Russell Investment Group has prepared a series of liability-driven investment (LDI) funds to help corporate superannuation funds limit the impact of interest rate movements on their ability to meet future defined benefit payments.
The four funds, which are currently canvassing for seed investors, will acquire interest rate swaps through five local and global investment banks to cover five, 10, 15 and 20 year horizons. LDI was pioneered in the United Kingdom as a way for pension funds to ensure current funding positions matched future liabilities, after the dotcom bust and simultaneous drop in asset values and interest rates suddenly turned surplus balance sheets into deficits virtually overnight.
While Australia has not had the same crisis as the UK, or the burden of paying out benefits as long-tailed pensions, markets have wiped the comfortable surpluses off many corporate super funds; as I&T News reported last month, Telstra Super’s assets recently dipped to only one percentage point above where the sponsor, Telstra Group, would be required to top up the fund.
Keith Knapman, director of asset/liability management at Russell, said that matching interest rate swaps with the various maturities of a fund’s defined benefit liabilities can help guard against interest rate volatility, which he said was the biggest risk to a corporate super fund’s balance sheet. “It’s like locking in the current interest rate; in effect you are locking in your current funding position,” Knapman said.
Movements up or down in the discount rate inversely impact the amount of money funds need today in order to match cash flows with future liabilities. “The classical solution to hedge against this risk is to buy bonds that mature in line with the expected future payments, but finding the right mix of bonds can be difficult and may require the portfolio to go overweight bonds at the expense of equities,” Knapman said.
“If interest rate swaps comprise approximately a third of the portfolio, you can neutralise interest rate risk while leaving the remainder of the fund to invest in higher return assets.”
A concern for investors is that the interest rate they lock today in could limit potential upside. Knapman said the purpose of an LDI was not outperformance, but a sacrifice of some surpluses to guard against deficits.
“There is implementation risk with such a strategy, but a fund need not invest all at once,” he said. “[The funding position] may get better, or it might get worse, but from a trustee’s perspective it makes for less surprises.”