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Drinks Co. Pension Fund Eyes Derivatives

Diageo's pension fund is looking at using derivatives and increasing its exposure to bonds to reduce the volatility of its portfolio.

Diageo's pension fund is looking at using derivatives and increasing its exposure to bonds to reduce the volatility of its portfolio. The fund, however, will not make any adjustments just yet, because it is waiting for its funding position to improve before making a switch out of equity.

Michael Glasgow, director of pensions in London, said the price is not right to sell equity and buy new instruments. Diageo still has a deficit, but as its funding gap closes, it will switch into bonds to lock in gains. Because of the strong employer covenant, the trustees have no need "to make that decision today," he added.

"Like many pension funds, [Diageo] has looked at liability-driven investment strategies and using derivatives in some way to reduce volatility," Glasgow continued, "but the price of doing what we need to do doesn't seem [worth it just yet.]" Investment banks have "tended to approach us and we've listened to a couple of them," which he declined to name. Diageo has looked at strategies to reduce downside equity risk as well as bond-like instruments, such as swaps.

Earlier this year the fund made its first foray into bonds. This was opportune. Diageo terminated a European equity mandate with Merrill Lynch Investment Managers and decided to put this money into bonds seeing as its long-term intention is build up a fixed-income portfolio. MLIM had put four different fund managers in charge of this portfolio in a short space of time and the departure of Patrick de Grose was the final straw, said Glasgow.

Equity markets are rising and there is no immediate plan to move the next tranche of assets into bonds. By maintaining its approximately 80% exposure to equity, the fund's valuation rose to GBP2.5 billion in September from GBP2 billion in April last year, on the back of the equity market recovery. The fund is now worth GBP2.6 billion, following an injection of GBP100 million from Diageo's sale of its shares in U.S. foods group General Mills.

The fund has a strategic allocation of 10% to real estate, although the property portfolio is actually worth 14.5% of scheme's assets. Diageo has also invested 5% of its assets in private equity since 1999 with Pantheon Ventures. The cash position varies, because the fund has to pay out GBP120 million in pensions annually. Hewitt Bacon & Woodrow is the consultant.

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