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3. Matching DB assets

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What you need to do

  • Understand the purpose of your matching assets, including the risks they are seeking to mitigate, so you can assess how appropriate and effective they are.
  • Understand the risks introduced by your matching assets, so you can ensure you have appropriate strategies and appropriate governance arrangements in place to manage these risks.

Using matching assets

You are legally required to invest assets backing DB liabilities in a way that’s appropriate to the nature, timing and duration of the expected future retirement benefits payable under your scheme[1]. To help achieve this, many schemes hold ‘matching assets’ in order to manage investment risk relative to the liabilities.

Different types of matching asset match the liabilities in different ways, with varying degrees of accuracy, and with different levels of expected return. Your scheme’s matching asset portfolio may comprise only physical (ie non-derivative) assets, eg fixed or index-linked gilts, corporate bonds, long-lease property and some forms of infrastructure. However, it is common practice for matching asset portfolios to use derivatives as well, to increase the level of matching achieved. This type of approach is known as liability driven investment (LDI).

In order to assess your scheme’s matching asset portfolio and how appropriate the assets used are, you need to understand why your scheme invests in matching assets. It may be to:

  • reduce the volatility in the funding level by investing in assets which respond to changes in interest rates and / or inflation in the same way as the liability value does
  • prepare for a liability transaction, eg a partial buy-in, by reducing the volatility of the assets relative to the transaction price
  • generate cash flows that coincide in timing and amount (ie match) with scheme cash outflows, such as the payment of pensioner benefits, in the short to medium term
  • seek to match the long-term cash flows of your scheme

You need to understand, at a high level, the principal characteristics of the liabilities or cash flows you’re trying to match and the main features of your scheme’s matching assets.

You can use this information to assess how effectively the matching assets are meeting your objectives for them, and whether any changes would be appropriate. Your investment adviser should be able to assist with this.

Footnotes for this section

  • [1] Regulation 4(4) Occupational Pension Schemes (Investment) Regulations 2005 (the 'Investment Regulations').

Understanding the risks of your matching assets

You need to understand the risks introduced by your matching assets. You may wish to consider risks in relation to:

  • credit / default
  • liquidity
  • collateral requirements and management
  • derivative counterparties
  • foreign exchange
  • concentration, eg in relation to specific issuers, sectors or portfolio factors
  • reinvestment / roll
  • political and regulatory
  • investment manager skill
  • basis

If your matching assets include derivative instruments, you should consider the additional risks these introduce. A key issue to understand is how the matching asset portfolio will behave in an environment of rising long-term interest rates (and therefore, falling values of liabilities and matching assets) and how this may impact on the collateral being held and potentially on the scheme’s other assets.

The use of derivatives in your matching assets may require you to hold a minimum amount of assets eligible to meet collateral requirements, such as cash or gilts. Your investment manager or investment adviser will be able to explain whether and how this affects your scheme and what processes and plans are appropriate to meet any collateral movements and to address the associated operational risks.

For more information see collateral management.

You might be holding matching assets to prepare for a future liability transfer exercise, eg a buy-in or buy-out of your scheme liabilities (or some of them). You should consider with your investment adviser whether the assets you hold for this purpose are likely to be acceptable to an insurer and, if not, the impact that might have on your liability transfer objective. In particular, you would then need to consider how to convert those assets into cash, the costs involved in realisation and any potential restrictions on sale.

Diversification

It is a legal requirement for scheme assets to be properly diversified[2]. Diversification means investing in a range of assets to ensure the scheme is not overly reliant on any single investment or portfolio of investments. Not all investments perform the same way under different economic and market conditions. Diversifying your scheme’s assets should therefore provide greater stability of investment returns and reduce risk.

You may wish to consider diversification of your matching assets in terms of:

  • asset classes
  • geography
  • bond issuers
  • derivative counterparties
  • asset managers

Footnotes for this section

  • [2] Regulation 4(7) of the Investment Regulations.

Governance

We expect you to have appropriate investment governance arrangements in place for your scheme’s matching assets so the risks are properly managed. In particular, the use of derivatives can introduce investment and operational risks that require careful oversight.

Liability driven investment

Derivatives, such as interest rate or inflation rate swaps, gilt repurchase arrangements (gilt ‘repo’) etc, can be used to match liability or cash flow characteristics more closely. They can also, through the use of leverage, provide increased exposure to interest and inflation rates and reduce the proportion of the scheme’s assets that need to be held in the matching asset portfolio to achieve a given level of matching. This type of approach is known as LDI.

Investment in derivatives is subject to additional statutory requirements. The law requires that this type of investment is only be made to contribute to a reduction in risks, or to facilitate efficient portfolio management[3].

The use of LDI typically enables pension schemes to achieve an improved balance between investment risk and return but it does introduce additional risks, eg around the use of leverage and in relation to operational risks around the management of collateral. Your investment adviser will be able to discuss the merits of an LDI approach to your matching assets with you.

Footnotes for this section

  • [3] Regulation 4(8) of the Investment Regulations.

Trustee toolkit online learning

Go to the Trustee toolkit The module 'An introduction to investment' contains tutorials called 'Types of asset: Common assets', 'Types of asset: Alternative assets' and 'Capital markets and economic cycles'. The module 'Investment in a DB scheme' contains a tutorial called 'Changing the asset allocation strategy'. You must log in or sign up to use the Trustee toolkit.

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