Issue: September 2012 / November 2012
Expert Opinion

Optimal strategy to partner savings

A fresh perspective on a complex financial concept is offered by Twané Wessels, marketing actuary at Momentum Employee Benefits.

Many pensioners have suffered a decline in the purchasing power of their pensions over the past four years because of inappropriate investment strategies that fail to synchronise the movement of assets and liabilities. Momentum is the first SA insurer to follow the trend amongst the largest international insurers to use dynamic hedging – the most sophisticated liability-driven investment strategy to date. Pensioners can confidently partner this investment strategy with their retirement savings to ensure solid future pension increases.

Dynamic hedging is a tango in which assets and liabilities move exquisitely in sync. It is carefully choreographed by actuaries to manage investment risk and navigate successfully through all scenarios.

An investment strategy has to dance off against a number of challenges. These include significant investment risk due to the long-term nature of retirement savings, and continuously changing retirement objectives that vary for different individuals. Assets therefore have to match a unique and dynamic liability-driven benchmark to ensure that pensioners’ reasonable benefit expectations can be met.

Trustees, advisors and some insurers are gambling with the future financial wellness of pensioners by using less sophisticated strategies like partial cashflow-matching techniques together with high-risk, maximum-growth strategies for the balance of the assets. In this case, asset and liability movement mimics disco-dancing instead of a synchronised tango.

Derivative overlays such as puts and zero-cost collars are short-term solutions to protect against extreme asset fluctuation, but the assets are still managed independently from the liabilities. Derivative overlays can also have unintended consequences like changing the effective asset allocation and sacrificing upside return when the market recovers.

On the other hand, a precise cashflow-matching strategy mimics a coordinated Macarena dance between assets and liabilities. This works well for a clearly defined liability; for example, where pension increases are guaranteed to match inflation and the liability can be matched exactly with a mix of inflation-linked assets.

However, this strategy is too expensive for the alternative case where pension increases target inflation and some investment volatility can be tolerated in order to seek higher expected returns. This is where dynamic hedging steals the limelight.

It takes two to tango. Dynamic hedging involves creating an asset portfolio that is continuously in sync with the liabilities, step for step. The asset portfolio consists of two parts, a bonusgenerating portfolio that includes risky assets and a fixedinterest portfolio that protects against interest rate movements. ‘Hedging’ in dynamic hedging is the precise rebalancing of these two parts to continuously align the sensitivity between the assets and liabilities.

The strategy is proactive rather than reactive: protection against market volatility is purchased upfront, rather than in adverse conditions when it is most expensive. The rebalancing operates within tolerance ranges to achieve the delicate balance between accuracy and cost, just as dance is the delicate balance between precision and beauty.

The beauty of dynamic hedging is evident in numerous benefits to shareholders and policyholders. Investment risk is better managed, resulting simultaneously in greater investment freedom and lower capital requirements, and therefore lower ongoing cost.

Shareholders benefit from being less exposed to downside risk. Policyholders benefit from higher expected pension increases in the long term and more accurate pricing. Compare the annual pension increases for Momentum’s dynamicallyhedged annuity versus increases for a traditionally-managed annuity (see graph).

Could dynamic hedging have been a saving grace for definedbenefit pension funds by managing investment risk significantly better for employers? Traditional strategies gamble on risky assets outperforming assets that replicate liability movement. This involves taking unrewarded risk for shareholders and policyholders which can just as likely turn sour.

But with dynamic hedging, assets and liabilities are synchronised. It is then possible to tango on a shifting carpet instead of seeing the rug being pulled out from under you.

Momentum Employee Benefits