The pension scheme of spirits producer Diageo has increased its inflation and interest rate hedge. Are all defined benefit schemes on this path as funding improves, or have yield movements made some rethink their options? 

 

The first quarter of this year saw yields pushing up somewhat before falling back again in the second quarter. Meanwhile funding levels have improved thanks to sponsor contributions and an equity market rally; the Pensions Regulator’s latest scheme funding analysis shows almost a third of schemes are now in surplus, with deficits having reduced by a median 31%.  

 

 

As funding improves, schemes have been advised to derisk and increase their liability-driven investments, rather than react to short-term yield moves. 

 

One of them is the Diageo Pension Scheme, of the multinational alcoholic drinks producer. The scheme has had a liability hedging programme in place for several years. More recently, "the trustee has been taking steps to increase the level of hedging in place to protect the Scheme against interest rate and inflation risk which now stand at approximately 80% of interest rate risk and 90% of inflation risk”, the scheme said. The hedge against interest rate risk is being progressively increased toward the 90% target. 

 

The reduction of interest rate exposure and, in particular, the scheme’s complete disposal of equities in 2019, have meant that the March 2020 market falls have only had a limited impact on the  investments, the trustees noted. 

 

 

Head of pensions strategy at consultancy Cartwright, Jonathan Seed, said the consensus is that interest rates will remain ‘lower for longer and that “for the foreseeable future [there will be] low interest rates”, although he noted that it is dangerous to take a view on whether rates are going to increase faster than the market anticipates or on directions generally. 

 

While most schemes hedge around 60-70% of liabilities, he has seen just one case where the scheme might have been slightly overhedged. Being overhedged “will hurt the funding position” if rates go up, and while it is unusual to be in that position “it’s definitely something worth checking”, he noted. “If you top up the LDI portfolio you have to be careful that you don’t overhedge.” 

 

The direction of travel for schemes is “more LDI investment”, said Seed, who added that most of the firm’s clients have funding-based triggers in place. “If they hit a trigger, we move quickly to increase the hedge,” he said.  

 

 

However, while most schemes held their course on hedging interest rate risk, there was “definitely a pause in inflation hedging” last year after the outcome of the retail price index consultation, he said. "Schemes were hoping that RPI hedge pricing could become a bit more competitive but that didn’t happen because there is such strong demand,” he added.  

 

Last year, the government said it would align RPI with the lower consumer price index including owner occupiers’ housing costs from February 2030, having consulted on whether to do so sooner. It also said it would not compensate holders of index-linked gilts who are seeing the value of their gilts decrease - many of them pension funds hedging RPI-linked liabilities. However, the BT, Ford and Marks and Spencer pension schemes are seeking a judicial review of the decision to replace RPI with CPIH. 

 

 

Increasingly, buy-ins are also becoming part of LDI. He said he has seen “a real pickup in Q2” in buy-in transactions, adding: “Then it’ about how you dovetail your buy-in policy with your LDI portfolio." 

 

This includes keeping an eye on liquidity, as transfers out can be significant particularly for small schemes. “Some schemes have higher outgoes from transfers than pension payments. They are much harder to predict, you have to be careful, making sure you have enough liquid assets,” he observed. 

 

 

Pension schemes fall into two categories, said Devan Nathwani, investment strategist at Secor Asset Management – those that are extremely well funded and near the end game which hedge a lot more, and those that have flight plans in place and increase hedging.  

 

“What we advise them is to stick to their plan and not be too tactical around yields and rates," he said, noting that he has not seen any clients overhedging. The trend is towards hedging more as schemes get more funded, he agreed. 

 

Nathwani said schemes are also increasingly looking to protect against equity market falls as they mature and come closer to their endgame. 

 

“As schemes derisk over time they’ll reduce equities but also become less tolerant of equity market drawdowns,” he explained, citing the market drop in March 2020 during the Covid crisis.  “When you are quite well funded... that can be quite painful.”  

 

Devan Nathwani