A handful of UK pension plans launched liability-driven investment programs since the late 1990s in an attempt to control volatility in their funding position following sharp falls in equity markets.
Denmark's ATP plan began its liability-led investment program after the local regulator announced plan's to introduce fair-value accounting of pension liabilities.
A pension plan's funding position can be at risk in an environment of market-value accounting if the plan maintains a mainly unhedged fixed-income portfolio while facing long-dated liabilities, warned Henrik Jepsen, head of fixed income at Denmark's ATP plan.
Consultants and money managers based in the U.K. and active across Europe say they have been busy advising clients on swap-based interest rate hedging strategies and restructuring of fixed-income portfolios.
Executives at ABP Investments, Amsterdam, which manages ABP pension fund assets, are considering a range of liability-matching options, including increasing exposure to fixed income, more frequent changes in the asset mix and the use of interest rate swaps, said Wim Barentsen, head of economics and financial markets.
The issue will be discussed as part of an upcoming asset-liability modeling exercise that will factor in the new accounting rules, said ABP spokesman Michel Meijs. Results will not be published until later this year.
PGGM officials later this month will publish details of its most recent ALM exercise. The report will address how the fund plans to tackle duration risk, said PGGM spokeswoman Ellen Habermehl.
Trustees of the Akzo Nobel fund late last year agreed to adopt a liability-driven benchmark next January, according to Bob Puijn, director of financial assets at the plan.
As a result, plan executives will likely use a combination of interest rate swaps and longer duration bonds to try to reduce the current mismatch between plan assets and liabilities. Mr. Puijn would not say when this strategy would be implemented, but added plan executives were waiting to take advantage of an expected rise in interest rates.
ATP started using liability-driven investing in 2001, when the local regulator announced it would introduce market-valuation accounting for pension plans. The plan's liability profile is such that a one percentage point rise in interest rates could trigger a 45 billion kroner loss to the plan, said Henrik Jepsen, head of fixed income at Denmark's ATP plan.
"I guess you could say the swaps program was triggered with the move to market valuations," he said.
"If we had kept to the old accounting rules with liabilities at book value then, on paper, we would have been unaffected by interest rates. But it would have been very dangerous for our assets to have been facing that interest rate risk."
The ATP plan's 200 billion kroner fixed-income portfolio is now completely hedged. That hedge is a strategic target, and plan officials may reduce it slightly on a tactical basis in order to benefit from improved returns should interest rates increase.
"But our asset-liability model shows that in the long run, there is no expected gain from being unhedged. Unless you feel that interest rates will go up in a big way, it is hard to argue that we should be less than fully hedged," Mr. Jepsen added.
Trustees of the Metal Box Pension Scheme put an inflation swaps program in place in late 2003 to shield the pension plan from volatility in limited price inflation.
"Benefits linked to limited price inflation make up a significant part of the pension plan's liabilities," said Philip Read, Metal Box's U.K. pensions manager.
The swap program was put in place primarily to protect the relatively mature plan against inflation volatility and the risk of deflation, which Mr. Read described as "an unrewarded risk." He admitted it was expensive, as the LPI swaps market is relatively small and has capacity constraints not found in the more conventional interest rate swaps market. Practical challenges were the education of the trustees, the demanding legal documentation and appropriate collateral arrangements. Watson Wyatt Worldwide, Reigate, England, advised; Mr. Read would not name the two investment banks with which the swaps were done.
Plan trustees have now set the strategic asset allocation mix in two categories: liability-matching assets and return-seeking assets. The liability-matching assets are 52% of total assets, comprising a mixture of gilts, inflation-linked bonds, corporate bonds and the LPI swaps.
"The duration (of the bond portfolio) is not as long as the duration of the liabilities. It would be useful to take duration risk entirely off the table, but that will be difficult to achieve," said Mr. Read.
The 48% in return-seeking assets include global equities, private equity, property, hedge funds and high-yield bonds, he added.
Compared with other U.K. pension plans, Metal Box has been ahead of the curve in its investment decisions for a number of years. In 1999, the fund shifted a significant proportion of assets into bonds. In early 2000, the plan appointed specialist managers and a scheme-specific benchmark, dropping its balanced approach and peer-group benchmark. By that time, the equity exposure had been reduced to less than 50% of total assets, from 70% previously.
Jelles van As, head of investments at the Hoogovens pension plan, last year is believed to have launched an inflation swaps program and increased the plan's allocation to long-dated bonds. Mr. Van As would not comment for this article but said details would be published in the plan's annual report due later this month.
The €9 billion Blue Sky Plan, Amsterdam, which covers staff of KLM Royal Dutch Airlines, last year began buying inflation-linked global bonds and cut its exposure to euro-denominated government bonds to better match its liabilities (Pensions & Investments, Nov. 15).
But the plans that have taken actual steps to implement liability matching strategies represent only a small number of the plans in the U.K. and Europe, industry observers say.
"We know of no more than around 20 U.K. pension plans that have used (interest rate) swaps to lengthen the duration of their fixed-income portfolios, but the number will grow exponentially each year," said Alan Rubenstein, managing director and head of the European pensions group at investment bank Morgan Stanley, London.
"Extending the duration of a pension plan's fixed-income portfolio is one of the biggest decisions you can make as a pension plan. It's not an easy decision to be made in an afternoon," said Rik Brouwer, senior investment consultant at Watson Wyatt Brans & Co., Amsterdam.
