Marsh & McLennan Companies UK Pension Fund has increased its interest and inflation rate hedge for its defined benefit scheme, to help protect its funding position against fluctuations in rates.
This is in line with other DB schemes decision to hedge. However, historically low gilt yields has made it more difficult to decide between increasing interest or inflation rate hedges.
Factors to consider when setting interest rate hedging
The scheme’s funding level
How much risk the scheme is running
How much risk the scheme can afford to take
A market view of the direction of bond yields
“Over the course of the past year we have taken a number of steps to ensure that the risk of a substantial worsening of the funding position is reduced if the investments go down in value,” the fund’s annual report stated.
It said the £4.2bn scheme –whose contributing employers are insurance brokers Marsh and Sedgwick, and consultancy Mercer – has a target allocation of 53 per cent to growth assets and 47 per cent to risk-reducing assets, as at December 31 2012.
MMC has also reduced its “overweight exposure” to UK equities and is looking at diversifying its assets, within its DB scheme.
The scheme is expecting to take further steps to reduce risk and is consulting with the company on the issue, according to the report.
Tim Giles, partner at Aon Hewitt, said schemes have been increasing their inflation rate hedge over the past two to three years, but over the past two quarters interest rate hedging has become more attractive to schemes.
“[Schemes are] working with liability-driven investment managers and working out [at] what rates they would be willing to get rid of risk,” Giles said.
Since schemes have seen better interest rates in the past they could be tempted to hold out for improved rates in the future, Giles added.
Simeon Willis, principal consultant at KPMG, agreed schemes have more recently been increasing their interest rate hedge as bond rates have improved.
“Bond levels in the market are more attractive than they were,” Willis said. “People accept that we are in a low interest rate environment and are coming to terms with the [the fact that] if they don’t hedge now, they are unlikely to improve returns over the next two to three years.”
The decision to increase the interest rate hedge depends on the individual circumstances of a scheme.
“If you’ve got rid of 90 per cent of your risk already then you may want to wait for better [market] conditions to come. If you’ve only got rid of 20 per cent of risk in the past, it is looking like a favourable time to do so,” said Giles.
Schemes deciding to increase their interest rate hedge are doing so primarily by investing government bonds or interest swaps and options.
However Nick Secrett, investment director at PwC, said schemes would need to believe interest rates would stay at their present level to conclude that it is better not to increase their hedge.
“Because the yield curve is steep, if [schemes] do not hedge and interest rates stay where they are, you’re going to be in a worse position than you are now,” he said.
