SA pension funds must consider alternatives to limit their liabilities

One of the biggest risks that Defined Benefit (DB) pension funds face is that of fluctuating interest rates and the subsequent impact that this has on the funds’ liability. As a result, it has become increasingly necessary for DB funds to reduce their int

In light of this, the South African DB fund market has increasingly begun to adopt a Liability Driven Investment (LDI) approach rather than a straight asset-based strategy, an investment strategy that has proven successful internationally for DB funds with potentially large liabilities.

LDI currently makes up about R40-billion of the local pension fund industry; yet, while it does present significant benefits to clients, LDI managers in South Africa currently only use a bond-based strategy, which has a rate of return linked to CPI. This means that a significant portion – between 70% and 80% – of the liability value needs to be in bond assets in order to hedge out the full interest rate exposure.

South African LDI managers should consider employing a swap-based strategy instead – with interest rate swaps being entered into on behalf of the client – as it requires far fewer assets to match the fund’s liability. As a result, only 30% to 35% of the liability value needs to be invested in swaps, leaving the remaining 65% to 70% to be invested in growth-seeking assets.

The reality is that if the fund is largely invested in bond assets, then a DB pension fund has a small chance of being able to close any liability gap. By utilising the majority of the fund’s assets in growth assets, it is possible to improve the funding position.

Traditionally LDI mandates tend to be off-balance sheet solutions. Liberty Corporate takes an alternative approach by carrying the liability on its own balance sheet. With the assets passed to the insurer, the company simply receives a policy of insurance, making the process administratively simple for the funds, as they are only required to enter into one, rather than multiple contracts.

For a company to enter into these trades in the derivatives market themselves, agreements must be put in place for each counterparty with which one transacts. This can be a cumbersome process and one that most pension funds simply does not have the framework, systems or manpower to manage effectively.

If a DB pension fund invests in a swap-based LDI strategy, they have a far better chance of granting the pension increase to the members that they have targeted, as they are far less likely to have fluctuations in their funding level.