In this paper, we consider the effect that duration drift in bond indices has on UK pension schemes.
Index tracking bond funds based on commonly used indices are widely used by pension schemes as the low risk assets in their investment strategies……
Sign up for our weekly Newsletter and receive the latest ETF and ETC news. Click here to register for your free copy
Alistair Jones, UK Strategic Solutions, Schroders
This is especially the case for smaller pension schemes. We test the presumption that index tracking bond funds are low risk assets by looking in more depth at the characteristics of these funds. Key findings are:
1. That the durations of index tracking funds change materially over time
2. The degree to which index tracking funds ‘match’ pension scheme liabilities can also vary substantially
3. The vast majority of schemes do not explicitly consider or manage these issues Why do pension schemes use passive bond funds?
It is common amongst UK pension schemes to have a strategic asset allocation to bonds and often to passive UK government bond (gilt) funds. These index tracking funds tend to track over 5 year, over 15 year and all stocks gilt indices.
The historic rationale for this type of allocation has been that these funds generally tend to behave similarly to pension scheme liabilities. Liability values, as calculated by Scheme Actuaries, are sensitive to changes in interest rates and inflation expectations. So too are gilts. Therefore the assertion has historically been made that:
– Fixed interest gilts are sensitive in value to changes in interest rates. Therefore they can be used to match fixed liabilities that are also sensitive to changes in interest rates
– Index-linked gilts are sensitive in value to changes in both interest rates and inflation expectations. They can be used to match real liabilities
Liability matching
According to recent statistics published by Mercer, the average duration of UK pension scheme liabilities is around 22.5 years. A bond fund with the same duration as a pension scheme’s liabilities would be expected to perform broadly in line with the liabilities when interest rates change. This type of bond fund could generally be said to be a good interest rate match for the liabilities.
A bond fund that is longer in duration than a pension scheme’s liabilities would be expected to be more sensitive to changes in interest rates, so a poorer match. Similarly a bond fund that is shorter would be expected to be less affected when interest rates move compared to the liabilities, again offering a poorer match.
The same duration properties apply when considering using index-linked gilt funds to match a pension scheme’s inflation-linked liabilities.
Figure 1 shows how the durations of index tracking gilt funds have increased over the last 10 years, in some cases substantially. The duration of two commonly tracked indices, the over 15 year and over 5 year index-linked gilt indices has increased markedly in recent years. Pension schemes invested in index tracking gilt funds should be aware that the durations of these funds are not static. Indeed they could now be somewhat different to the liabilities that they were originally intended to match.
One of the reasons for the increasing durations of gilt indices has been changes to the structure of the UK gilt market. This has caused particular gilts to fall out of the indices. This can be seen quite clearly when looking at the step changes in the duration of the over 15 year index-linked gilt index (dark orange line). In Figure 1 it can be seen that in 2005, 2009 and 2012 the duration stepped up when the 2020, 2024 and 2027 index-linked gilts fell out of the index respectively.
It should also be noted that since around 1980 interest rates have generally been decreasing, as shown in Figure 2. This also causes the duration of the gilt universe, and pension scheme liabilities, to lengthen. Lower interest rates mean that the effect of discounting puts more weight on longer dated gilt cashflows.
Pension schemes investing in index tracking gilt funds should also be aware that they are receiving little yield on their investment. Figure 2 shows that yields are low on gilts by historical standards. Also total returns on schemes’ gilts are likely to be poor or even negative if/when yields increase from their historic lows.
The dangers of drifting durations
As shown above, the drifting durations of index tracking gilt funds can lead to mismatches with pension scheme liabilities. This mismatch is often not explicitly considered or managed by pension schemes and shows no signs of being rectified any time soon. The likelihood is that this position could actually get worse. Given that most defined benefit pension schemes are now closed to new members, the average age of UK pension scheme membership can be expected to get older with time. This will likely cause the duration of liabilities to run down in the future.
The opposite effect has been witnessed in UK (and US) government bond markets where there have been concerted efforts over the last decade to lengthen duration. In recent years the US Treasury has openly stated its goal of lengthening the average maturity of its debt. Whilst the UK government has not been as explicit in stating its gilt issuance intentions, it is planning to issue “ultra long-dated gilts”.
This may cause index tracking gilt fund durations to further increase.
What should pension schemes be doing?
How should pension scheme trustees interpret this information? There are a number of issues that trustees could consider when assessing how they invest in index tracking gilt funds.
– Risk can be reduced versus liabilities by investing in tailored liability matching strategies that match the duration of pension scheme liabilities. Pension schemes can invest in physical bonds to match their liabilities. They can also invest in Liability Driven Investment (LDI) funds.
These can allow schemes to target closing their deficit by investing freed up capital in growth strategies that target returns in excess of their pension scheme liabilities.
– Investing in an index tracking bond fund may have created an unwanted, and in effect active, duration position versus the pension scheme’s liabilities. If taking an active duration position, this may be better rewarded by allowing a skilled bond manager to take duration positions to enhance returns. This could take the form of an actively managed bond fund.
– Interest rates are currently at low levels relative to history. When they eventually rise, the value of a pension scheme’s index tracking bond funds and liabilities will fall. Pension schemes that are invested in index tracking bond funds with durations longer than their liabilities will suffer greater losses on their bonds than liabilities. In this environment, the presumption that government bonds are a low risk asset may well not hold.
Source: Schroders
Subscribe to Our Newsletter
