Hedging your pension bets

Pension fund managers are having a hard time. The Pensions Act was closely followed by the introduction of the minimum funding requirement (MFR), and now the 1997 Budget has deprived them of income from reclaiming tax credits on their dividend income. These profound changes have not only created much head-scratching by fund managers but also FDs have made concerned at the effect the changes may have on the contributions that companies make to ensure their funds comply with the new regulations.

While the MFR only applies to “defined benefit” schemes, where the members are entitled to a level of pension which is independent for the investment performance of the fund, companies which have to make up a funding shortfall could face very large additional contributions. The impact of the change to tax credits alone is large. Actuaries have estimated BT may have to find #166m, British Gas #90m and ICI #62m. These numbers make FDs sit up sharply.

There are other worries too. The most fundamental difference between the MFR and other methods is that the actuary must use the current market value, rather than the present value of the future cash flows, as the basis of valuing the fund’s investments. As the stockmarket fluctuates, short-term volatility will affect the MFR calculation and companies will have to correct deficits within one year if they find themselves 10% underfunded, making cashflow forecasting and financial planning a potential nightmare.

One way to avoid volatility is to match short-term pension liabilities by investments in bonds and longer-term liabilities by investments in equities. Unfortunately, most funds in the UK have about half their portfolios invested in UK equities and another 20% in overseas equity markets. On the basis of the “ideal” portfolio, they are significantly over-invested in equities.

Neil Record of Record Treasury Management advises pension funds on currency management and says: “The problem in matching equities with long-term liabilities is that the benchmark portfolio assumes a rate of return for equities which does not take account of volatility. The only way to minimise variation in the funding level is to invest 100% in UK government bonds.

But for most funds, the sacrifice in return would be unacceptable.” Equities have outperformed bonds 75% of the time since 1918 and pension funds are not going to sacrifice returns by moving substantially into bonds. So pension funds have to find other ways to reduce short-term volatility.

About 20% of the total assets of UK pension funds are invested overseas.

The FD will have a conversation with the fund manager about that. Not only do pension funds expose themselves to market fluctuations, as with UK equity investment, but they are also taking currency risks. Funds may be tempted to liquidate their overseas investments so as not to add currency risks to those they are already taking in attempting to meet the MFR rules.

But there are ways of reducing volatility while retaining foreign investments – hedging, for example. In the 10 years to 1996 the returns on overseas bonds and equities have been remarkably similar to UK investment – provided they were hedged.

Moreover, the volatility of the hedged portfolio was similar to UK volatility whereas the volatility of the unhedged portfolio was markedly greater – so some form of hedging clearly helps.

How should FDs and fund managers consider a suitable hedging strategy?

A framework for a decision is:

– Choose a benchmark hedge ratio. Neil Record advises the use of an absolute benchmark rather than one which is related to a peer group of funds. For pensions an absolute measure is easier because liabilities can be estimated reasonably accurately.

– Decide whether the fund should adopt an active or passive policy.

– Select currency managers.

– Evaluate the results.

Currency overlay is the name given to the separate management of the currency exposures related to overseas equities or bonds in a portfolio.

A passive policy says you do not make any money in currency in the long run; the foreign exchange market is a casino and nobody can beat it. Transaction costs are low and risks are reduced so the advocates of passive policies always hedge in accordance with the preferred hedge ratio of the portfolio.

On the other hand, an active policy treats currency quite explicitly as a source of expected return on a portfolio; an opportunity to be grasped rather than just a problem to be solved. Active policies can have a variety of objectives. Some have the sole objective of adding value but also have higher risk. Others attempt to gain most of the upside from currency movements but limit the downside. Either way volatility is reduced and in the context of the MFR rules this a crucial benefit to UK pension funds who wish to retain their overseas investments.

According to Stephen Gavell of US-based State Street Global Banking, interest in currency overlay management is also rising in the States, even though, traditionally, US pension funds have not invested abroad to the same degree as those in Europe. “This is because the amount of US pension assets invested abroad has grown at a compound 25% over the past five years and will probably grow again by a similar amount over the next five,” says Gavell. “Presently US pension funds have invested over 10% of their assets abroad. That is the kind of level at which currency begins to have a significant potential impact on overall performance.”

So there is a growing international interest in the concepts of currency overlay for pension funds. But how does it work?

Academics have long argued about currencies and have spent a lot of time trying to determine whether currencies are a zero sum game. They probably are but only over a much longer horizon than any investor, even a pension fund, can live with.

Currency markets are notoriously difficult to predict and taking a view either way does not really improve your risk profile. Systematic dynamic hedging can take several forms, but the principle is to maintain a variable hedge which increases as the foreign currency falls in value and decreases when the base currency is weak. Being a responsive system, rather than predictive, it will rarely be possible to capture the full extent of an exchange move, but this is not necessary in order to achieve substantial reduction in volatility as well as to contain negative cash flows at manageable levels. As a bonus, those investors who have adopted the dynamic approach have made a positive contribution to returns as well.

Pension funds should look carefully at currency risks explicitly. They have new situations to deal with but they should not disinvest abroad because they fear currency risks.

More information about currency overlay can be obtained from Neil Record at Record Treasury Management, on (01753) 852222.