The John Lewis Partnership Trust has introduced a liability hedging programme increasing its hedge ratio to 60 per cent, in a move experts said would protect significant recent contributions.
The retail giant has paid almost £1bn into its non-contributory pension scheme in the past 10 years, despite a valuation methodology that makes significant allowance for investment returns.
Experts said schemes with any liability exposure to gilts will look to fully hedge interest rate risk as a neutral position, using time-based strategies rather than market triggers.
You have to make sure you can accommodate collateral requirements, and that could put a limit on how much hedging you can do
Ben Gold, Xafinity
The £5bn John Lewis Partnership Trust’s derisking drive will use leverage to ensure the scheme can retain “a return-seeking portfolio that aims to reduce concentrations of risk by diversifying across a range of asset classes and geographies”, according to the sponsor’s latest annual report and accounts.
The financial statement also indicated the removal of rate risk will be completed within the next five years: “In 2016 the trustee initiated a three to five-year interest rate and inflation hedging programme which will increase liability matching to 60 per cent over this time period.”
Planning for the future
A company the size of the John Lewis Partnership, which owns the eponymous department stores, Waitrose supermarkets and a range of financial services companies, might not be an obvious candidate for liability-driven investment.
Employers with strong covenants are often said to be able to tolerate volatility on a scheme’s balance sheet. And with a £479m actuarial deficit that is less than half the accounting deficit, the scheme is also less exposed to long-term interest rates than most.
Nonetheless, argued Giles Payne, a director at HR Trustees, the duration of the scheme’s liabilities meant it would be prudent to allow for a deterioration in John Lewis’s financial situation, especially given the fast-paced nature of the retail market.
While the scheme has cut its accrual rate, changed its indexation basis and requires its employees to wait five years before joining, it remains open to new members.
“With youngish staff you could see some of those liabilities going out maybe 70, even 90 years,” said Payne.
He said it would therefore be prudent of both the scheme and regulatory framework to set a strategy “that allows for the possibility that John Lewis isn’t going to be there forever”.
Are valuations a problem?
Moreover, without a fundamental change in valuation methodology, noted Ben Gold, head of investment consulting at Xafinity, schemes will still be tied to movements in the gilt market.
Schemes allowing for investment returns in their valuations “still have a ‘gilts-plus’ valuation even if the ‘plus’ is a big number, so unless they change their approach, gilts are still a matching asset”, he said.
John Lewis slashes deficit with CPI switch
Retailer John Lewis has agreed a new recovery plan with the trustees of its defined benefit scheme after a large reduction in the funding deficit, due in part to a change in inflation indexing.
He said the scheme’s decision to implement LDI therefore made sense in terms of protecting their recent contributions, but added that trustees should consider whether gilts-plus is right for their scheme.
Where schemes are still exposed to long-term interest rates, experts said the prospect of rising interest rates should not dissuade trustees from hedging rate risk. Those rises in interest rate are built into yield curves, meaning that any failure of rates to meet those assumptions in reality will worsen scheme deficits.
However, a rising rate environment does have implications for the collateral required by schemes using leveraged solutions.
“You have to make sure you can accommodate collateral requirements, and that could put a limit on how much hedging you can do,” said Gold.
Don’t wait for markets
Where schemes are not limited by their ability to hold collateral, they will want to hedge all of their interest rate risk as a neutral position.
“I’ve seen increasingly trustees having an appetite to hedge either the full value of the liabilities or even beyond that,” said Simeon Willis, director at consultancy KPMG, who added that the failure of market-based triggers meant increasing coverage over a short period of time now looked a more popular strategy.
Some employers may take a view on how much LDI should be deployed by a scheme, for example asking the scheme to take more investment risk, lessening the burden on the sponsor.
Willis said companies were entitled to do this, but warned trustees to pay careful attention to covenant when assessing these decisions.
“The key is that the company has the strength to weather any deterioration in the market that might come from taking that position,” he said.
