The curse of the UFR-drag
Roll risk management for pension funds
For the valuation of pension liabilities, pension funds in the Netherlands use the so-called interest rate term structure (IRTS) with the ultimate forward rate (UFR). This curve basically allows pension funds to apply a higher rate to value their liabilities – the UFR is currently at 1.9% – than interest rates observed in financial markets. Now pension funds are suffering from the so-called UFR-drag.
Of course, the higher UFR is beneficial for all pension funds’ funding ratios. It is seen as a necessity, since the expected long-term return on assets is much higher than rates observed in financial markets. It is therefore argued it does not make sense to value liabilities using low interest rates like the ones observed in the markets. However, there is another side to the story. Since the UFR is much higher than the market long-term interest rates, pension funds suffer from a ‘UFR-drag’.
What is a UFR-drag and what are the implications?
Before we go into the specifics of the UFR-drag, let’s first have a look at another definition: roll. Investors often look at ‘carry and roll’ when assessing securities to select for their fixed income investment portfolios. ‘Carry’ refers to the spread the investor can earn over a reference rate, such as EUR swap rates. ‘Roll’ refers to the valuation with interest rates for shorter tenors as time passes.
When (part of) a specific bond curve is upward sloping, investors generally prefer investing in the longer-term bonds on that part of the curve. It is expected that as time passes these bonds will be valued at a lower interest rates and therefore earn an additional return. This also applies to the liabilities. If the curve is upward sloping, roll will have an increasing impact on the value of the liabilities as time passes.
The UFR-drag is simply the difference in roll between liabilities valued with the IRTS with UFR and the IRTS without UFR. If a pension fund fully replicates the cash flow profile of its liabilities in its investment portfolio, the value of the liabilities will increase more than the value of the investments as time passes (irrespective of interest rate development). As a result, the funding ratio will decrease.
Sensitivity of UFR-drag
The magnitude of the UFR-drag depends on two main drivers:
- The difference in slope of the IRTS with UFR compared to the IRTS without UFR
This follows directly from the definition; if there is no difference between the curves, there will be no drag. However, the further the UFR lies above the long-term zero rates, the bigger the UFR-drag will be. The curves as of the end of June are presented in Figure 1.
- The duration of the fund
The difference in the slope of the curve only appears for tenors over 20 years. This means that liability cash flows beyond the 20-year tenor will suffer from the UFR-drag (see Figure 2). Hence, mature pension funds will be less impacted than younger pension funds. The younger the fund, the larger the UFR-drag.
Figure 1 – Zero curve and IRTS with UFR of ultimo June 2020
Figure 2 – Expected cash flow profile of a young and a mature fund
Roll Risk Management
The simplest way to manage the UFR-drag is, of course, to hold a sufficient buffer to fully compensate the drag. The required buffer is easily calculated by taking the difference between the value of the liabilities based on the IRTS with UFR and the IRTS without UFR. For young funds, a buffer up to 20% can be needed, while a buffer of approximately 5% may be sufficient for mature funds.
However, the funding ratios of most funds have already been severely hit due to the low interest rate environment, which makes holding a sufficient buffer unfeasible. The second way is to create ‘carry and roll’ in the fixed income portfolio to compensate the roll in the liabilities. Roll can compensate to a certain extent, but the majority should come from carry. Young funds would require an excess yield of approximately 50bps, whereas mature funds would need about 25bps. Please note that a higher expected return is accompanied with additional risks.
UFR-drag is a serious risk for pension funds. It increases with (i) the spread between the UFR and long-term interest rates and (ii) the duration of the fund. Since almost all pension funds have liabilities that exceed the 20-year tenor, they ought to account for and manage roll risk. A buffer should be held or additional yield should be earned to compensate for the drag.
How can we help?
Zanders has an extensive track record in market risk management, credit risk management and treasury management. Specifically, there are two main areas where we can help asset managers to manage the UFR-drag:
- Roll risk management
Support on the implementation or review of roll risk management frameworks, models, reports, and operational processes.
- Search for yield through investment in loans
Zanders has broad knowledge and experience in setting up and managing loan portfolios. We support asset managers and banks with the development or validation of rating models for investment in loans and lending to private and public sectors. We also advise corporates and public institutions on treasury management and funding (including WSW and WFZ loans).