Using matching assets to manage investment risk relative to the scheme liabilities.
Issued: March 2017
Last updated: September 2019
19 September 2019
The latest updates to this guidance reflect a number of regulatory changes introduced in 2018 and 2019, including The Pension Protection Fund (Pensionable Service) and Occupational Pension Schemes (Investment and Disclosure) (Amendment and Modification) Regulations 2018, and The Occupational Pension Schemes (Investment and Disclosure) (Amendment) Regulations 2019.
The update has involved significant rewriting of various sections throughout the Investment Governance and Investing to Fund DB Schemes portions of the guidance; you may, therefore, find it useful to re-acquaint yourself with the guidance as a whole.
Updated information on investment decisions and your statement of investment principles, stewardship, reporting, sustainability and financial and non-financial factors may be of particular relevance.
1 August 2019
We have made some small updates to this guide to reflect the fact that an industry led body: The Cost Transparency Initiative, has produced standardised templates which we encourage trustees to use to obtain information about costs and charges from their provider.
Other minor changes have been made including minor editorial changes.
30 March 2017
First published.
What you need to do
- Understand the purpose of your matching assets, including the risks they are seeking to mitigate, so you can assess how appropriate and effective they are.
- Understand the risks introduced by your matching assets, so you can ensure you have appropriate strategies and appropriate governance arrangements in place to manage these risks.
Using matching assets
You are legally required to invest assets backing DB liabilities in a way that’s appropriate to the nature, timing and duration of the expected future retirement benefits payable under your scheme. To help achieve this, many schemes hold ‘matching assets’ in order to manage investment risk relative to the liabilities.
Different types of matching asset match the liabilities in different ways, with varying degrees of accuracy, and with different levels of expected return. Your scheme’s matching asset portfolio may comprise only physical (ie non-derivative) assets, eg fixed or index-linked gilts, corporate bonds, long-lease property and some forms of infrastructure. However, it is common practice for matching asset portfolios to use derivatives as well, to increase the level of matching achieved. This type of approach is known as liability driven investment (LDI).
In order to assess your scheme’s matching asset portfolio and how appropriate the assets used are, you need to understand why your scheme invests in matching assets. It may be to:
- reduce the volatility in the funding level by investing in assets which respond to changes in interest rates and / or inflation in the same way as the liability value does
- prepare for a liability transaction, eg a partial buy-in, by reducing the volatility of the assets relative to the transaction price
- generate cash flows that coincide in timing and amount (ie match) with scheme cash outflows, such as the payment of pensioner benefits, in the short to medium term
- seek to match the long-term cash flows of your scheme
You need to understand, at a high level, the principal characteristics of the liabilities or cash flows you’re trying to match and the main features of your scheme’s matching assets.
Things to consider: matching assets
- How sensitive are the matching assets to interest rates?
- Which interest rates are used to measure the sensitivity (eg gilts, swaps, corporate bonds)?
- How sensitive are the matching assets to future inflation?
- To what extent do you want your matching assets to match the change in the value of the liabilities and/or to match scheme cash flows?
- Over what timescale and how closely are you trying to match the liabilities or cash flows?
You can use this information to assess how effectively the matching assets are meeting your objectives for them, and whether any changes would be appropriate. Your investment adviser should be able to assist with this.
Understanding the risks of your matching assets
You need to understand the risks introduced by your matching assets. You may wish to consider risks in relation to:
- credit / default
- liquidity
- collateral requirements and management
- derivative counterparties
- foreign exchange
- concentration, eg in relation to specific issuers, sectors or portfolio factors
- reinvestment / roll
- political and regulatory
- investment manager skill
- basis
If your matching assets include derivative instruments, you should consider the additional risks these introduce. A key issue to understand is how the matching asset portfolio will behave in an environment of rising long-term interest rates (and therefore, falling values of liabilities and matching assets) and how this may impact on the collateral being held and potentially on the scheme’s other assets.
The use of derivatives in your matching assets may require you to hold a minimum amount of assets eligible to meet collateral requirements, such as cash or gilts. Your investment manager or investment adviser will be able to explain whether and how this affects your scheme and what processes and plans are appropriate to meet any collateral movements and to address the associated operational risks.
For more information see collateral management.
You might be holding matching assets to prepare for a future liability transfer exercise, eg a buy-in or buy-out of your scheme liabilities (or some of them). You should consider with your investment adviser whether the assets you hold for this purpose are likely to be acceptable to an insurer and, if not, the impact that might have on your liability transfer objective. In particular, you would then need to consider how to convert those assets into cash, the costs involved in realisation and any potential restrictions on sale.
Diversification
It is a legal requirement for scheme assets to be properly diversified[14]. Diversification means investing in a range of assets to ensure the scheme is not overly reliant on any single investment or portfolio of investments. Not all investments perform the same way under different economic and market conditions. Diversifying your scheme’s assets should therefore provide greater stability of investment returns and reduce risk.
You may wish to consider diversification of your matching assets in terms of:
- asset classes
- geography
- bond issuers
- derivative counterparties
- asset managers
Governance
Liability driven investment
Derivatives, such as interest rate or inflation rate swaps, gilt repurchase arrangements (gilt ‘repo’) etc, can be used to match liability or cash flow characteristics more closely. They can also, through the use of leverage, provide increased exposure to interest and inflation rates and reduce the proportion of the scheme’s assets that need to be held in the matching asset portfolio to achieve a given level of matching. This type of approach is known as LDI.
Investment in derivatives is subject to additional statutory requirements. The law requires that this type of investment is only be made to contribute to a reduction in risks, or to facilitate efficient portfolio management[15].
The use of LDI typically enables pension schemes to achieve an improved balance between investment risk and return but it does introduce additional risks, eg around the use of leverage and in relation to operational risks around the management of collateral. Your investment adviser will be able to discuss the merits of an LDI approach to your matching assets with you.
Example 14: LDI
The assets of the XYZ Pension Scheme are invested 60% in global equities, 10% in index-linked gilts, 10% in fixed gilts, 10% in corporate bonds and 10% in property. The bonds are benchmarked against the over-5 years FTSE index-linked gilts index, the over-15 years FTSE gilts index and the all stocks corporate bonds index, respectively. The duration of the assets held, as advised by the scheme’s investment consultant, is around five years.
The trustees are in the process of completing their actuarial valuation and the draft actuarial report indicated that:
- the scheme is 80% funded on their technical provisions (TP) basis
- the liabilities are broadly split as 50% fixed, 50% inflation-linked (uncapped)
- the duration is 18 years for the fixed liabilities and 22 years for the inflation linked liabilities
As part of their quarterly update, the scheme’s investment consultant advises that:
- there is a significant mismatch between the duration of the scheme’s assets and liabilities
- a 1% reduction in interest rates would increase the value of the liabilities by around 20% but only increase the value of the assets by around 5%
- as the scheme is only 80% funded, the value of liabilities, compared to the assets, would increase by more than 15%
The trustees are concerned about the level of risk in their scheme assets compared to the liabilities. They instruct the investment adviser to analyse the sensitivity of the assets and liabilities to a range of factors, and to propose changes to the investment arrangements to reduce the degree of interest rate (and inflation) mismatch without initially reducing the expected return on assets.
The investment adviser proposes an incremental approach whereby the trustees would initially allocate 30% of their assets to LDI and gradually increase their allocation afterwards. The adviser proposes that the initial allocation to LDI would be funded from the scheme’s existing bond investments. The adviser also recommends that the LDI portfolio should be constructed using:
- a bespoke bond portfolio, ie a portfolio of bonds that better reflects the profile of the scheme’s liabilities compared to the current bond holdings which are based around common industry benchmarks
- interest rate and inflation rate swaps, as these derivative instruments would allow the introduction of a limited amount of leverage (on average two times) to enable a greater reduction in liability risk
The investment adviser also advises that, due to the use of derivatives (swaps) and leverage, collateral would need to be held and managed. The adviser explains the extent of the collateral risks that the scheme would be exposed to and develops a collateral risk and management plan for the trustees, which would be periodically reviewed.
Learning point: Trustees may wish to consider LDI to enable them to better manage the interest and inflation risks within their schemes. However, LDI introduces some additional risks, eg around leverage and collateral management, and trustees should understand these and take appropriate steps to manage them.
Trustee toolkit online learning
The module 'An introduction to investment' contains tutorials called 'Types of asset: Common assets', 'Types of asset: Alternative assets' and 'Capital markets and economic cycles'. The module 'Investment in a DB scheme' contains a tutorial called 'Changing the asset allocation strategy'. You must log in or sign up to use the Trustee toolkit.
Footnotes for this section
- [13] Regulation 4(7) of the Investment Regulations.
- [14] Regulation 4(8) of the Investment Regulations.