Monday, 20 November 2017

    LDI: A solution for the masses

    Pádraig Floyd explains everything you ever wanted to know about liability-driven investing but were too afraid to ask

    Pension fund investing used to be so simple. You managed your assets in a prudent fashion until people retired and then paid them a pension for the rest of their life.

    That is until the end of the last century, when things started to get complicated for trustees.

    A lack of diversification and a general blindness to warning signs meant that things went wrong in 2000. The ensuing crash and several years of pain – not to mention the Myners Report – made it very clear that pension schemes and their advisers had got things very wrong.

    Defined benefit schemes realised they had placed too much faith in the equity markets to deliver excess returns that would ensure they could meet their liabilities when it came to paying out pensions.

    And so liability-driven investing (LDI) was born. But what is LDI?

    THE EARLY YEARS

    In the early days of LDI, it was envisaged as a buy-and-hold strategy, says Lucy Barron, LDI solutions strategist at AXA Investment Managers. “Investment was primarily swaps-based. You identified the liabilities to be hedged, then buy and hold swap assets to match them,” she says.

    The early adopters of LDI in the early and mid-2000s were large, sophisticated schemes

    “During 2008, there was significant market volatility and at this point gilts became cheaper than swaps so schemes wanted to implement hedging by buying gilts on an unfunded basis using instruments that had not previously been used by pension schemes, such as gilt repo and gilt total return swaps.”

    DB pension schemes in the UK have been on the LDI journey for almost a decade, says John Belgrove, a partner at consultancy Aon Hewitt: “The early adopters of LDI in the early and mid-2000s were large, sophisticated schemes with good governance who were concerned about accounting deficits and implemented a buy-and-hold approach.”

    It’s a strategy built to move with the value of liabilities over the life of those liabilities

    The evolution of LDI has been considerable in quite a short space of time. And there are three distinct phases to the development of LDI.

    “It’s a strategy built to move with the value of liabilities over the life of those liabilities,” says Raymond Haines, head of strategy and research, State Street Global Advisors.

    “But at a very basic level, it is important to understand that the objective of the portfolio is to mimic the liabilities, rather than the performance benchmark or returns target.”

    Trustees therefore need to understand what LDI will mean for their own schemes. “Now we have LDI for the masses,” says Belgrove, as pooled fund instruments have been developed that provide access to LDI. “It is no longer niche for defined benefit schemes – it’s known everywhere. But not all schemes have strategies in place.”

    THE GROWTH OF LDI

    Today’s LDI is more sophisticated and Belgrove estimates between a quarter and a fifth of schemes have formal LDI mandates.

    “Others have a nod to it – they increase bond allocations, but it is a very blunt tool – and manage risks without eating all their capital. It is certainly no longer niche or viewed with such suspicion,” he says.

    Every fund should have an LDI strategy. However, if they have a recovery plan, they effectively already have one, Haines points out. It may be a pooled fund strategy with collective vehicles to provide protection.

    It will be mainly bonds or synthetic portfolios, which require less capital. Alternatively, if on a segregated basis, you’ll have a mixture of bonds and swaps.

    “For the majority of funds, this is an appropriate way to do LDI, once you have determined the size of the gap you need to fill, the time you will have to do it and how much risk can you take considering the size of the liabilities,” says Haines. “A huge dilemma is nominal interest rates because the present value of liabilities goes up automatically as interest rates fall and pension funds have had a perfect storm of rising liabilities and falling returns.”

    THE GROWTH OF LDI

    The latest movements in LDI are a direct response to yields falling so sharply, says Kerrin Rosenberg, chief executive of delegated investment manager Cardano UK: “The industry would like more protection but won’t buy it at these values.”

    In seeking ways to replace the gilts and index-linked bonds that are the mainstay of any LDI strategy, schemes are moving into other asset classes, a tactic Rosenberg does not recommend. “These I refer to as ‘dirty hedges’, by which I mean they are imprecise, rather than being inherently negative,” says Rosenberg. “They won’t give the same protection as gilts and swaps, which are better and cheaper.”

    Even corporate bonds with credit risk in them are being proposed

    This may include the use of infrastructure, social housing or ground rents, says Rosenberg, that offer some form of inflation link which may be highly likely to materialise, but is not guaranteed. “There are all sorts of grey,” he says, “even corporate bonds with credit risk in them are being proposed, and some [assets] are very dirty.”

    Rosenberg also doesn’t like these ‘dirty hedges’, because although they are low risk, most are illiquid with indifferent returns. “It’s like a low-alcohol beer – it’s hard to sell and you’re probably better off just not drinking or having a soft drink that tastes good instead.”

    ALTERNATIVE APPROACHES

    New, more sophisticated strategies are also being delivered in LDI through so-called ‘swaptions’, what Rosenberg refers to as a “less common, but more intelligent approach”.

    A swaption is a derivative which is an option on a swap. Some schemes are doing two-way trades where they effectively bet both ways. If it moves one way, they lose a premium, but in time, the other trade will compensate them.

    The appetite for using derivatives is a significant obstacle, because for a number of asset owners, it remains quite scary

    However, few schemes will use these approaches, says Aon Hewitt’s Belgrove.

    “The appetite for using derivatives is a significant obstacle, because for a number of asset owners, it remains quite scary,” he says.

    Instead, he sees a collateralised approach as a safer way of protecting against gilt yields going down. Julian Lyne, head of global consultants at fund manager F&C, agrees that derivatives and also leverage are words that strike fear into the hearts of trustees.

    They are so associated with the financial crisis that they appear toxic to some. “We spend a lot of time doing training in the UK explaining the ‘D’ word and the ‘L’ word,” says Lyne. “It’s not financial Armageddon and we explain how we manage it and control it in pooled funds. Even in segregated approaches, leverage will only be 3.5-4 times, which is capitally efficient for trustees and provides a lot more flexibility.”

    COSTS

    Given its special nature, many expect LDI will be expensive. Nothing could be further from the truth, says Rosenberg. “In the context of other asset management costs, these are tiny, typically less than 0.2% and often below that. Most have sliding scales for larger assets and the marginal costs are very low – even as low as 5bps. It is much cheaper to manage LDI than an equity and hedge fund portfolio.”

    Given its special nature, many expect LDI will be expensive. Nothing could be further from the truth, says Rosenberg

    Though there are trading costs to consider – cash, buying swaps/gilts – LDI uses standard liquid instruments that are cheap as chips to run. Far more important is opportunity cost, says Rosenberg. “This is not pounds in the pocket, but the risk of not hedging liabilities when IL gilts yield is zero and then moving to 1%. This probably equates to 15%-20% of the cost of a transaction.

    LDI is like an insurance policy

    Conversely, you become hugely regretful if you didn’t hedge at zero, he adds. “LDI is like an insurance policy,” says Haines. “People are hung up on the rates we are enjoying or suffering, depending upon which side of the balance sheet you sit on.”

    What schemes should really worry about is their direction based upon funding levels and whether they are aiming at buyout in 10, 15, or 20 years. Then they should decide on the glide path of return-seeking assets.”

    KEEP CALM AND CARRY ON

    It all comes down to market levels and whether interest rates remain at current low levels, says AXA IM’s Barron. “Clients are aware of the risks and while they may reduce them, can they afford to deal with them? We have increasingly seen clients tackling the inflation and interest rate risks separately when they view hedging one of the two components to be attractive and using their risk budget accordingly.”

    There is no such thing as a ‘no brainer’ in the investment world

    But, warns Rosenberg, don’t get sucked into the kind of assumptions that resulted in funding disasters. Yields may be historically low, but where are the guarantees they will rise and you will be able to de-risk at a lower cost in the future?

    Yields have slipped over the past 25 years and “looking in the rear view mirror” says this is not the right time to sit tight, he says. “We need to inject a little humility into the conversation. There is no such thing as a ‘no brainer’ in the investment world, and with average markets anticipated, I think that is how it should be.”   

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