Study: European Funds Imprecisely Model Their Liability Hedging Portfolios

(September 28, 2010) — A recent study by EDHEC-Risk Institute has shown that nearly half of all European pension funds are imprecisely modeling their liability hedging portfolios.

Samuel Sender, applied research manager at the institute, said the primary challenge for a pension fund, according to the latest research, is meeting its liability by hedging it away, fully or partially. The EDHEC Survey of the Asset and Liability Management Practices of European Pension Funds discovered that 45% of pensions have poorly defined liability hedging portfolios. Meanwhile, a quarter of schemes have failed to fully identify their liabilities. Sender said the second challenge is to gain access to performance through optimal diversification within and between asset classes. The last challenge, according to Sender, is for pension funds to respect their minimum funding ratios by insuring away risks.

Furthermore, the report indicated that European pension funds have a “blinkered view” of their risks. While accounting risk is managed by only 33% of respondents, more than half ignore sponsor risk, or the risk of a bankrupt sponsor leaving a pension fund with deficits.

The report additionally highlighted that there are more inflation-linked securities in the UK than in continental Europe. Indexation to inflation is the norm in the UK, with 64% of respondents having more than 20% of their assets in inflation-linked assets. About 40% of schemes in the UK use derivatives for at least 20% of their LHPs, but only 12% of the portfolio run by schemes in Continental Europe, Professional Pensions reported.

The study by EDHEC-Risk Institute consisted of interviews with 129 pension funds, advisers, regulators and fund managers with a total €3 trillion in assets under management. Pension fund assets represented €900 billion.