What is Liability Hedging?
The funding level is an important measure for the ongoing management of a defined benefit pension scheme. It is often a very volatile number as a result of a mismatch between the assets and liabilities which makes management of the pension scheme more difficult.
Liability hedging is an investment strategy that aims to make the assets of a pension scheme behave more like the liabilities. The result of this is a more stable funding position which provides the following benefits:
- More certainty over reported position and hence security for members
- More certain contribution level
- More effective investment strategy
Traditionally this has been done with bonds, but in the last few years there has been a large increase in the use of derivatives for the same purpose. Please see our Education section for further details on the mechanics of liability hedging.
How RMS adds value
We create bespoke liability hedging solutions for each client and provide a full service from initial education and consultation, to full implementation and ongoing management and governance.
Our approach to liability hedging is focussed around the following principles:
1. There is no "off the shelf" solution
- We know that every pension scheme is different, whether that is the liabilities of the scheme or the risk return requirements – a liability hedge should be tailored to the pension scheme’s requirements
2. Cost effectiveness
- We believe that the solutions we offer provide the risk reduction requirements for each client whilst being easy to govern and cost effective
3. Independence
- We are independent of any investment bank and have extensive trading experience. This means that we are best placed to execute the required trades and achieve best price.
4. Ongoing governance
- We know that every pension scheme’s circumstances and requirements change over time and as such the existing liability hedge may no longer meet the requirements of the scheme. We can provide ongoing governance and strategy support and are not afraid to advise on any changes in strategy that we believe will add value to our clients.
Liability risks
Pension Scheme liabilities are very sensitive to the assumptions made when valuing them. Interest rates, which determine the discount rate, and inflation which determines the salary and pension increases are two of the main assumptions that cause significant liability fluctuations.
Asset risk is often the main focus of Pension Schemes risk management strategies, but liability risk contributes to funding level volatility as much, if not more than the assets. Interest rate and inflation risks are examples of unrewarded risk in most circumstances i.e. we do not expect to get a positive return for taking this risk like you might expect from investment in equities, for example.
How liability hedging helps
Liability hedging aims to stabilise the interest rate and inflation fluctuations in the liabilities by investing in bonds and swaps that mirror the movement in the liabilities for changes in interest rates and inflation. Stabilising the funding level in this way makes planning easier when establishing future contributions, and prevents unexpected shocks in funding level deterioration. This increases member security and makes contribution flow more stable which is often preferable for Sponsoring employers and managing cashflow.
The swaps that we use in liability hedging are over the counter (OTC) derivatives which are traded with a counterparty bank. We have ongoing relationships with most of the major players in this market but no ties to any particular bank. Therefore we are in a position to implement the trade at a fair price and with the counterparty of the Scheme’s choice. To manage counterparty risk, we also facilitate the collateral process for the Scheme on an ongoing basis so that if the liability hedge has a positive value we have assets from the bank to cover this position. We also monitor the default probabilities and credit ratings of our counterparties to ensure they remain appropriate.
Liability hedging has been a hot topic in the press and many pension schemes are now employing this strategy to reduce the unrewarded risk in their liabilities. Government bonds have an important role in liability hedging but these are often of too short a duration to fully match the liabilities and involve tying up the majority of the Schemes assets in low return assets. The use of swaps mitigates both these drawbacks as the swaps can be designed to exactly match the liabilities and also frees up the majority of the assets to be invested as the Trustees deem appropriate to provide the required risk return profile for the Scheme.
We create bespoke solutions for each client and provide a full service from initial education and consultation, to full implementation and management. The liabilities of each Scheme have different characteristics and the Trustees objectives are often different. Therefore, our flexible solutions allow these individual aspects to be addressed in an efficient and cost effective manor. Our ongoing management and governance of these strategies also means that the portfolios can be updated for any significant changes in the liabilities or the Trustees objectives.
To see how your Scheme might have benefited from Liability hedging since your last valuation, take a look at our Liability Update Tool which enables you to estimate your current funding level now and what it might have been if you had had a liability hedge in place.