A guide to liability driven investment
LDI strategies are increasingly common, but what do trustees need to consider? Luisa Porritt explores
In overseeing a pension scheme, a trustee’s goal is to ensure that scheme is able to pay out benefits to its members. Logic dictates that to achieve this objective, schemes should concentrate on meeting their liabilities.
Until the early 2000s, there was widespread belief that investing heavily in equities would provide ample returns to cover liabilities. The problem with that approach was it did not pay enough attention to the risk inherent in the need to pay out benefits consistently over the long term.
When equity markets crashed in 2000-2003, many schemes were left without stable cash flows needed to meet their liabilities, and sponsors had to step in to plug the gaps. This rang the death knell for many final salary DB schemes, which were compelled to begin closing to new members.
In the past 15 years schemes have gradually moved away from buying equities and property”
Liability driven investing (LDI) became a popular response to the failure to understand and manage risk. The introduction from 2001 of accounting standard FRS17, which forced sponsor companies to declare whether their schemes were in deficit or surplus on their balance sheets, speeded up this process.
The regulator also advised trustees to take into account the pressure placed on sponsors by running large deficits, cautioning that they should avoid a situation whereby schemes could end up in the Pension Protection Fund.
Consequently, in the past 15 years schemes have gradually moved away from buying equities and property, which offer higher prospective returns than gilts, towards LDI, says David Felder, an independent trustee at Law Debenture.
LDI uses assets with long-dated cash flows to match a scheme’s liabilities, taking account of interest rate, inflation and longevity risks. Robert Gall, head of market strategy in the financial solutions group at Insight Investment, describes LDI as an effective way of ‘concentrating risk’.
“It’s not about what’s most attractive, or has the best return, but what’s a good match to [paying out] pension benefits,” says Rupert Brindley, managing director and strategist in the global pension and advisory solutions group at JP Morgan Asset Management (JPMAM).
Although long-dated corporate bonds carry some of the required characteristics, such as expected long-dated cash flows, only gilts are seen as meeting the criteria for ‘pure’ LDI, says David Hickey, a managing director in SEI’s institutional group for Europe, the Middle East and Africa (EMEA). This is due to the high credit quality and liquidity UK government bonds typically carry.
At a glance:
- LDI uses assets with long-dated cash flows to match a scheme’s liabilities.
- It seeks to provide protection against interest rate, inflation and longevity risks.
- It is a derisking strategy, complementary to establishing a flight path.
- Basic LDI relies on buying gilts and swaps, but more complex strategies are evolving that use different assets to the same end.
Some other bonds issued by government agencies, such as National Rail, or supranational bodies, like the European Investment Bank and the World Bank, may also qualify, says Nick Horsfall, senior investment consultant at Willis Towers Watson (WTW).
The problem with the purist approach is that government bonds have become expensive, fuelled by the Bank of England’s bond-buying programme—even the Bank reports difficulty in obtaining bonds at a sensible price, says Brindley at JPMAM. Some schemes are therefore forced to consider corporate bonds instead.
he problem with the purist approach is that government bonds have become expensive”
Banks do not regard corporate bonds as acceptable collateral, but they can be used in addition to LDI as part of a ‘buy and maintain’ strategy to support future cash flows, says David Will, senior investment consultant at JLT Employee Benefits (JLT EB). Since they offer interest rate cover but not inflation protection, corporate bonds are supplementary to core LDI, says Felder at Law Debenture.
Protection against moves in interest rates and inflation is a core component of LDI. Use of derivatives is a way to manage this risk, due to the hedging characteristics of these instruments.
Historically, schemes used interest rate and inflation swaps for such purposes. But gilt and swap curves have inverted since the financial crisis, making it cheaper to hedge with gilts rather than swaps, says Will.
Evolution of the concept
This is just one development that has prompted a move away from conventional LDI, though most schemes deploy some form of it. Dynamic funds, which allow delegated managers to take a more active approach to LDI on a scheme’s behalf, choose hedging instruments that are appropriate at different points in time, such as equity derivatives.
Such innovations have given small and mid-sized schemes the opportunity to do more within the framework of LDI than they were able to in the past, says Will. The majority of schemes however continue to access LDI through pooled vehicles rather than segregated mandates, preventing them from using a bespoke hedge, but providing enough flexibility to suit their needs.
The principle of LDI should be understood as the overall way in which a scheme is managed, argues Hickey at SEI. “100% of a pension [scheme’s] strategy is about meeting liabilities—whether that’s through bonds, equities, or alternatives.”
Gall at Insight calls this a ‘holistic balance sheet approach,’ whereby risk is managed across the entire portfolio.
100% of a pension scheme’s strategy is about meeting liabilities”
Whereas trustees may appoint one manager for LDI, another for an equity strategy and/or another for investing in alternatives, asset managers say it is important to look at the blend of assets used in a portfolio.
“Trustees tend to take a bottom up approach – they get different managers for everything,” says Hickey. But this is shifting, he adds, as 10% of pension assets are now delegated to fiduciary managers.
LDI can be restrictive. Not only is there a finite number of government bonds, but these are an expensive, low-yielding asset. This is causing some schemes to look beyond traditional LDI, and seek income from long-dated infrastructure or property.
Transparent and comprehensive reporting is key to understanding a strategy’s effectiveness, says Shoqat Bunglawala, head of the global portfolio solutions group for EMEA and Asia Pacific, ex-Japan, at Goldman Sachs Asset Management. Clear reporting on the change in value of the LDI assets compared to the corresponding change in value of the liabilities is key, he adds.
Trustees need to monitor how the LDI portfolio is behaving at least every three years, when they receive formal funding information from the actuary. What they must look out for is whether the portfolio is responding to interest rate and inflation changes in the manner expected.
Schemes not following LDI are in a minority”
Some trustees review their strategy more often, as part of monthly or quarterly meetings, while others examine it yearly, or on an ad hoc basis in response to a significant event, such as an enhanced transfer exercise.
If an actuary adapts their mortality assumptions, this changes the scheme’s liability profile, underpinning the need for trustees to keep an eye on what is happening and be responsive when required. The introduction of pensions freedoms may yet have an impact on liabilities, points out Horsfall at WTW.
Schemes not following LDI are in a minority. Usually, their sponsor is strong, and has given the green light to trustees to take risk, vowing to step in if and when things go wrong. That situation is increasingly rare, as focus has shifted to derisking. According to Hickey, 90% of his clients use LDI and 60% of them have a flight path—another form of derisking. Other schemes not requiring LDI are those looking towards a buy-out by an insurer, in which case risk will already have been reduced.