European pension funds are considering using swaps to lengthen the duration of their fixed income portfolios as the focus on liability matching becomes more intense, according to DW sister publication BondWeek. The move comes as accounting changes due to be introduced across the European Union in January will inject more volatility into pension fund liabilities and a new Dutch pension law to be introduced in 2006 sets strict limits on underfunding.
"We are predicting the long-end of the European interest rate curve to flatten as pension funds start to enter swaps to increase the duration of their portfolios," said Meyrick Chapman, derivatives strategist at UBS in London. The final version of the Dutch reforms are expected in the coming weeks and the Netherlands-based funds could start hedging from then. Chapman estimates Dutch funds along will have to move between EUR45-75 billion euros into the long-end of the curve.
Denmark introduced legislation in 2001 requiring pension funds to value liabilities at fair value rather than discounting them at a fixed rate of 4.5% and pension funds there have already responded by lengthening duration using swaps. "A 1% change in interest rates implies a ¤5 to ¤6 billion change in the value of our liabilities," said Henrik Gade Jepsen, chief fund manager at ATP, a ¤36 billion scheme in Hilleroed, talking at last week's European Fixed Income Summit in London. ATP has used swaps to increase the average duration of its portfolio to eight years from about six years, with the duration in individual portfolios, such as the European government bond portfolio, raised as high as 12 years.
Rules requiring fair value accounting are now set to be introduced throughout Europe, when the E.U. adopts the International Financial Reporting Standards in January. All European-listed companies will have to report balance sheet liabilities at fair value, rather than a discretionary rate, which is the current standard. This could dramatically increase the volatility of liability valuations in a changing interest-rate environment.
In addition, the Netherlands is preparing a new Financial Assessment Framework under which pension funds will have only one year to recover any underfunding. To manage the anticipated volatility in funding ratios, and avoid underfunding, Dutch pension funds are considering increasing their investments in long-dated assets and their use of credit-default swaps.
Gerlof de Vrij, head of strategy and research at healthcare pension fund PGGM in the Netherlands, said using swaps appears to be a no-brainer because it reduces mismatch risk without affecting returns. He warned, however, swaps merely transform risk from duration to money market risk, rather than reducing it outright.