This was one of the key findings of the pension fund insurer PPF’s research into investment strategy among UK pension funds, which was carried out by auditors KPMG on 95 pension schemes with assets totalling £191 billion.
“Our survey found that there has not been the headlong march into hedging that people first thought - a finding echoed in the UK’s National Association of Pension Funds' (NAPF) own research,” said PPF chief executive Partha Dasgupta at the NAPF’s annual investment conference on March 5.
Nearly half of the pension funds that responded to the survey, 39 out of 95, matched or hedged up to 10% of their liabilities with bonds and/or derivatives. Only four pension funds matched or hedged between 91% and 100% of their liabilities. However, Dasgupta expects this will increase in the long term.
“During the next year, our survey shows there will not be much activity in this area, although it will increase during the next 10 years, possibly as schemes realise the recovery plans they put forward to the Pensions Regulator,” he added.
Pension funds were expected to use more hedging strategies as more of them follow liability-driven investment (LDI) strategies. According to KPMG, it is now generally accepted that LDI refers to investments where a certain degree of hedging of interest rate and/or inflation risks takes place. This may be achieved through either a portfolio of physical bonds or a portfolio of bonds and cash with a derivatives overlay.
A move towards LDI among UK pension funds was spurred by changes to the UK Pension Protection Act of 2004, which came into effect in April 2005 and accounting rule FRS 17, introduced in January 2005. These brought pension funds’ assets and liabilities on to their balance sheet, and forced pension funds to calculate their liabilities using a discount rate based on AA-rated bonds rather than comparatively high long-term equity returns.
Similar regulations were introduced later in the US, affecting all non-public pension funds. The Federal Accounting Standards Board 158 accounting rules were in effect from the start of 2007 and the Pension Protection Act of 2006 came into force in January this year. This means the US pension funds are catching up to the UK in terms of implementing LDI.
“The US pension fund industry is three years behind the UK and Europe in terms of LDI implementation, primarily because pension accounting and funding rule changes happened earlier in Europe,” said Ryan McGlothlin, managing director at risk management consultancy P-Solve in Framingham, Massachusetts.
This means US pension funds have not had as much time or incentives to implement LDI, so their use of derivatives for hedging in this strategy is not thought to be as established as it is among their UK equivalents.
“I would estimate that less than 5% of US pension funds use derivatives-based LDI strategies, but that this number will grow quickly,” adds McGlothlin.