Surplus to requirements: rates and inflation hedging in the endgame

Up to now, the key question of liability hedging has been whether to hedge the funding level or the deficit of a scheme, depending on the trustee view of which is more important.

Hedging type	Liability hedging target	Immunises
Funding level	Funded value of scheme liabilities (i.e. the value of the assets)	Changes in funding level due to moves in rates and inflation
Deficit	Total value of scheme liabilities	Changes in deficit from moves in rates and inflation

Improving funding levels – more than 100% funding levels and surpluses are becoming more common

Given the substantial increase in scheme funding positions over the last year, we estimate that the median scheme is close to full funding on a buyout basis (i.e. can afford to transfer scheme liabilities to an insurer under a risk transfer transaction), therefore, a significant number of schemes are running a material surplus on a buyout basis.

Whilst the theoretical aspects of liability hedging remain the same, the question for these schemes is now subtly but importantly different. Should these schemes hedge the buyout surplus or the funding level?

Hedging funding level or surplus?

Below we illustrate how the two approaches differ for an example scheme that starts off 110% funded on a buyout basis and where there is a large drop in (real) interest rates, causing liabilities to shoot up:

Stepping back – big picture

In making this decision it’s important to consider:

• How could a scheme surplus be used?
• How would the liability interest rate and inflation exposure vary under different approaches?

Whilst this is heavily scheme-specific and dependant on legal aspects such as a scheme’s own rules, a surplus may be able to be used in the following ways:

1. Uplifting current DB member pensions in % terms
2. Providing current DB members with a one-off lump sum
3. Transferring surplus to the sponsor, with a potential use case being to better support DC pensions

One way to consider when assessing how to hedge a scheme’s interest rate and inflation liabilities is using a cashflow chart. As in the example above, we assume the scheme could secure currently promised benefits for £100m with an insurer and the value of assets is £110m. Meaning there is a surplus of £10m and a funding level (on a buyout basis) of 110%.

In the below the blue bars signify the current promised benefits to members. The green bars then show how the surplus could be used.

The light green bars show the additional cashflows if there is a 10% percentage uplift to all benefits (Option 1 above). The dark green bars show the cashflows if the surplus is instead used to provide a £10m cash lump sum or is transferred out the scheme at the point of buyout (Options 2 or 3); we assume a buyout will happen relatively soon with the surplus extracted at the same time.

This could imply the following liability hedging approach:

Option	Implied hedging target	Rationale
Option 1	110% of buy-out liabilities (£110m in exposure terms)	The additional discretionary benefits would have interest rate and inflation exposure
Option 2 or 3	100% of buy-out liabilities (£100m in exposure terms)	Surplus would be a near-term obligation with little interest rate or inflation exposure

 

If the surplus of the scheme were to be extracted more gradually, the dark green bar under options 2 and 3 would shift further into the future and could be more spread out. Under this scenario it could make sense to hedge somewhere between the value of liabilities and the assets i.e. do something between surplus and funding level hedging

Other factors

Whilst the decision around hedging level will be driven by potential use of a surplus, there are wider considerations such as:

• Uncertainty around the cost of a buyout (unless insurers have already been approached). This may favour hedging to funding level, as this target is less sensitive to assumptions around buyout pricing
• Collateral headroom. This may favour hedging the surplus, as less LDI exposure will be required (albeit a well-funded scheme will typically be running a relatively low level of leverage)

What to hedge?

In conclusion, schemes may want to consider how scheme surpluses could potentially be used and recognise the potential implications for their liability-hedging strategy – either to hedge their funding level or their surplus.

  

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