Swaps: “The hand in the absolute return glove”

Liability Driven Investing (LDI) or Liability-Matching, as it is sometimes called, aims to produce a very specific amount of capital at a given point in the future.  Not unlike an individual’s own retirement fund, an LDI strategy aims to cover the future costs of paying a group of pensioners a pre-defined amount of money.  So even if a pension fund manages to beat the market, it might still fall short of its future commitments if, say, workers all live to 100.  Conversely, it might under perform its peers and still meet its liabilities.  To calculate a pension’s funding position, actuaries discount these future cash flows back to the present and compare them to the current value of the pension’s assets.  As a result, the discount rate used can have a dramatic effect on the present value of these future cash payments.

Unfortunately, pension sponsors have no control over the discount rates used for this calculation.  When rates go up, the present value of future payments to pensioners goes down.  When rates drop, the present value of those future payments rises.

While earning a steady return on assets may sound appealing, fluctuating liabilities would naturally lead to dramatic fluctuations in a pension’s funding status.  One solution has been to simply match all the future liabilities with bonds of an equal duration.  This way, when falling rates push up the present value of future liabilities, the bond holdings will also rise in lock-step.

Earning a steady return (for example, by investing in a low volatility absolute return strategy such as a fund of hedge funds) only makes sense if liabilities are also steady.  This article from April’s Global Pensions magazine makes this very point:

“These liabilities will change as long term interest rates change. If rates fall and the value of liabilities goes up, assets need to be going up too, or it’s tough times ahead. An absolute return strategy doesn’t give you that.

‘If an absolute return approach is giving you 8% year on year, it’s great in theory, but if interest rates are falling, meaning your liabilities are going up at 12% a year, suddenly 8% doesn’t look so good,’ warned (UK-based pension consultant Danny) Wilding.”

So what can be done about this?  As the article points out, pension plans can swap their (uncertain) future cash payments for fixed (certain) interest payments that will not fluctuate.  This way, both assets and liabilities are stable and unaffected by changes in rates.  For this reason, Global Pensions says such swap agreements could turn out to be the “hand in the absolute return glove”.

While Global Pensions refers to absolute return funds as something other than hedge funds and private equity (which are, coincidentally, “funds” that aim for “absolute returns”), the conclusion is clear:

“…they may be expensive…but managed well and partnered with a decent LDI or swap scheme, absolute return funds could provide a lot of pension funds with the stability and growth needed to pull them out of their often huge deficits.”

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