This year’s currency risk contenders include trade disputes, the slower economy in China and Europe, and the possibility of changing base rate differentials, just to name a few.
It’s difficult to figure out how so many diverse forces come together to form a single vector. In the words of Danish scientist Niels Bohr, “it’s impossible to foresee, particularly concerning the future.” Uncertainty does not sit well with forex traders if the old adage holds true. Considering these dangers, how are pension funds reacting?
Having a fund’s risk unhedged might be a risky move for investors. When it comes to currency risk, “often currency risk is one that has no benefit,” PGGM senior strategist Frank Vinke explains: “So hedging out this risk may improve the quality of the portfolio.”
Setting a proportion of currency risk you wish to hedge out and adhering to it is the passive method. For example, a portfolio of US corporate bonds hedged back into euros at 100 percent eliminates both the credit and the currency risks associated with holding the portfolio. Instead, active management entails adjusting the hedge to take advantage of changes in the exchange rate.
How Do Pension Funds Work?
Traditional pension plans, usually referred to as pension funds, have been on the decline in the private sector for many years now. Employees in the public sector, such as those in law enforcement, now make up the majority of those having both active and expanding pensions. A defined-benefit pension, like it’s written here, is the most popular sort of conventional pension. A proportion of an employee’s pay during the previous several years of work is used to calculate monthly benefits after retirement. How long they’ve been employed by the organization is also taken into consideration. Those benefits are paid for by both employers and workers.
The average income of the last five years of work may be used as an example of a pension plan that pays 1% for each year of service multiplied by five. So, a 35-year-old employee with an average final-year salary of $50,000 would earn $17,500 a year from that employer.
Benefits received from employer-sponsored pension plans, such as those supplied by businesses, may lose purchasing power over time as inflation takes its toll.
When it comes to pensions, the biggest in the country, the California Public Employees’ Retirement System (CalPERS), pays out 2 percent every year in many cases. That means a 35-year-old employee making $50,000 a year might be eligible for a yearly bonus of $35,000 if they had 35 years of service.
Private pension plans may be classified as either single-employer or multi-employer. In the latter case, unionized employees may be employed by many companies.
The Employee Retirement Income Security Act (ERISA) of 1974 governs both kinds of private pension systems. A primary objective of the legislation was to make pensions more financially secure by creating the Pension Benefit Guaranty Corporation (PBGC).
An annual premium is paid to the PBGC by employers for each member in their pension plans; the PBGC ensures that workers will get their retirement and other benefits if the firm goes out of business or chooses to discontinue its pension plan.
In light of the increasing downside risk, it’s only natural that hedge methods to reduce or even take advantage of it would gain in popularity. But Schulze disagrees: “The balance between active and passive requirements has not changed at all.”
Some pension plans have lowered management costs by turning completely passive, simplifying the process. Rob Schreur, CIO of the UK’s National Grid Pension Scheme, says, “We halted active currency management three years ago, after a review of all components of the scheme’s portfolio.” In his explanation, he says that the scheme was not satisfied that active currency managers could consistently contribute value after fees.
Going passive, according to Schreur, has saved the plan roughly 20 basis points on the relevant component of the portfolio, or about €4.6 million per year. Schreur
According to, for most pension funds, active management probably doesn’t justify the extra costs in terms of governance and management fees that are required to set up and supervise such a mandate.
A key motivator is a desire for a more straightforward form of government. “In reality, that may lead to increased complexity – thus, for example, we do not hedge small currencies such as the Danish krona,” advises Vinke of the PGGM starting point of hedging out all currency risk.
Another benefit of not completely protecting against safe-haven currencies like the US dollar is that it tends to increase in times of stock market declines in the US. Finally, an enhanced risk/return profile is achieved by not having a 100 percent hedge in the portfolio. A more common alternative is to hedge to a percentage of 70 percent.
According to Schulze, the most economical way to invest in currencies is via funds that have access to a variety of return sources, such as active currency management. “Pension funds need to outsource to people with the proper capabilities and the capacity to move swiftly,” he continues.