Locking up liabilities

Nick Martindale explains how pension funds are turning to LDI strategies

With wild fluctuations seen in the returns of many asset classes over the past few years and the continued trend towards closing defined benefit schemes to new members, it is hardly surprising that better matching investment strategy to liabilities has become a priority for many pension schemes.

“The current market turmoil has been a timely reminder to trustees that, ultimately, the provision of members’ benefits is underwritten by the sponsoring employer,” says Lincoln International’s managing director of the pensions team Alex Hutton-Mills.

“The strength of this promise and the ability to support investment risk depends on the employer covenant standing behind the pension scheme. Unfortunately for some trustees, the current market falls have impacted not only a pension scheme’s funding position but also reflected a worsening of future prospects for some companies.”

Against this backdrop, implementing liability-driven investment (LDI) strategies as part of a broader move towards de-risking has become more common. A recent survey by KPMG found the number of LDI assets under management has increased by 16 per cent over the past two years, and this trend is likely to continue.

“LDI is a broad term that describes a way of reducing the extent that a pension scheme’s deficit will increase as a result of interest rate and inflation changes,” says KPMG CFA principal consultant Simeon Willis. “All pension schemes should consider some degree of LDI to improve efficiency of their overall risk exposure as they are all exposed to liability risks. An LDI strategy can range from simply holding long-dated bonds to holding a complex portfolio of swaps.”

New accounting requirements such as IFRS19, which requires companies in the UK to post the funding position of pension funds on balance sheets, are also driving growing awareness of the need to better match liabilities with assets, he adds.

The basic principle of LDI is that assets and liabilities are aligned to reduce the movement between them by locking in at a certain level, says Pitmans Trustees managing director Richard Butcher. “In practice, this generally means gilts and bonds are held to back inflation-linked liabilities while equities and property are held to back other liabilities,” he says. “But other assets can also be used. More sophisticated strategies use hedging in place of holding assets to give downside protection. Some will also use hedging to protect against currency movements, for example to allow the holding of overseas equities.”

There is also now a growing appreciation of the range of options available under an LDI strategy, says Cardano head of clients Richard Dowell. “LDI has commonly only been associated with bond investing rather than the very important point of actually managing assets against the liabilities,” he says. “This is what I would call a real LDI strategy and in this context it makes sense for all pension schemes. Trustees need to invest the assets to meet the liabilities, and consciously managing the potential rewards and risks of the asset and liabilities can help them do this in a much more stable way.”

F&C head of UK institutional Julian Lyne says many larger schemes now understand the need to hedge their liabilities and are realising that in such a turbulent environment even the liability-matching side of a portfolio requires a dynamic approach. “Five years ago you’d put a hedging strategy in place and forget about it but in the past two years a lot of swap-based strategies that had been put into place have been converted into gilt-based ones because you can get better returns and valuations,” he adds. Fitting in with this, there has also been a move towards more intelligent implementation of strategy, he says, with use of tracker mechanisms to trigger hedges at certain points.

LDI has traditionally been the preserve of larger schemes, but there is also strong interest from smaller and medium-sized organisations, says Lyne.

“We’re delivering more innovation on the pooled fund side so the small and low-governance schemes can at least put in place some hedging strategies,” he says.

“Ultimately schemes are looking to split their assets into liability-matching and return-seeking pots and then have separate strategies for both those areas. For example, schemes may decide to hedge 75 per cent of their liabilities and try to have a pot of return-seeking assets in order to get returns and reduce the deficit.”

Schemes considering going down this route need to consider a number of factors first, including the return target, funding position, risk measures and ultimate objective. “You need to know the shape of the risks you are exposed to in order to hedge them correctly,” says Willis. “Trustees also need to consider how much they should hedge and tactical considerations such as whether they have a view on inflation.”

The next step would be to evaluate which model is right for a particular company, including segregated mandates, bespoke pooled mandates and a dynamic LDI strategy, says Lyne. “We also have something for people who don’t want to take the full leap into LDI called equity bond funds, which basically consist of passive gilts, so trying to get that balance between increasing duration to try and get a better match and also giving exposure to equity markets,” he says.

An LDI strategy, though, is not foolproof. “Matching is a principle that works in a broad sense,” says Butcher. “But there are no assets that behave in exactly the same way as liabilities, except annuity policies. Even gilts, which produce a stream of inflation-protected income and so are a fairly good match for a pension, are not perfect. A gilt has a known duration whereas a pensioner doesn’t.”

Having a lower level of return-seeking assets also means schemes could see lower returns in the long run, although Dowell points out this does not necessarily mean they will miss out on opportunities. “A safety-first approach can be built for trustees that targets a good level of outperformance but with low levels of risk,” he says.

Another common industry concern is that schemes could lose out if they hedge at current long-term interest rate levels and those rates then rise. “This is not actually true,” says Willis. “Any loss on the assets will be offset by a fall in the liabilities, leaving the overall outcome neutral. Secondly, the market has already priced in future rises in interest rates so a rise which is in line with current expectations will in fact lead to no loss on the assets, or the liabilities.”

For many schemes, an LDI strategy will provide a more viable means of de-risking than either a buy-in or buyout, even if this remains the longer-term aspiration. “Buy-ins or buyouts primarily deal with generating the required returns on assets and on the liability side mortality risk,” suggests SSgA senior LDI portfolio manager within the investment solutions group Ben Clissold.

“They also aim to remove the sponsor risk by having them pay all the money necessary for the pension scheme to be self-sufficient today. But schemes that have a strong sponsor and a well diversified asset allocation, combined with interest and inflation hedges, may consider LDI cheaper and more efficient.”

In this context, the move towards LDI makes sense, not only as a kneejerk reaction for schemes that have been spooked by the volatility of the last few years, but also as part of a coherent strategy with a clearly defined, long-term goal.

“The act of closure [of defined benefit schemes] has started a discussion between trustees and employers about what the end-game is for the pension scheme,” says Hutton-Mills.

“Unless a scheme is very large, the only realistic target to aim for is a buyout with an insurance company. The question then becomes over what period this objective can be achieved. The answer depends on the liabilities, how much the employer can afford to pay in and how much investment risk to take.”

Written by Nick Martindale, a freelance journalist

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