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Liability sensitivities One of the key challenges that every pension fund faces is setting aside the right amount today to meet future obligations. A healthy funding ratio depends on having sufficient assets to meet future liabilities. Central to this is the ‘time value of money’: by taking into account the rate of return that a fund can gain by investing current assets over time, actuaries can calculate the present value of future liabilities. Consider a fund that must repay £1,000 in five years. Knowing that it can achieve a rate of return of 4% over five years, how much should it set aside today? £1,000 1.04 x 1.04 x 1.04 = x 1.04 x 1.04

£1,000 = £821.93 (1.04)5

Unfortunately, market rates are not so predictable and actuaries must contend with fluctuating interest rates. As rates fall, the present value of


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Fig. 1: Types of swap Inflation swap Swap fixed cashflows for realised inflation cashflows

Interest rate swap Swap fixed cashflows for floating cashflows (floating cashflows usually based on short-term interest rates)

pay fixed

pay floating Counter party

Pension fund receive inflation

Pension fund

Counter party receive fixed

Source: BlackRock

future payments increases, and vice versa. As a result, future payments to pensioners are sensitive to changes in the nominal discount (interest) rate. In addition, liabilities are typically made up of a very long-dated series of cash flows paid over time. These factors make it harder for pension funds TRUSTEE to match current assets to future TRAINING payments. BlackRock’s next The matter is further complicated trustee training by price inflation. Most schemes in sessions: 12 October the UK have inflation linked liabilities, in Birmingham which means that payments must and 13 October in reflect movements in a given inflation London on Liability index. An increase in inflation will Driven Investments. increase the value of a fund’s future For more liabilities against current assets. In information or other words, future payments are to register, please sensitive to movements of inflation email trustee. indices and funds need to consider masterclass@ investing in assets that reflect that sensitivity.

Since its emergence less than a decade ago, liability-driven investing (LDI) has evolved into a dynamic and customisable approach capable of exploiting new opportunities via a range of instruments, structures and techniques. This article builds on existing articles in the our Trustee MasterClass series1 to examine in closer detail how pension liabilities are sensitive to inflation and interest rates and how funds can hedge against them.


or visit trusteemasterclass. com.

The hedging toolkit Today, pension funds have access to a broad toolkit of strategies to help them hedge against interest rates and inflation risk. These strategies include

using bonds, swaps, repurchase agreements (repo) and gilt total return swaps (TRS). Bonds provide coupon and redemption payments, which provide cash flows over time. Market forces price in expected inflation and interest rate movements, giving bonds interest rate and in some cases inflation sensitivity, making them a valuable hedging tool. Conventional bonds provide fixed cash flows in the future and can be used to hedge fixed liabilities. The cash flows from index linked bonds provide inflation sensitivity because they are linked to an inflation index. However, the market for index linked bonds is not as liquid as conventional bond markets. Pension fund liabilities can also be hedged using interest rate swaps and inflation swaps (see Figure 1). Swaps allow pension funds to precisely match movements in interest rates and inflation by swapping fixed cash flows for floating ones. At the outset, both streams of cash flows are equal, meaning that swaps have the added


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repo-ed out, which means that the investor has exposure to both the gilts repo-ed out and the additional gilts purchased. Gilt TRS (see Figure 3) are another unfunded way to gain exposure to gilts. They exchange cash flows linked to the return of a gilt or basket of gilts in return for a set of cash flows linked to a floating rate of interest. They have similar risk/reward characteristics to direct, physical investment in the underlying instruments, but like other swaps, TRS don’t require an initial outlay to enter the position, providing LDI investors with the ability to gain additional interest rate and inflation exposure.

Fig. 2: Repo structure Start of Contract

cash Pension fund

Counter party government bond

End of Contract

government bond Pension fund

Counter party cash + interest

Source: BlackRock

benefit of being unfunded. Pension funds can gain specific exposure to interest rates or inflation without an initial capital outlay. With an interest rate swap, a pension fund will pay a floating rate to a counterparty, typically based on an interbank lending rate, in return for a fixed rate. This has the effect of providing known cash flows in the future to meet liability cash flows. With an inflation swap, pension funds will swap a fixed, expected rate of inflation in return for the actual rate of inflation. If inflation is higher than expected (i.e. higher than the fixed rate) the present value of the future liabilities will also rise. However, the fund will gain on the swap, which will offset the rise in liabilities, reducing inflation risk. Historically, pension funds opted to use bonds and swaps to hedge their liabilities against interest rate and inflation risk. More recently,


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many have begun to embrace other tools – gilt repo and TRS – that offer an unfunded method of increasing their government bond positions. Gilt based strategies have become particularly prevalent in the UK since sterling swaps began trading at a premium to government bonds following the credit crisis. In a repo (see Figure 2), one party will sell an asset with an agreement to buy back the asset at an agreed price on a specified future date. The largest repo market is in government bonds, allowing UK investors to exchange gilts for cash and buy them back at a later date at an agreed premium. See the illustration below. Repo markets provide a number of uses for LDI investors. Investors that want to use bonds to hedge their liabilities can repo out existing gilts and use the proceeds to purchase additional gilts. The investor retains economic exposure to the assets

Fig. 3: Gilt TRS structure return leg gilt total return Client financing leg 3M LIBOR ± spread

Counter party

Source: BlackRock

TAKE NOTE! Read Pensions Insight’s feature on LDI:

In conclusion, modern LDI is not a ‘swap and forget’ strategy. Skilled LDI investing is dynamic and flexible and will choose from the wide variety of strategies available to investors depending on the needs of the client, instrument liquidity, inflation expectations and relative value opportunities across the yield curve. The next Trustee MasterClass articles in the series will focus on each LDI instrument in turn. 1

See ‘Liability-Driven Investing’ and ‘Working with Derivatives’ at


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BlackRock Trustee Masterclass - LDI in practice