In this blog series, I have been explaining why I think Implementation Managers can be a friend to pension trustees. In my experience as a consultant, schemes that have appointed an IM are more efficiently run – from a governance, operational and risk management perspective. As a result, their trustees have clearer heads to nail investment strategy.
Last week I explained one of the ways an IM can help trustees keep investment risk to a minimum as their scheme transitions to full funding – what I called the “Dynamic Risk Management Framework”. This week I am expanding on another key risk management benefit of an IM – hedge ratio rebalancing.
An important assumption: hedge ratio = funding ratio
For a pension fund, liability exposure to interest rates (gilt yields) and inflation represents an unrewarded risk. In other words, exposure to these risks is not expected to generate a positive return over time.
Therefore, crucially, my assumption in this blog is that our starting point is where the hedge ratio equals the funding level. This is the point at which the funding ratio (assets divided by liabilities) is essentially immunised against interest rate and inflation.
If you’re a trustee reading this and you’ve not made a conscious decision about your hedging strategy, my honest advice is to put IMs on the backburner and debate this – the governance ‘bang for buck’ is almost certainly going to be in a completely different league.
Why is a hedge ratio rebalancing framework beneficial to a trustee?
First, a whistle-stop reminder of how an LDI benchmark works. An LDI benchmark is crucial for your LDI manager because it tells him/her how much hedging to do. That is, it tells them to hedge to a defined hedge ratio (as explained, for the sake of argument let’s assume that level is equal to the funding ratio).
If the funding ratio rises (as we hope it will!), the hedge ratio is left trailing behind (it is static!). The increasing difference between the funding ratio and the hedge ratio means scheme risk starts to rise.
To correct this, your investment consultant will (hopefully!) come to the trustees with a recommendation to update the hedge ratio so it equals the funding ratio once again. The actuary / investment consultant / LDI manager will then go away and recalculate / rescale the LDI benchmark. This process of updating is generally slow, governance-heavy and potentially expensive.
Enter hedge ratio rebalancing. In a nutshell, this is an automatic mechanism to adjust the hedge ratio if the funding ratio changes.
So how does hedge ratio rebalancing work?
This is best illustrated using an illustration:
What role does the Implementation Manager play?
Your IM needs to be able to monitor your scheme’s funding ratio on a regular basis so they can compare it to the current hedge ratio. I explained how you can allow an IM to do this fairly easily in my previous blog.
If the funding ratio rises above (or falls below) a pre-determined tolerance range, the IM will automatically update the hedge ratio to bring it back in line with the funding ratio (as illustrated in the diagram above).
Summary
What’s next in the blog series?
Part 4/4 will be coming soon. I’ll be looking at asset transitions – particularly how IMs can significantly reduce trustee governance burden, as well as admin for trustee secretaries / in-house teams.
