Albert Kuller explains how liability driven investment should be a ‘conventional’ strategy for trustees to implement, instead of a time sensitive solution to be viewed with suspicion

Sometimes lost in the whirl of deficit calculations is the simple fact that the vast majority of defined benefit schemes are fortunate that a large proportion of their liabilities are due far out in the future.

While it is obviously crucial to understand the current position, trustees should be predominantly concerned with being able to pay all their future liabilities and subsequently close up shop when there are no more members left to pay.

Chasing short-term returns and over-obsessing with outperformance should not really be a key concern. Instead trustees should take full advantage of the fact that they can let time do its job; admittedly this is easy to say, but sometimes harder to do.

Liability driven investment (LDI) has been with us in various forms for longer than many think: the first holistic LDI solution for a FTSE100 company was implemented nearly 10 years ago.

Simply put, LDI is investing in assets that move in unison with the liabilities of a pension scheme. However, for some, the terminology and indeed methodology can feel very alien. Hedging, leveraging, swaps and the like can be daunting at first and feel like a move into Nick Leeson territory.

While it is true that the day-to-day running of such investments has its complexities, there are some very skilled managers with the appropriate systems and governance structures in place to provide this service to pension schemes.

Often, we hear trustees asking if now is the right time to use LDI to reduce exposure to interest rates and inflation. In truth this is often, subconsciously, simply a method of deferring a
difficult decision.

As discussed in our previous article ‘Mean reversion’ (PA Nov 2012), we believe there is little point in trying to second-guess movements in inflation and interest rates. These factors are highly dependent on monetary policy and political factors, and historically professional investors have failed miserably when trying to foresee these movements.

Therefore, rather than trying to ‘time the market’ to implement an LDI strategy, trustees should really consider the following questions:
• Can the scheme currently afford to hedge out its inflation and interest rate risks?
• Can the scheme’s sponsor afford to bridge any funding gap that the scheme cannot overcome by investment in growth assets?

Instinctively, some trustees would perhaps not answer yes to both questions.

However, the average UK DB pension scheme at the end of August 2012 was around 80 per cent funded on a S179 (Pension Protection Fund, PPF) basis and the average maturity of a UK DB scheme is, according to the PPF, around 20 years.

Accordingly, it can be argued that a scheme with a medium strength covenant, a recovery plan in place and, give or take, 20 years until maturity does not need to target aggressive asset outperformance and pray for a mean reversion of interest rates to be able to pay pensioners fully, in a timely manner.

Furthermore, if no action is taken interest rates could, in an adverse but not unimaginable scenario, creep down to even lower levels and eventually cripple a DB scheme’s ability to fulfil its obligations. This is the risk which must not be ignored.

So we feel that there is a persuasive argument that most schemes should seriously consider some sort of LDI strategy to better align their asset and liability movements.

Rather than seeing the strategy as an innovation to be viewed with suspicion, trustees should use LDI as a rather conventional (although operationally advanced) instrument to be put in the asset allocation toolbox.

While building up a perfect hedge is very costly and difficult there are now several pooled solutions that can provide a sufficient hedge and thus reduce trustees’ night-time worries.

By hedging out exposure to inflation and interest rates, a scheme sponsor would also know, with much greater certainty, how much money it needs to put into the scheme going forward. Consequently, the risk for unpleasant surprises that could ultimately drive the sponsor into insolvency would diminish and the sponsor could more accurately estimate the future costs of running the DB scheme.

While it may Look Daunting Initially, LDI is surely a feature of the DB landscape for many years (and schemes) to come.

Written by Albert Kuller, investment consultant, Capita Employee Benefits

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