Liability hedging: The soul of a pension scheme?

By Andrew Drake

In a world of near-zero interest rates, the question of whether to hedge liabilities has never been more relevant or controversial. 

To some in the pensions industry, you've simply got to get on with it. “Expected returns don’t pay liabilities, cash does”. Liability risk is the biggest risk by far. According to this group, those with a full hedge are sitting pretty while the unhedged are in a world of trouble. Combined deficit estimates for UK plc of £600bn+ are commonplace. A stack of £1 coins this big would stretch to the moon and back. It's a huge amount of money. 

But if you listen to some others, this is all an elaborate hoax. The way pension fund solvency is calculated is "an affront to common sense". The risk isn't real. It's an "artificial construct", an accounting fiction. Hedging this fiction at insanely low yields is "misallocation of capital on a truly heroic scale".

What's going on?

Beliefs matter. Even if implicit, they drive our behaviour and actions. And beliefs about the fundamental purpose of a pension scheme's assets are what's fuelling this battle. Are the assets there to pre-fund (fairly certain) future cash promises, valued as if there is no backing sponsor? Or to try and generate enough return to keep down the contributions (both company and employee), leaving the sponsor strong and most likely to meet its (uncertain and contingent) commitments? 

The answer for every scheme is different because each situation is unique. But there are some common themes. For example, the interaction between funding, investment strategy and covenant should be considered together. And the effort is worth it, because if you can agree the asset purpose, the pieces of the investment strategy puzzle start to fall into place. And no piece is more important than liability hedging.