Larger schemes are showing greater interest in using forward rather than spot rates to assess whether to increase their interest and inflation hedges, in order to gain a more accurate picture of fair value.
Pension schemes, especially in the private sector, have been looking to derisk by increasing their key liability hedges at points of market value.
But despite expectations, gilt yields have fallen this year from a low base. The UK 30-year gilt yield stood at 3.1 per cent yesterday, down from 3.7 per cent at the start of the year.
Forward vs spot rates
• The spot yield shows the rate offered for lending starting from today
• The forward rate shows the yield that will be delivered at a future time
Le Roy van Zyl, principal in consultancy Mercer’s financial strategy group, said while the majority of schemes are still using spot rates when setting hedging triggers, there is an increasing trend towards forward rates. He added it allows trustees to identify which areas of the yield curve are less expensive than the average.
“Trustees are saying we want to hedge but these rates just don’t look attractive,” said Van Zyl.
Peter Martin, head of manager research at consultancy JLT Employee Benefits, said spot rates give investors a first impression of pricing, whereas forward rates give a more sophisticated viewpoint.
“It may [indicate] to people that now is not a good time to implement that hedge in inflation rates,” said Martin.
The aggregate deficit of schemes in the Pension Protection Fund’s 7800 Index is estimated to have increased to £170.6bn at the end of last month, from £80.3bn the same time last year.
Looking at forward rates rather than spot rates may encourage trustees to hedge sooner. Van Zyl said some schemes using forward rates may find they have already reached the trigger level at which they are comfortable increasing their hedge.
“Even when the spot rates are looking relatively high they were able to identify areas where they could increase their hedge,” he said.
However Rod Goodyer, partner at consultancy Barnett Waddingham, said a scheme needs to have a longer time horizon to effectively use forward rates because a scheme that is very focused on buyout may not want to be taking tactical views.
It helps explain to schemes assessing fair value what has already been priced into the market, he said.
“The only way schemes are going to benefit is if rates rise more quickly or rise to a higher level,” Goodyer said.
However using forward rates is a more complex way of assessing the fair value of yields, which may be difficult for smaller and medium-sized schemes.
Van Zyl said: “It typically tends to be the larger schemes [that use them] but that’s more because the larger schemes have a larger governance budget."
