Rik Albrecht: The protection portfolio does not protect everyone
This column was originally written in Dutch. This is an English translation
There is no shortage of creative solutions amongst asset managers for the optimal hedging portfolio. However, one question that is often overlooked by directors is: who receives the risk premium and who ultimately bears the risk?
By Rik Albrecht, CFA, director and chair of the investment committee at various pension funds and asset manager at Roccade.
Under the solidarity-based premium scheme, older members receive mainly the guaranteed return, whilst younger members receive mainly the excess return. Under the indirect method, which most pension funds have opted for, the guaranteed return is based on the DNB interest rate term structure. This is derived from the Euribor swap curve and includes an interbank risk premium of approximately 0.15 per cent. This is relevant because this mark-up creates a mismatch between the allocated protection return and the earned protection return. Ultimately, this cash drag is passed on mainly to younger participants via the excess return. Consequently, the structure of the protection portfolio affects the distribution of risks between generations.
Many boards are faced with the question: what do we do about that shortfall of approximately 0.15 per cent?
The first option is to accept the cash drag. This keeps the protection portfolio – consisting of swaps plus cash – simple and cost-effective, but also means that younger people are expected to forgo a structural excess return of approximately 0.15 per cent.
The second option is to offset the cash drag with spread products such as government bonds, mortgages or corporate bonds. This is the solution that receives a great deal of attention in practice, with all manner of variations.
A third option receives strikingly less attention: keep the protection portfolio of swaps plus cash as pure as possible and recoup the cash drag elsewhere in the portfolio, for example with an additional 1% to 2% in shares.
At first glance, the second and third solutions appear different, but economically they fulfil the same function here: they seek to offset the structural cash drag with a risk premium and are both assessed on the basis of the ratio between expected return and risk at portfolio level.
However, this optimisation takes place at the level of the pension fund as a whole. This overlooks the question that remains strikingly under-discussed at board meetings: who receives the risk premium? And who ultimately bears the risk?
With spread products, the additional spread premium is incorporated into the protected return.
But when spreads rise unexpectedly, the loss in value is ultimately absorbed by the excess return. The same economic principle applies to additional equities: the extra equity return is used to offset the cash drag, whilst any outliers are absorbed by the excess return.
In both cases, the risk premium and risk are economically decoupled. The return offsets the cash drag of approximately 0.15 per cent and thus contributes to realising the protected return for older members under the indirect method, whilst volatility is primarily passed on to younger members via the excess return. This can add up significantly, particularly in pension funds with an ageing membership.
None of the three solutions is objectively superior. Each choice involves a different trade-off between mismatch risk, diversification, costs, governance and redistribution. The board must therefore make it clear in advance how risks and risk premiums are distributed across cohorts.
The protection portfolio protects older members against interest rate risk. However, under the indirect method, the cost of providing that protection is partly borne by younger members. The protection portfolio therefore does not protect everyone.