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Are you anchored to higher interest rates?

James Fermont

In this blog on liability driven investments, James Fermont describes how human psychology sometimes gets in the way of good investment decisions.

Pension scheme trustees that decided to use liability-driven investment techniques to hedge their scheme’s liability risks a few years ago can give themselves a pat on the back for getting it right. But for those that held off, falling gilt yields have brought continued angst and now make committing to hedging even harder.

Why is it that most pension schemes still have significant amounts of unhedged liabilities?

This can at least be partially explained by a branch of economic theory: behavioural finance. This suggests that most people, even professional investors, simply don’t make truly rational investment decisions. Instead, their emotions and unconscious biases that have evolved over millions of years influence their decisions.

One of the key concepts of this theory is “anchoring” – being influenced by past information when looking into the future. In the case of this critical hedging decision it’s easy to be anchored to much higher yields of ~4%-5% pa that were available only a few years ago and unconsciously assume the only way from here is up. So it’s not surprising that many schemes have decided not to hedge all their liabilities.

What approach should pension schemes take?

The rational approach is to consider the balance of supply and demand in markets and use this to guide you on future yield movements. As an example, let’s take a look at how the ownership of UK government bonds has changed over the last 15 years.

LCP Yeild chart

There are 3 interesting points that I always draw from this chart:

  • Holdings by pension schemes (and insurers), in blue, have increased materially over the last few years. As pension schemes continue to mature and de-risk, I don’t see this trend abating.
  • The volume of issuance has increased significantly – but the government has plans to keep a lid on this, and this won’t increase indefinitely.
  • The scale of the Bank of England’s ownership, acquired through its QE programmes, is clear to see (in green). There is limited incentive for the Bank to sell these holdings until the economy is growing robustly and inflation is back on target.

Evaluating the market in this manner helps trustees reach a decision on hedging without behavioural biases. When implementing that decision, as always, being prepared and able to act quickly is often the best strategy.

This blog has been extracted from our isse 4 of LCP Vista magazine – click here to download LCP Vista