REVIEW OF FINANCIAL MARKETS


THE SPONSOR COMPANY The hedging being undertaken considers only the assets and liabilities of the scheme, even though the scheme has recourse to the sponsor in the event of shortfall. The sponsor, in its business activities, has exposure to many of the same risk factors as are considered in the scheme context. For example, most companies


prosper as interest rates fall and this constitutes a natural offset of some or all of the discount rate exposure of a DB scheme. There are similar relations arising from the limited price inflation of DB scheme benefits, and of course, the presence of a larger population of pensioners consuming but not producing carries opportunities and benefits for most companies. It is clear that any economically justified hedging would not follow the partial consideration of the scheme alone, but rather it would be concerned with the sponsor and scheme combined – their net exposures. Given TPR’s fervent desire


to eliminate any reliance of a scheme on its sponsor company, we can only hope that the incongruity of their recent advice on LDI to trustees, on the agreement of standby lines of credit with sponsors for use in times of market distress, struck them as much as it did us. The specific advice commences with: “Schemes may prefer to establish a line of credit with their sponsoring employer to ensure liquidity.” This emphasis on scheme funding,


once expressed as ‘funding trumps covenant’, is the cause of much excess and unnecessary expense for schemes and their sponsors. In effect, this is considering the fund alone as meeting the promise made by the sponsor, rather than the fund defraying the sponsor’s costs of production of the promise made. Using market-based discount rates for the valuation further distorts the valuation; this is the current cost of replacing the benefits promised using market assets rather than the cost of producing the


8See Clacher and Keating, Submission in Evidence to Work and


Pensions Committee 9


ibid


benefits as originally promised by the sponsor employer. The fund’s value as security for


members in the event of sponsor insolvency was always secondary and has been further reduced in relevance by the introduction of the Pension Protection Fund (PPF).


// THERE CAN BE SOME PROFOUNDLY UNDESIRABLE CHARACTERISTICS TO REPOS AND DERIVATIVES //


THE PENSIONS REGULATOR TPR has, in its statutory obligation to protect the Pension Protection Fund, an incentive to consider only the level of scheme funding. Its obligation to consider corporate growth prospects has been relegated to trustees. The obligation to protect the PPF also provides an incentive for TPR to promote and encourage the use of market-based discount rates. This in effect is estimating the cost of producing the projected promised benefits today, though these benefits were promised previously on different terms by the sponsor


employer through time. TPR has been an avid supporter and zealous promoter of LDI strategies in all its forms. This amounts to the promotion of


riskier investment asset allocations. For a scheme in deficit, for the assets to match the variability of liabilities, they must be riskier than those liabilities. If these assets are also to reduce the deficit, they must be riskier still. The promise of LDI was that this asset allocation strategy would do both. The expense of LDI immunising


portfolios reduced the expected returns of assets and raised the effective cost of provision for schemes, and that in turn led to the use of derivatives and repo. We have publicised our concerns over the lawfulness of schemes using repos and derivatives fully in our evidence submission to the parliamentary Work and Pensions Committee.8


The


authorities’ response to the 2007–09 financial crisis, which saw short interest rates fall dramatically while gilt yields responded only slowly, provided the incentive for schemes to adopt leveraged LDI strategies en masse.


64


REPO AND DERIVATIVES Setting aside our concerns over the lawfulness9


of the use of repo and


derivatives by schemes to leverage assets and hedge liabilities, there can be some profoundly undesirable characteristics to these instruments. There are in essence two types of


derivative: those which carry recourse for the counterparty to scheme assets, such as interest rate swaps, and those which don’t, such as options (the right but not the obligation to undertake some activity). It is possible and indeed usual for derivatives to provide leverage, that is to have a small price relative to the notional amount of underlying asset exposure they control or reference. In fact, a fairly priced interest rate swap will have a price of zero at inception. In practice, there will be a price applied reflecting the counterparty’s concern with their potential credit exposures over the life of the contract, a ‘haircut’. Non-recourse derivatives such as


options may be highly leveraged, but as there is no further recourse to the scheme fund, the presence of leverage within them simply increases the riskiness and potential returns of the instrument. There are debates to be had over the suitability of the use of options within a prudently diversified portfolio of assets, but that debate would be institution specific. The fund’s exposure is limited to the price initially paid for them, whereas it is the counterparties of the swaps and repos who would lose if a fund’s net asset value became negative and the fund is wound up. By contrast, derivatives such as


interest rate swaps do offer the counterparty recourse to the fund’s other assets; these take the form of collateral calls or variation margin on contracts outstanding. These calls reflect adverse variation in the price of the derivatives contract. The standard risk management tools


for financial contracts are initial and variation (or maintenance) margins. The initial margin is set to reflect the variability of the underlying asset and the variation margin reflects changes in the current price of the contract. Similar risk management techniques


are applied to repo transactions. These are agreements under which an asset is ‘sold’ to a counterparty for spot


THE REVIEW MARCH 2023


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