Article 30 September, 2020

On-Risk vs. Off-Risk: Why do we still compromise?

Liability hedging is a widely used tool today to reduce the impact of falling interest rates and rising inflation on Defined Benefit pension scheme funding.

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At a recent industry conference, I was struck by the remarks from one of the sessions about risk management and setting liability hedging targets. Liability hedging is a widely used tool today to reduce the impact of falling interest rates and rising inflation on Defined Benefit pension scheme funding.

For many schemes, this has dampened the escalating gap between scheme assets and liabilities at a period of heightened uncertainty for corporate sponsors. However, it was noted that setting a liability hedging target is often a trade-off between risk management and return generation. But do we really need to compromise?

As an industry, the last 15 years have seen Defined Benefit schemes construct an investment strategy based on two components, an on-risk block and an off-risk block. The off-risk block has evolved from being traditional UK government and corporate bonds to being principally an allocation to Liability Driven Investment (LDI).

In doing so, this has created the perception that the amount I allocate to the off-risk block determines what happens with my overall strategy. A higher allocation means I can hedge the scheme against a larger proportion of the interest rate and inflation risks in the liabilities. A lower allocation means I can target more return through my on-risk block. However, this represents a tradeoff or compromise that Trustees may be forced to accept as part of their strategy today and journey planning.

NEWSFLASH...there is no need to compromise. For over a decade, tools have been readily available for all schemes, irrespective of size which don’t suffer the trade-off between risk and return. This hinges on the use of segregated liability hedging – a bespoke portfolio designed for each scheme. High minimum fees priced out all but the big players in the past, but for many years this approach has been no more costly than alternative off-risk pooled products. Despite the affordability of segregated LDI today, most new entrants into LDI are going pooled. But why? In part, this has been driven by the popularity of fiduciary management with many fiduciary managers accepting the compromise and putting their clients in pooled arrangements[1]. At R&M our clients don’t have to compromise, we have over 100 schemes already using segregated LDI today.

“NEWSFLASH...there is no need to compromise. For over a decade, tools have been readily available for all schemes, irrespective of size which don’t suffer the trade-off between risk and return.”

By widening the trustee toolkit, this can deliver a higher level of liability hedging with fewer assets allocated to the traditional off-risk block. Fewer assets in the off-risk block means more assets to invest on-risk or to allocate to cashflow generating assets. Given schemes need return, risk management, and cashflow more than ever, this is the ideal time for Trustees to revisit their approach to LDI.

If you want to know more, contact us at R&M and we will provide a free assessment of what is possible for your scheme today… no need to compromise

[1] Source, XPS Liability Driven Investment: A £1 trillion market. Annual Survey 2019. https://www.xpsgroup.com/media/1938/ldi-april.pdf

This article constitutes a financial promotion and has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248).

Please note that this communication is directed at, and intended for, the consideration of Professional clients only. Retail clients must not place any reliance upon the contents.

The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.

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