AA Tracker for Pension Liabilities under IAS 19
During the ﬁnancial crisis many pension schemes showed a high degree of fundedness due to high discount rates. Since then interest rates and credit spreads tightened strongly, leading to a signiﬁcant rise in pension deﬁcits. Furthermore, high volatility of the pension deﬁcit has potential capital implications on the corporate balance sheet. Hence, demand has been huge for an immunisation strategy, i.e. hedge, against the tightening and the volatility of the IAS 19 discount rate.
The rate at which post-employment beneﬁt obligations ("PBO") are discounted can be decomposed into the risk-free interest rate and a credit spread with AA-rating. Hence an immunisation strategy needs to address both aspects and both capital markets: Rates and Credit.
IAS 19 requires corporate pension schemes to be discounted at a rate "in reference" to a high-quality (i.e. AA-rated) corporate bond yield with currency and maturity commensurate to the pension liabilities. Accordingly indices such as the iBoxx EUR AA 10+ index have been deployed as discount rates. However, since the universe of AA-rated long-dated corporate bonds is very sparce with less than 10 debtors, the yield of the iBoxx index is primarily driven by heavy shifts due to drop-outs or newcomers to the index, which is an absolutely unhedgeable effect.
The AA-Tracker methodology was developed from the perspective of a liquid and investible index, which at the same time fulﬁlls the criteria under the IAS 19 rules as a discounting index. Hence the same index can be applied on both sides of the balance sheet of a corporate pension scheme allowing to immunise the volatile movements of the pension deﬁcit in a very elegant and sustainable fashion. Overlays in form of iTraxx and rates swaps & swaptions can also be used for managing the discount rate match.
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