Stress test your pension

Topic:

Funding & investment

Date published:

Tuesday, 11 December 2018

Author:

Gerald Wellesley

In a world where few of the old rules seem to apply, surely it’s strange to be using previous experience to estimate certainty about the future? This is what stochastic modelling does and many pension schemes use it as a basis for decision making.

Even the conventional approach that bonds are the best diversifier for equity risk is now open to question. The simultaneous fall in both stock and bond values in recent simultaneous falls may well not be the aberration that traditionalists think. After all, since the financial crisis, both stocks and bonds have performed very strongly – why wouldn’t the reverse be true if we really are seeing inflation making a return in the current high employment environment (in the UK and US at least)?

Another question: is liability driven investment (LDI) even the ‘must have’ instrument it has been if rates were to rise faster than expected to combat inflationary pressures?

With all these uncertainties (don’t even mention Brexit), surely the best planning pension trustees can do is stress test their scheme’s resilience to a range of scenarios.

How about this one…

Let’s say you are a trustee of a £1bn pension scheme. You have the following diverse range of assets that together provide a low value at risk (VAR), so you feel reasonably resilient:

• High yield bonds
• Investment grade bonds
• Gilts
• Private corporate credit
• Global equity
• Private equity
• Diversified growth fund (DGF)
• Infrastructure
• Property
• LDI

Now, picture an unexpected 1% upward move in interest rates (prompted, say, by an inflation spike). With a 33% allocation to 20 year duration LDI leveraged 3 times, the pension trustees receive a collateral call of £133 million (£666m borrowed x 1% x 20).

To meet this, the pension scheme (alongside many others) needs to liquidate assets. You can’t readily sell corporate bonds because, post the global financial crisis, the banks no longer make markets in them. So, you liquidate the DGF instead and join other pension funds in selling equities that are your most liquid assets.

The high yield and investment grade bonds see spreads widen just as equity prices are sliding. The real asset portfolio funds are also under selling pressure, so trade at a discount to net asset value for those who are able to sell. So you sell gilts and reduce your hedge. Perhaps the capital loss you take on these in a rising yield market will be more than offset by the reduction in your liabilities, but that’s a gamble and it won’t help stem the unrealised losses elsewhere (the highly geared floating rate private credit portfolio certainly isn’t a tail wind in this market either).

Granted, most pension schemes will have planned for the collateral calls, but many schemes won’t have performed cross portfolio stress tests to understand what a scenario like this might bring. It also means they won’t have plans in place to avoid being a forced seller in a stressed market.

You think this scenario is unrealistic? How unrealistic?

Perhaps you need a stochastic model to tell you.

Back to opinions