Should councils take a closer look at the FX exposure of their pension funds?
Following the recent news that Croydon Council is considering hedging the currency risk in its pension fund, Jackie Bowie, CEO of Chatham offers her view on optimal strategies to achieve the best outcome.
All councils owning foreign assets in their pension funds are exposed to foreign currency risk. Given the demise of Sterling over the past three years, these assets are now worth more in Sterling terms. Since the Brexit referendum in June 2016 the US dollar and Euro are approximately 12% stronger.
So, should councils now be locking in gains with currency hedges if they haven’t done so already?
Overall, funds should not make a currency hedging decision based solely around a single event, such as Brexit, and the decision should definitely not be driven by a market view. Macroeconomic events will always crop up in different guises. Some, like Brexit, will be known events while others will take the market by surprise. Therefore, funds need to ask themselves whether they are willing to tolerate currency risks that can significantly impact the performance of the fund, or whether they will evaluate the full extent of the exposure and design a hedging strategy to manage it.
When deciding whether to hedge your exposure, it is crucial to evaluate the cost of hedging against the risk, especially if the foreign assets are expected to be held for a long time. This is when interest rate differentials come into play. Currently, hedging Euro assets back into Sterling benefits the value of the portfolio by approximately 1.3% per annum. Euro interest rates are in negative territory while UK rates are positive. However, if a council owns US dollar denominated assets, then hedging the FX risk of these investments will come at a cost as US interest rates are higher than those in the UK. Currently that cost is around 1.75% per annum.
There are lots of stories about hedging programmes ‘gone wrong’, but currency hedging reduces risk back to the currency denomination of the pension fund, which allows the success of the fund to be dictated by the performance of the assets that you have invested in, rather than unwanted risks.
Hedging the FX risk of foreign-held assets requires considerable expertise. Independent and impartial advice is available to help you navigate all the options and to ensure that the right strategy is in place for your pension fund. After a thorough evaluation, the trustees of a council’s pension fund may decide not to hedge; however, this will be an informed decision and ensure that the currency exposure to any future events will not come as a surprise.
To discuss any of the issues raised in this article, please contact Jackie Bowie or call on +44 (0)207 493 3310.