Having a set of automated trigger points feels like a sensible governance solution – whether in an investment advisory or fiduciary context. As a result, the scheme automatically divests from growth assets to add to matching assets (therefore increasing the level of liability hedging) at each funding level trigger point. However, two important questions are often overlooked: What investment conditions led to the trigger point? And what should I do next given my longer term funding goals?
Matt Simms, Director of Solutions, P-Solve
To illustrate this, imagine a scheme where the funding level has improved past a trigger point due to great performance from the growth assets. From this point it would seem sensible to reduce the amount of growth assets held, all else being equal (as they have performed strongly). However, does this mean that we should increase the liability hedging levels? Instead, the level of hedging could remain the same but with more matching assets held and therefore less need for derivative based hedging (i.e. lower leverage).
Now let us imagine the other scenario where the funding level improvement has been driven by interest rate rises (supposing we are not fully hedged). Within this scenario growth assets aren’t necessarily any less attractive than they previously were, in fact they may even have struggled recently with interest rate rises so it may be a bad time to sell them (as there may be greater expected returns available). However, given the interest rate rises which have led to the improved position, this may in fact be a good time to increase the level of liability hedging. This could be achieved by increasing the amount of derivative based hedging whilst still maintaining the same allocation to growth assets.
This example is keeping things very simple. In reality at P-Solve we would always advocate that trustees should consider the current market environment before implementing any changes. Hopefully, however, this illustrates that, as a starting point, being aware of what has driven funding level improvement and being able to separate the decisions on the amount of growth assets and levels of liability hedging is a more sensible approach than automated de-risking.