Using so-called swaps will help trustees of pension funds better match future liabilities with current assets as the industry moves towards a heavier reliance on fixed income products to bear the cost of a rapidly ageing population, according to analysis from Legal & General.
Swaps are essentially an easy way for pension funds to exchange excessive cash flow from current investments for fixed income in future, when pension benefits must be paid, says L&G financial economist Andrew Clare.
”It’s like swapping to a fixed rate mortgage from a variable rate mortgage,” he says.
A major benefit of swaps is they enable pension funds to swap the fixed cash flow from the current bond portfolio for cash flows related to RPI flows.
This is particularly important because research suggests up to 80% of scheme liabilities can be retail price index related, according to L&G figures.
Funds currently tend to hold equities to counter inflation, but this grates with the trend of pension funds increasing their fixed income holdings to meet the changing demographic profile, which will see a bulge of employees hitting retirement in the next couple of decades.
As funds increasingly looking to increase the fixed income portion of their portfolios, it becomes imperative to also find a hedge against inflation when buying corporate and government bonds.
Although swaps are easy to buy into, Clare warns it may take some time before they become more widely used by pension fund trustees.
One reason is cost, while another is they work best as long-term instruments rather than ones that fund managers should jump in and out of at short notice.
A particular UK issue is the lack of long-term gilts: there may not be enough issuance to satisfy some swaps demands, while the yield rate beyond 10 years is falling, meaning there is no “decent” value on long bonds.
The other issue is timing in terms of when to execute a swap.
Clare says pension schemes are really only in a position to consider swaps if they are not in deficit, and that has not usually been the case following the recent three-year bear market in equities.
Few schemes could, for example, do currently afford to do what Boots the Chemist did with its scheme at the end of the 1990s, when it switched its fund into fixed income.IFAonline
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