Adequate liquidity management a prerequisite for interest rate hedging by Dutch pension funds

Especially for liabilities with maturities of more than five years, funds do not fully hedge the risk of rate changes.  Rate changes may also have consequences for pension funds' liquidity position.  While the survey shows that pension funds need not run into liquidity problems if interest rates rise, adequate management of the liquidity risk remains of the essence.

Pension funds’ financial position is sensitive to (long-term) interest rate changes. As investments have short-term maturities and liabilities long-term, their interest rate sensitivity is usually lower than that of liabilities.  This implies that a pension fund's financial position weakens in the event of an interest rate decrease. Indeed, an interest rate change has a more marked impact on the value of the liabilities than on that of the investments.  Pension funds have various options to protect themselves against interest rate movements, e.g. buying long-term bonds or using derivatives, like interest rate swaps.  If opting for an interest rate swap, a fund will periodically receive a fixed interest in exchange for payment of a variable (short-term) interest (see Figure 1).

Hedging on average: full for short-term maturities, partial for long-term maturities

In practice, pension funds hedge their interest rate risks only partially. This appears from a survey among 27 pension funds, which jointly account for 79 percent of the pension sector’s invested assets.  Figure 2 presents an aggregated overview of the incoming cash flows of interest rate sensitive investments and outgoing cash flows of technical provisions by maturity. The technical provisions represent the current value of a fund's estimated pension payments. If the outgoing and incoming cash flows for a specific maturity are equal, a fund’s funding ratio is not sensitive to movements in the interest rate for this maturity. 

From the survey it appears that pension funds have in fact fully hedged their sensitivity to short-term interest rate changes (maturities of up to 5 years). The cash flows from the technical provisions in the first five years are indeed offset by a more or less equal amount of cash flows from the interest-rate sensitive assets. For maturities from five up to and including 30 years, interest rate hedging gradually declines, while for maturities upwards of 30 years interest rate hedging is relatively low. Another outcome of this survey is that pension funds did not significantly in- or decrease their interest rate risk hedging in the past two years. The hedging percentage reported varied from 35 to 40 percent.

It follows that for long-term maturities, pension funds on balance hold fewer interest rate sensitive investments than liabilities. This makes pension funds’ funding ratios sensitive to long-term interest rate movements, as reflected in the calculation of the effect of interest rate movements on the funding ratio.  On 28 February 2011, the average funding ratio of the 27 pension funds stood at 109.1 percent. In the event of a decline of the interest rate curve by 100 basis points, the average funding ratio would fall by 10 percentage points to 98.8 percent. In the event of an interest rate rise by 100 basis points, however, the average funding ratio would increase by more than 13 percentage points to 122.4 percent. These outcomes vary from one pension fund to another. The financial position of funds that have practically fully hedged their interest rate risk are of course less sensitive to interest rate fluctuations. In this context it should be noted that the question whether and to what extent pension funds wish to hedge the interest rate risk is at the discretion of the fund. DNB primarily assesses the integral investment policy for compliance with the relevant statutory provisions.

Liquidity position in the event of an interest rate rise

Besides an effect on the funding ratio, interest rate developments also have an impact on pension funds' liquidity position. In the event of an interest rate rise, an interest rate swap's value for a pension fund will decrease. In such a case, the fund will often be obliged to pledge collateral to the counterparty in order to avoid counterparty risk.  his may result in an unexpected liquidity need and, hence, liquidity risk for the pension fund. From the survey it appears that in the event of an interest rate rise by 200 basis points, 20 out of the 27 pension funds possess sufficient triple-A government bonds to be able to meet the collateral requirements. Against the depreciation of the interest rate swaps (of EUR 38 billion) these funds still hold enough government bonds with a triple-A credit rating (EUR 63 billion) in this scenario. 

This does not necessarily imply that the other seven funds would not have sufficient suitable collateral in such a scenario. Besides AAA treasuries, cash may also serve as collateral. Furthermore, the collateral requirements in bilateral agreements are usually less stringent, accepting also bonds with a lower credit rating as collateral, provided that the pension funds have not lent out these bonds at that moment. It is therefore important that pension funds, when concluding interest rate swaps – and also when using other derivatives in this context – also weigh in the liquidity risks entailed from an integral balance sheet perspective.