Stick or switch? Reducing swap-spread risk in the endgame

As DB schemes mature and many seek to reduce risk relative to insurance pricing, we believe the most important economic components to consider are interest rate risk, inflation risk and credit spread risk. We’ve written about both the interest rate sensitivity of buy-in liabilities and their credit sensitivity. However, another common question relates to swap yields versus gilt yields and how schemes can reduce ‘swap-spread risk’ relative to insurer pricing.

What swaps do insurers hold?

Insurers predominantly match cashflows with physical assets: credit, direct investments (DI) and a relatively small amount in gilts.

This means most of the interest rate exposure should in theory come from physical assets (rather than derivatives). However, a meaningful level of interest rate derivative exposure can be required (to fully hedge interest rate risks), for example:

• The credit/DI might not be long enough duration to hedge longer-dated liabilities
• Some of the underlying DI cashflows might be more floating in nature rather than fixed
• Overseas assets will need to have overseas interest rate exposure hedged back

Aligning with insurers

Given the nature of insurance regulation (liabilities are discounted by swaps), interest rate and inflation hedging derivatives implemented by insurers are typically swaps-based rather than gilts-based.

Buyout-aware investing is about investing like an insurer’s strategy, and therefore aligning with buyout pricing. From a clean sheet of paper, the indicated starting point for a pension scheme to hedge versus a buyout basis would be to:

• Generate most interest rate exposure from physical assets
• Implement any derivatives required to ‘fill the gaps’

Most pension schemes have more gilt-focused liability hedging portfolios. E.g. in general, most insurers hold around 10-25%[1] in UK gilts and, typically, pension funds may hold on average around 45%[2]. This means that strategically as part of a transaction, some gilts typically need to be sold.

While switching gilt derivatives to swap-based exposure could lead to better tracking versus buyout pricing, it should be assessed whether the potential benefit is worthwhile, particularly in the context of:

• Transaction costs
• Time required for trustees/consultants to consider
• Reduced expected return e.g. at 28 March 2024 gilts yields were 74 basis points (bps) more than swaps for maturities of both 2052 and 2068
• Future planned de-risking from growth assets, meaning derivative exposure will likely reduce over time

What is the risk?

Like all liability-driven risks, the quantum of risk can be considered as the combination of:

• The underlying market risk, in this case ‘swap-spread’ volatility
• The size of the exposure; in this case the difference between a schemes gilt/swap exposure versus that implied by an insurer-pricing basis

The former is more straightforward to observe. As highlighted below, swap spreads are typically far less volatile than the other key risks of interest rates and credit spreads.

The latter is extremely complex to assess, noting derivative exposure will differ materially by insurer and this information is not publicly available to the level of detail required.

In addition, where insurers provide ongoing indicative pricing or first-round quotes (particularly for smaller/medium transactions) this may just reflect the price of the physical assets required to match the liabilities and not go into granular detail around derivatives required.

This risk is therefore typically very hard to observe (and therefore hedge) in the journey planning phase.

When is it worth it?

When getting to a specific quote, and particularly if in-specie transferring assets or entering a price lock, the gilts versus swaps question can become more important.

This is because an insurer will charge more depending on how much restructuring they need to do, reflecting both transaction costs and risk of divergence over the insurers transition period (the time between the assets being received and implementing the preferred target portfolio).

This highlights how a strategic relationship with an insurer can potentially be valuable. In particular, this opens up the ability to discuss with an insurer whether certain trades (e.g. switching gilt to swap exposure) prior to the buy-in transaction would likely improve pricing and if so guide on the potential magnitude.

This could enable a scheme to consider whether such trades would be worthwhile, e.g. would a potential saving on the buyout premium outweigh the expected transaction costs?

Time to invest like an insurer

In terms of investment approach, we believe the key focus for schemes looking towards buyout should be to invest more like an insurer by de-risking from growth assets towards lower-risk assets such as credit. This is likely to reduce the level of leverage the scheme is running and therefore its derivative exposure, as credit exposure can contribute to the interest rate hedge.

Once this step has been taken, there may be merit in considering whether the remaining derivatives could be tilted to be swaps-focussed, noting that this is heavily scheme-specific and that any potential benefit may be hard to quantify.

[1] Source: LCP De-risking Report October 2022

[2] Source: PPF – Purple Book 2023