This has been the case for over 20 years and trustees are being urged to review the use of hedging strategies as we move into an era of higher inflation.
The concept of liability-driven investment (LDI) first emerged as a pension strategy in the late 1990s. A few years later, when UK accounting standards were changed in 2001 to require companies to mark their pension scheme liabilities to market, the adoption of LDI started to gather pace.
The use of hedging strategies accelerated further with the introduction of the Statutory Funding Objective (SFO) in the Pensions Act 2004 and subsequent changes in The Pensions Regulator (TPR) Codes of Practice. But the relentless decline in gilt yields also played a key role. Ever-rising deficits focused the minds of trustees and sponsors.
Advocating liability hedging strategies was like pushing on an open door. Debate centred on how to design and execute a plan that would increase hedge ratios. Some schemes adopted yield targets, some set funding-level triggers and others opted for mechanistic time-based approaches. Rarely did anyone ask whether defined benefit (DB) schemes were over-hedging.
The need to rethink hedging strategies
Our view is that things have now changed. Trustees and sponsors should be reviewing their scheme’s use of hedging strategies. Prior to the Ukrainian conflict, the prospective economic and market environment was one of higher inflation, higher interest rates and a cessation or unwinding of quantitative easing.
The crisis has unquestionably increased the probability of higher inflation. Central banks have not yet indicated that tighter monetary policy will be delayed, but even if this is the case, structurally higher inflation will make it difficult to sustain the near-zero rates we have experienced for more than a decade.
In short, with inflation caps on member benefits for all but a small number of schemes, and a much-reduced probability of lower rates and gilt yields, the absolute amount of liability risk has arguably diminished. The main challenge for schemes going forward could be generating adequate returns.
Liability hedging strategies will no doubt remain important. UK pension regulation makes hedging liability risk essential. But decisions on the levels of hedging for interest rates and inflation require more nuance, subtlety and finesse than automatically hedging all risks. Schemes and sponsors will need to embrace the fact that there is no universally ‘correct’ answer to the hedging problem, regardless of market conditions. There will be a range of answers based on individual scheme circumstances, market pricing, and emerging trends in economies and markets.
In this paper, we aim to provide a framework that allows schemes and sponsors to think differently about the liability hedging issue. This will enable them to develop a pension strategy suited to the range of possible economic and market environments that lie ahead rather than the environment of the past decade and a half. For many schemes, the answer to the question of whether they are over-hedged might well be ‘no’; for just as many, it might be ‘possibly’; for others, it will be ‘probably’. Whatever the answer, now is the time for all schemes to take a deeper look at liability hedging strategies.
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