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experience of the members of the pension
plan. It is typically structured as a cash
flow hedge in such a way that the net cash
flow (liability cash flow and hedge cash
flow) is fixed with respect to changes in
longevity/mortality.
By contrast, a standardised index hedge is
based on the longevity experience of a broad
longevity index, such as a national population
index, but calibrated to match the sensitivity
of the actual liability (reflecting the specific
pool of members) to changes in mortality
rates. It is often structured as a hedge of value,
rather than a hedge of cash flow, so that
any increase in the value of liabilities due to
changes in mortality rates would be offset by
a compensating payment provided by the
hedge. In other words, the net value of the
liabilities at a future date (liability value and
hedge value) is locked in.
Unlike a customised hedge, a
standardised hedge does not completely
eliminate longevity risk, because of the basis
risk between the pension plan's longevity
experience and that of the longevity index's
mortality. This means the degree of risk
reduction, while still significant, will be
less than 100% and hence there will be
some residual risk remaining after hedging.
However, this basis risk can be reduced to
acceptably small levels by calibrating the
standardised hedge to match the mortality
sensitivity of the plan's liabilities --
providing hedge effectiveness between 85%
and 90% as illustrated for a specific pension
plan in Figure 2.
While customised hedges can provide
complete risk mitigation, they are generally
more costly, more cumbersome to adjust or
unwind, and provide more counterparty credit
exposure than a standardised hedge. They also
require detailed data on the benefit structure,
demographics and mortality experience of
the pension plan to be disclosed to the end-
investors. In addition, customised hedges are
sometimes implemented on a first-life-only
basis, providing only single life cover for a
joint life benefit -- another form of basis risk.
Standardised hedges, on the other hand,
are more economical, less complex,
potentially much more liquid and do not
require disclosure of data to the end-investors.
The key disadvantage is that standardised
hedges do not completely eliminate the
longevity risk, but they do reduce the
exposure significantly.
Optimisation of the
return-seeking portfolio
With the unrewarded risks having largely
been removed, the next step is to optimise
the asset portfolio to ensure that the
return-seeking assets produce the best
risk-adjusted returns. Traditional pension
plan asset allocation consisted of equities,
bonds and sometimes a relatively small
allocation to property. The focus has
now changed substantially, with trustees
looking for diversification from alternative
asset classes to reduce their over-reliance
on listed equity markets and to reduce
their funding deficit with its associated
dependence on a sponsor covenant.
The introduction of alternative asset
classes, such as hedge funds, private equity,
commodities, infrastructure and active
currency management has opened up new
investment opportunities. These can provide
higher expected returns, lower volatility,
lower correlation with traditional asset
classes and absolute return strategies.
More pension plans have incorporated
these alternative asset classes to expand
their efficient frontier and improve their
risk-return characteristics, subject to having
the necessary governance structures in
place. However, there is still a long way to
go for pension plans to reduce their historic
reliance on listed equity markets.
Portfolio protection
A large number of pension plans and
corporates would like to maintain exposure
to equities to generate outperformance
above their liabilities, but are looking for
ways to provide protection against falling
equity markets, while still maintaining
equity upside exposure.
Most pension plans, however, do not
want to pay the upfront premium that would
be associated with a put option protection
strategy. Therefore, they have typically looked
to finance the downside protection by selling
some of the unrequired upside potential. This
is referred to as a `costless' collar strategy, and
entails buying a put option at the desired
level of protection required, while selling a
call option at the level that would equate to
the cost of the put option in order to provide
financing for the protection. Trustees are
increasingly using equity derivative protection
strategies that are tailored to their specific
risk/reward trade-off.
Conclusion
Optimising the allocation of the risk budget
is imperative to ensure efficient portfolio
management. With trustees and corporate
sponsors more comfortable with, and proactive
at, using derivatives structures to manage risk,
these strategies will be more prominent in the
pension solutions set going forward.
Lukas Steyn is a member of the JP Morgan
European Pension Advisory Group
PensionsInvestment strategies
October 2008 35
Figure 2: Distribution of liability value in 10 years without a
LifeMetrics-based standardised longevity hedge
Unhedged for longevity risk
Hedged using standardised longevity hedges
Hedging longevity risk has reduced the
volatility of the liabilities by 86%
Combined liability and hedge values in 10 years
Unhedgesnumberofoutcomes(/1000)
Hedgednumberofoutcomes(/1000)

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