Following the events of the Gilt Crisis in 2022, the Defined Benefit (“DB”) market has focused on the risks associated with leverage in Liability Driven Invest (“LDI”) funds. However, there are a number of other risks associated with liability hedging that have become more significant, especially as many schemes are targeting higher hedging levels post crisis. These warrant attention.

DB pension scheme liabilities are generally linked to inflation (as well as interest rates) and therefore schemes commonly hedge their inflation-linked liabilities to reduce the risk of changes in inflation adversely impacting funding positions.

UK inflation reached a 40 year high in 2022 and inflation expectations remain volatile, as investors question the future level of inflation. The dynamic nature of the current economic environment means that it is difficult to accurately predict the future path of inflation and therefore expectations continue to change. Volatility in inflation expectations and specifically, its impact on a scheme’s inflation hedge, is therefore a key risk.

Pension schemes typically use a combination of index-linked gilts and LDI to hedge their inflation-linked liabilities, however there can be a mis-match between a scheme’s inflation sensitivities and those of the market instruments used for hedging. Often, the inflation linkage of pension scheme liabilities can change due to changes in inflation expectations. Specifically, the impacts of “caps” and “floors” on pension increases (e.g. CPI capped at 2.5%) and revaluation assumptions (e.g. RPI V CPI) mean that pension scheme liabilities can become more, or less, linked to inflation as expectations change. Clearly, this can have a detrimental impact on funding positions (although it may also prove beneficial in some instances). Given the risk from inflation hedging, it is important to understand a scheme’s liability profile and the impact of the scheme design on the liability hedge.

Following the events of Q3 2022, many DB pension schemes experienced significant improvements in funding levels and have generally sought to increase hedging levels, whilst being reluctant to introduce or increase leverage. As an alternative to leverage, some schemes have introduced larger allocations to longer-dated bonds in order to increase hedge ratios, as longer-dated bonds are generally more sensitive to changes in interest rates (i.e. have a higher duration). This approach can have significant benefits, in that it can reduce collateral payments and financing costs from using leverage. However, it introduces an additional risk as the interest rate sensitivity of the hedging instruments will not match the interest rate sensitivity of the scheme liabilities across the yield curve.

Due to changes in economic factors, the yield curve is constantly changing. Specifically, shorter-term yields may change by a greater, or lesser, amount than longer-term yields, resulting in ‘twisting’ of the yield curve. Schemes exposed to yield-curve risk may therefore be over, or under, hedged to any movement in interest rates and inflation. Although yield-curve movements do not have an impact on a scheme’s hedge if the shape of the yield-curve is constant. If the yield curve shape changes, it can evidently have a detrimental impact on a scheme’s funding position (although it may also prove beneficial in some instances). Yield-curve risk therefore represents a significant risk to pension schemes and is worthy of monitoring.

The purpose of liability hedging is to reduce risk. However, hedging liability exposure is complex, and with hedging levels higher than ever, and yield movements remaining volatile, even a small mis-match in hedging can have a significant impact on a scheme’s funding position.

We suggest considering the following actions:

George Scurr - Senior Investment Analyst, Quantum Advisory