When institutions want to match their assets to their liabilities (i.e. their scheduled payments to pensioners), they have essentially two choices. They can invest in a portfolio of bonds that has the requisite payment schedule or they can use an “overlay” – a swap contract that can single-handedly modify the duration of the assets in order to match liabilities.
But while the swap idea sounds enticing (it allows pensions to maintain their existing portfolios), it comes with a cost. In this article from P&I, Goldman Sachs’ Chris Sullivan says many of their clients use swaps to start with and then opt to rejig the portfolio itself in order to match liabilities. It turns out the swap requires a lot of collateral. Reports P&I:
“Using an overlay strategy has a cost, however. The pension fund must post collateral for interest rate swaps. Many pension funds post a small amount at the beginning, then agree to post more collateral on the swap if interest rates increase. If interest rates decrease, the counterparty the fund negotiated the swap with pays collateral to the pension fund.
“Many pension funds are not familiar with using derivatives or the collateral issues that come with them, said Chris Sullivan, managing director and co-head of fixed income for Goldman Sachs Asset Management.
“Those pension funds often approach LDI providers with the vision of using an overlay strategy, then decide to make direct investments in fixed income instead after they find out how much collateral could cost the plan.”
SEI, however, seems to disagree. P&I reports that nearly all of its clients use swaps to match assets and liabilities. In fact, Jim Morris, senior vice president, global institutional solutions at SEI tells P&I:
“Of course a fixed income manager is going to want clients in an account where they can charge a fee…”