Dynamic hedging: the best of both worlds

The benefit of a liability hedging strategy is that it provides funding level stability while maintaining full exposure to balanced fund returns.

By Johan Kriek, Head: Liability Driven Investments

Conflicts between pensioners and fund sponsors (employers)
In our previous article on this topic, Time to shift gears on LDI, we argued that unpredictable, low-return markets lend themselves to strategies which provide more certainty on meeting the pensioner promises made to fund members by their employers.  Importantly, we highlighted that traditional balanced investment strategies, while best suited to generating inflation-beating returns over the long term, may lead to volatility in funding levels if future investment returns are poor.  This decrease in funding levels, even leading to funding deficits in some cases, increases the financial strain on the employer (given that they are required to make good any shortfall).

And this is the crux of the conflict that often emerges between employers and pensioners:  pensioners are looking for higher exposure to riskier, return-seeking assets (which should translate into higher pensioner increases over time) while employers are looking to minimize the probability of having to make good any deficits that emerge. 

Traditional approaches to addressing these conflicts

1. Cashflow matching

One way in which traditional approaches to liability-driven investing have tried to manage this conflict is through matching a portion of the fund’s liabilities, with a common approach being to match the first number of years’ pensioner cashflows (‘cashflow matching’ strategies).  This approach essentially uses LDI techniques to remove the interest rate risk on a portion of the fund’s liabilities.  Given that not all of the fund’s liabilities are matched (and assuming that the fund is adequately funded at the outset), the remainder of the assets can be invested in return-seeking assets.  Under this approach, one is able to satisfy the concerns of both the pensioners (by maintaining exposure to growth assets on a portion of the assets) and the employer/fund sponsor (by providing certainty around immediate pensioner cashflows).

2. Bonds strategy

A second ‘better bonds’ strategy is to restructure the fund’s existing bond allocation.  In essence, this strategy entails investing the fund’s existing fixed income allocation in very long-dated inflation-linked bonds, with the aim of removing the interest rate sensitivity of the entire liability.  Once again, only a portion of the assets are allocated to an LDI strategy while exposure to growth assets is maintained.

However, there are a number of issues with these approaches that we believe makes them sub-optimal in the long run.

Traditional approaches do not optimally address these conflicts
How does one decide on the split between assets used to match and assets that remain invested in growth assets?

In traditional approaches, this is a subjective decision often driven by the existing percentage allocation to fixed income.  As an example, a fund that has 40% of its assets invested in fixed income would typically earmark these assets for an LDI strategy. It would then determine either the number of years’ cashflow that can be matched using the given fixed-income asset value, or determine which long-dated inflation-linked bonds to buy.  A related point is that these subjective splits between growth and matching assets are determined at a single point in time and only revisited infrequently (if at all), making them sub-optimal as market circumstances change.

In trying to address the concerns of both fund sponsors (employers) and members, these strategies lead to compromises.  An obvious one is the determination of increases to be granted. This is very subjective under both strategies.  If one limits increases to the matched increase under the ‘cashflow matching’ solution, the benefits of higher exposure to growth assets do not directly feed through to pensioners over this period.  This could lead to issues around inter-generational equity.  Similarly, under ‘better bonds’ strategies, determining the level of increase to be granted is a subjective decision, and the full benefit of exposure to risk assets is not generally passed through to members. (Note: this assumes a 40% allocation to long-dated inflation-linked bonds, and a 60% allocation to growth assets.  The 60% allocation to growth assets is generally expected to generate returns to provide  increases on 100% of the fund).

In addition, although funding level volatility is reduced, it still persists.  Under ‘cashflow matching’ strategies, matching is only implemented on a portion of the liability profile with the remaining unhedged liabilities leading to changes in funding levels.  Under ‘better bonds’ strategies, interest rate risk is hedged for the entire liability for parallel moves in the yield curve.  Any changes in the shape of the yield curve could lead to deficits emerging.

The best of both worlds
In the title of this article we make a bold statement: providing funding level stability while maintaining full economic exposure to balanced fund returns.  Even in spite of the issues highlighted with the traditional approaches outlined above, we know that this is possible and we know how to deliver on the promise.  Sanlam Investments has been running ‘dynamic hedging’ LDI strategies for third-party clients since 2008 and has had enormous success in doing so. 

Using techniques adapted from financial economic theory, we are able to provide clients with funding level stability across the entire liability lifecycle, regardless of changes in the level and shape of the yield curve.   In addition, pensioner increases are 100% based on the returns generated by the client-specific and chosen balanced fund strategy, with affordable levels of increases being objective and transparent.  As such we are able to bridge the gap between pensioners looking for higher exposure to growth assets and fund sponsors looking for funding level stability.

Conclusion
While we recognize that ‘dynamic hedging’ is not a ‘one size fits all’ solution suitable in all situations, we believe that it fills an important space in the range of LDI solutions offered by Sanlam (and  also externally in the market).  Compared to traditional ‘cashflow matching’ and ‘better bonds’ approaches, dynamic hedging provides funding level stability regardless of any changes in the level or shape of the yield curve, allows pension increases that are 100% driven by investing in growth assets, and provides boards of trustees with a transparent and objective risk-management solution.