Currency hedging can expose UK defined benefit (DB) pension schemes to a significant level of liquidity risk, according to Railpen, the £34bn (€40bn) scheme for employees of the UK rail transport sector.
John Greaves, director of fiduciary management at Railpen, said that falls in the value of pound sterling versus the US dollar are “one of the biggest liquidity stress events that we think about”.
Discussing the benefits of illiquid assets in pension fund portfolios, Greaves said that the interaction between hedging, leverage, and illiquidity in portfolios needs to be carefully managed. However, currency hedging is often “the biggest liquidity drain”.
Greaves referred to the example of Canadian and Australian pension funds, which have large allocations to illiquid assets, volatile currencies and often large currency hedging programmes.
“Currency hedging can be a big risk to a portfolio. It is often not seen as leverage, but it is essentially another levered overlay on the portfolio. Currencies like the Canadian dollar or the Australian dollar tend to behave in a procyclical way, particularly versus the US dollar. This means that currency hedges are often out of the money when portfolios are experiencing a shock”, he said.
The same tends to happen to sterling investors that hedge their foreign currency exposure, as the British pound is also volatile and procyclical, argued Greaves.
“This wasn’t always the case in history but certainly for the last two decades or so that has been the case as the US dollar has emerged as the safe-haven currency for investors. Perhaps that will change again in the future”, he noted.
“Currency hedging can be a big risk to a portfolio. It is often not seen as leverage, but it is essentially another levered overlay on the portfolio”
John Greaves, director of fiduciary management at Railpen
A 2023 paper published in the journal New Political Economy estimated that as of 2021, UK pension schemes had roughly £300bn of derivatives exposure and that 43% of that exposure consisted of foreign currency forward contracts.
The paper, titled ‘UK pension funds’ patience and liquidity in the age of market-based finance’, said that it was likely that the majority of those contracts sell USD forwards to buy GBP.
In 2021, the Bank of England published a paper analysing the behaviour of UK institutional investors during the ‘dash for cash’ of the spring of 2020. The paper said: “A range of pension funds, insurers and investments funds had to meet large variation margin (VM) calls on their interest rate and currency hedging exposures.”
Railpen’s Greaves added: “Investment strategy is about balancing different risks, including illiquidity, leverage, and currency. We run quite extreme stress scenarios to test the resilience of our portfolio to make sure we can continue to steer the portfolio towards our objective of paying pensions in all market environments.”
As part of a study on the benefits of investing in illiquid assets, Railpen has identified the ideal share of illiquid assets for its open DB pension schemes today is between 30% and 40%. This is lower than the average among Canadian pension investors, which is over 50%, but higher than the average UK pension scheme.
The current allocation to illiquid assets for Railpen stands at around 32%.
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