Rest easy

“DON’T GO SWIMMING until an hour after you eat.” “Eat your carrots – you’ll see better in the dark.” “If you go outside with wet hair you’ll get sick.” It’s my mother's voice exhorting me. It’s probably your mother's voice, too. Or maybe she told you “too much TV was bad for your eyes” or “clicking your knuckles causes arthritis”. Old wives’ tales are as old as language itself. They’re part of our oral tradition. Why do we hold on to such stories about our health when medical science advances have proved most of that sage advice is wrong? Perhaps the advice seems intuitive, or we still cling to it as at the very least it gives us peace of mind, as parents ourselves, that we aren’t making any obvious parental mistakes.

What gives the stakeholders of a defined benefit pension fund that peace of mind? For pensioners, it would surely be the knowledge their pension will be paid each month and that it will keep pace with the cost of living. For the employer it’s likely to be the security the ongoing obligations of the fund can be met without any requirements to increase contributions and that its own profitability won’t swing monthly in line with the pension fund’s solvency. All stakeholders want to rest easy at night, despite the announcement of yet another financial headline that might cause world markets to free fall.

Traditional investment wisdom offers up “truisms” such as “equities will outperform bonds over long periods”, “cash is the risk-free investment” or our personal favourite “don’t invest in inflation-linked bonds – they’re too expensive”.

At some point over the past three years it would have been possible for almost all defined benefit funds to meet stakeholders’ objectives by ignoring traditional wisdom.

Understanding liabilities

Changes to South Africa’s accounting and pension fund legislation over recent years mean defined benefit pension fund liabilities must be determined with reference to prevailing interest rates and, consequently, now have a “market value” that can be determined accurately. An actuary valuing pension payments that increase annually with inflation will use the market yields on appropriate inflation-linked bonds for that purpose. That introduces “interest rate” risk: the risk of a change in the value of liabilities due to any moves in the level of interest rates across all durations. A sudden drop in inflation-linked bond yields will cause the market value of the liabilities to increase (and vice versa).

The variability in a fund’s solvency level (its ratio of assets to liabilities) is further exacerbated by an investment in equities. That’s because the assets move in line with equity returns and the liabilities, by contrast, with bond returns. The average pension fund therefore resembles a hedge fund: long equities and short bonds.

In graph1 we plot the evolution of the solvency level of the average SA defined benefit pension fund since January 2007. We assume the assets of the pension fund are equal to its liabilities at the outset of the period and set out how the solvency level would have moved over time by assuming the pension fund was invested in the median balanced manager’s portfolio. The pension fund is targeting annual increases of headline inflation. (See graph 1.)

The financial position of the average fund see-sawed wildly over the three-year period. The financial director of the sponsoring company would have experienced extreme accounting volatility in the financial statements. Yet a statutory actuarial valuation, conducted once every three years, would have revealed no change in the solvency level over the period. There’s an asymmetric risk for pensioners. In the initial period – where equities performed well and solvency levels were very healthy – pensioners would have received a maximum of 100% of inflation as their annual increase. However, most funds awarded no increase to pensioners last year as investment markets fell and liabilities increased due to the credit crisis and fall in real yields respectively.

Peace of mind

Peace of mind in this context would be to lock in the solvency level when it’s above 100% and meet the objectives of the stakeholders listed above. By investing in an asset that moves in the same way as the liabilities, favourable financial positions can be locked in and a fund can remove the interest rate risk, investment risk and inflation risk (ie, the risk pensioners’ pensions don’t match inflation). The cost of that peace of mind involves foregoing the outperformance associated with a long-term holding in equities. That’s because de-risking involves buying a tailored portfolio of Government bonds.

Watch out for the sting in the “tail” of this old wives’ “tale”

Understanding where the risk sits in a pension fund is crucial to meeting objectives. For example, investment strategies focused on meeting the initial pension obligations with appropriate bond investments but not addressing the later obligations do little to de-risk the fund. For example, “cash flow matching strategies” are currently being considered by certain defined benefit funds. Those are strategies that – in exchange for a capital sum of money – a counterparty, such as a bank, will promise to pay the fund’s excepted cash flow obligations over a period of, say, 10 years. The risk inherent in such a strategy, without regard to the tail, can’t be underestimated. We illustrate the interest risk still present in such funds in graph 2.

A fund that de-risks by investing in a matching asset to address the next 10 years of pensioner obligations still has an interest rate risk exposure of 75%. That despite the fact 10 years of obligations can account for 60% of the value of the liability.

While that strategy is better than a balanced fund approach it doesn’t take into account the risk sitting in the tail. When inflation-linked bond yields fall it’s the obligations many years into the future that have the greatest impact on the liability. Those “matching” strategies give trustees a false sense of comfort that annual pension increases in line with inflation will be granted.

Cash flow matching may yet become another “old wives’ tale” (if you’ll excuse the pun).

Back to basics

It’s now possible to invest in a portfolio of Government bonds that tracks the movement in a defined benefit fund’s pensioner liabilities. Annual pension increases of inflation can be guaranteed and accounting volatility can be removed. There can be such a thing as a free lunch. Don’t let the “tail” get the better of you!

COSTA ECONOMOU

Colourfield Liability Solutions

ECONOMOU has a wealth of retirement fund experience, having served as a valuator, employee benefit and investment consultant to a large number of South African retirement funds. He’s pioneered the advice the retirement fund industry has seen in liability-driven investment strategies, having implemented the first one in 1999. He’s a fellow of the Institute of Actuaries and also holds an MBA from the University of the Chicago Booth School of Business. He works at Colourfield Liability Solutions, a liability-driven investment management boutique.

SHAUN LEVITAN

Colourfield Liability Solutions

LEVITAN is an MSc graduate and a fellow of the Faculty of Actuaries and has played a significant role in the Creation and implementation of liability driven investment strategies. He has a flair for innovation and his academic papers and research have received acclaim. He works at Colourfield Liability Solutions.