ALM risk-return profile. The analysis presented below in Figure 1 is a simplification, as several risk and return measures are considered simultaneously in practice. However, real-life cases have proven that the approach and results presented in this article also hold in practice.

In the base case, the pension fund is expected to have a funding ratio of 118 over the five year horizon. But the situation could also turn for the worse. Figure 1 shows that the pension fund also faces a probability of 4.5% that the funding ratio gets below 75 during a five-year period. The aim of the board is to reduce risk, while giving up as little upside as possible. The traditional way to bring down market risk would be to reduce the equity allocation. We choose an alternative approach instead, that hedges the so-called tail risks using put options. The optimal option strategy is based on an ALM study and generally comprises a series of tailor-made over-the-counter options. Figure 1 shows that the put option reduces the risk of low funding ratios quite well. The probability of a funding ratio below 75 is reduced by 80%, to 0.9%. For extreme risks (e.g. a funding ratio below 70), the option strategy does even better: that risk is completely eliminated.

It is interesting to see what risk reduction could be achieved, were the pension fund to decide to sell equity instead of using options. We assume that the equity allocation is reduced from 50% to 39%. When this allocation is chosen, the expected funding ratio is as high as in the previous case with option protection (see figure 1). This enables a fair comparison of the associated market risks. When the equity allocation is reduced, the probability of a funding ratio below 75 is reduced (from 4.5% to 2.8%), but the reduction is less than when options are applied (from 4.5% to 0.9%). The same holds even stronger for more extreme risk measures. In the example above, the focus has been on one specific risk and return measure, but other goals can be achieved as well. One interesting alternative strategy is to minimise risk under the constraint that the expected funding ratio remains unchanged. Figure 1 shows that this could be accomplished by increasing the equity allocation to 63% and adding a series of put options. While the expected funding ratio is as high as in the base case, the probability of a funding ratio below 75 is aptly reduced to 2.4%.

Managing equity derivatives is a fair bit more complex than managing interest rate swaps. To understand the fair value of a derivative, a good financial model is a necessity. The basic pricing formula for a put option may be common knowledge, but reality is more complicated. The option’s underlying asset is generally a basket of indices, not a single stock or index, as a pension fund will strive for an option on a basket of liquid international indices that serves as a good proxy for the equity investments.

The option term is quite a delicate issue: a strategy of short-dated options, with terms up to, say, two or three years, is often not efficient, as it over-protects against equity risk. But when options are too long-dated, say with terms over seven to 10 years, liquidity (and therefore price) becomes an issue. For proper valuation, implied volatilities and correlations between indices should be used, market variables that are hardly observable and difficult to obtain. When the currency risk for foreign equity investments is hedged, this should be incorporated in the option value by means of a quanto adjustment. Practice shows that pension funds tend to lack the required trading and financial engineering expertise and experience.

So, what’s in store for the months and years to come? Triggered by new regulations and accounting standards, pension funds have become aware of the substantial interest rate and inflation risk they run. Some parties have finished the implementation of a liability driven approach, others are currently working on it. For this purpose, derivatives have proven to be very useful instruments.

In due course, the focus of the pension fund industry will broaden from interest rate risk and inflation risk to equity exposure. Equity risk premiums are important to keep contribution rates low, balance sheet impact limited and pension schemes viable. Again, derivatives will play a pivotal role. Structured put options can be used to hedge the risks of equity positions. Such hedges should be based on the strategic objectives of the pension fund and its sponsor. Tailor-made derivatives strategies are typically designed by means of advanced asset and liability models. Both in the design and implementation phase of derivatives-based strategies specific expertise and experience are required. Special points of attention include the integration of derivatives in ALM, adequate transaction execution and operational implementation. Some of these points may be quite new to pension funds. However, practice in Denmark, the Netherlands and the UK has shown that a full implementation of a derivatives-based strategy can be successfully achieved.

Joeri Potters, Jeroen van der Hoek and Janwillem Engle are consultants at Cardano Risk Management, in Rotterdam (www.cardano.com)