Growing trend

Paul Bourdon
Managing director and head of European pensions solutions group
Credit Suisse
Bourdon is a managing director of Credit Suisse’s Asset Management business, based in London. He is head of the European pension solutions group within products investment solutions and marketing. Bourdon joined Credit Suisse in September 2006 from Threadneedle Investment Management where he was an executive director in charge of investment solutions and structured products group.

Bob Guzman
Head of LDI investment
Aberdeen Asset Management
Guzman oversees a team that manages around £5bn in LDI strategies on behalf of clients around the world. He and his team started to develop Aberdeen’s LDI platform in 2001 and first made it available to clients three years ago. Guzman started his fixed income investment management career in 1986.

Neil Walton
Executive director and head of strategic solutions
Schroders Investment Management
Walton’s investment career spans over 17 years. He joined Schroders in 2005, taking up responsibility for the provision of strategic and liability led input to clients. Prior to joining Schroders, Walton was a senior consultant at Mercer Investment Consulting. He is a fellow of the Institute of Actuaries and has a degree in actuarial science, City University.


As a growing number of pension funds adopt LDI, the investment approach continues to evolve. What major new developments can pension funds expect to see over the next 12 months?

Bourdon: Early LDI focus has been on hedging liabilities and reducing risks in the asset portfolio by moving equity type assets into bonds.
We believe schemes should be putting more emphasis on generating returns that are risk managed (and risk should be taken where it is rewarded), but which help to alleviate the long-term cost of funding the pension commitments. This includes diversifying into other asset classes and targeting maximum drawdowns for the portfolios by managing the overall risk benchmarked against liability cashflows.
We also expect to see some UK schemes starting to question the extent to which they can manage all the governance issues arising from their pension fund. One solution is to outsource some of the responsibility of managing the scheme through fiduciary managers. Some asset managers have all the relevant skills and administration to work alongside trustees and consultants and take on more responsibility for the scheme. This is a growing trend in Holland.

Guzman: We don’t actually envisage any major new developments this year. Segregated and pooled LDI solutions are already available to meet the needs of the vast majority of pension funds. Along with the growing number of funds adopting an LDI approach, perhaps one development will be that solutions are increasingly tailored for individual schemes.
However, the lack of more radical developments, in the short term, should be considered as a good thing. LDI is a complex subject and peoples’ understanding and acceptance of it will not be helped by significant changes that do little to improve what is already an efficient way to match liabilities. Longer term we expect the focus to be on longevity. Increased life expectancy and the accurate calculation of it is a big issue for pension funds.

Walton: We expect to see a greater adoption of LDI as a framework for understanding and managing asset, liability and plan sponsor risks. We see LDI as a way to develop a total solution for a pension scheme’s assets.
In terms of new developments, this can be split in two:
• Diversification of growth-focused assets, which for many will involve mandates that target real returns from a wide range of assets. These mandates aim for lower volatility of returns and will be key for growth risk management, especially when combined with bond and swap investments to manage liability risks.
• Greater flexibility and efficiency from the “next generation” of liability hedging pooled funds, thus allowing schemes of all sizes to access genuine LDI solutions.

Is LDI applicable to all pension schemes, or are there circumstances under which another strategy would be more suitable?

Bourdon: The simple answer is yes. An LDI proposition will consist of a risk-managed portfolio and a return-seeking portfolio. The extent to which you hedge liabilities or reduce overall risk can vary from scheme to scheme. However, at the end of the day you need to provide for the pension commitments within the framework of the scheme sponsor’s covenant – or ability to continue funding liabilities.

Guzman: While each scheme has its own unique characteristics and set of problems, an LDI solution can be applied to all funds. However, in practice trustees of specific schemes may decide not to implement a LDI strategy. This may be because they view themselves as too small, their liability mismatch will naturally close over time, or they have strict covenants to follow.

Walton: In our view, LDI is a framework that allows a sensible investment strategy to be developed with regard to all risks (assets, liabilities, plan sponsor). This framework is therefore appropriate for all pension schemes.


How effective can pooled approaches be in making LDI accessible to smaller schemes?

Bourdon: Pooled approaches initially started off with different buckets (for example, five to 10 years) of swaps attaching to cash or bond portfolios – very much a generic solution.
Second generation pooled or wrapped funds now allow schemes to choose a more bespoke hedge portfolio which includes swaps (possibly interest and inflation swaps) and a much more diversified mix of assets, including private equity, hedge funds, commodities, or property, either through generic products for smaller schemes (for example, less than £30m to £50m, depending on asset mix required) or bespoke portfolios for bigger schemes. The pooling or wrapper takes away many of the operational problems around using derivatives. These make LDI accessible to smaller schemes.
There still remains the problem for the trustees however of understanding all the issues involved in coming up with an appropriate LDI solution.

Guzman: Very effective. Setting up the documen-tation that allows schemes to invest in swaps can be time consuming. Even though there are standardised International Swaps and Derivatives Association agreements, the bespoke legal documents are complex. Investing directly in derivatives also has governance issues with which small schemes may not be able to cope.
There are also custody and accounting considerations, as new systems may need to be put in place to implement the more sophisticated transactions. For larger schemes with the appropriate resources, the benefits more than outweigh these disadvantages. Solutions to the problems faced by smaller schemes are therefore most likely to be found in pooled fund structures.

Walton: Pooled approaches are very effective at making liability hedging techniques accessible to smaller schemes (or schemes that prefer the simplicity of pooled funds).
If we remember that the future benefit payments from a scheme can only be estimated by the actuary, then the notion of an exact hedge of the liabilities becomes an unrealistic aim. In this context, using pooled funds that usually bracket future years together (i.e. pooled funds covering 10-year periods) can be used to get close to the underlying estimated benefit cashflows and are a very effective tool to build a liability hedge.
Complex benefit structures, involving scheme-specific caps and collars to inflation-linked benefits may prove a challenge for a pooled solution and there may be some trade-off between ease of implementation and accuracy of the liability hedge.
A second issue is around collateral. Pooled swap funds typically require significant cash being posted at inception to support the swaps and this may reduce assets available for growth investing. An effective approach recognises this issue and aims to avoid locking away cash that may be better employed in cash plus or growth strategies.
The effectiveness of access in terms of governance and costs associated with these investments is a strong positive. Smaller schemes typically have fewer resources and so time and cost issues are important – this can make pooled solutions very effective especially if trustees are unfamiliar with the underlying instruments.


How should schemes approach the monitoring of investment performance for LDI?

Bourdon: Most fund managers or consultants involved in LDI solutions will provide investment performance reports and monitoring.
In addition to the normal asset performance monitoring and reporting, the client will need to see how the swap overlay portfolio has performed and any movement of collateral. The asset and liability hedging swap portfolios should be compared against the latest pension liabilities to ascertain the latest expected funding position and liability mismatch. The improvement or otherwise over the reporting period can then be monitored.

Guzman: Schemes should start evaluating their LDI manager right from the start in terms of the execution and cost of implementing the strategy. From then on performance measurement should be the same as with any other strategy employed by a specific scheme.
A range of swap benchmarks have been launched over the past few years and Aberdeen has been in consultation with the major benchmark providers to assist the development of appropriate LDI indices.

Walton: An LDI framework is based around the mindset of delivering the scheme liabilities and managing the risks associated with this. An LDI approach should thus be monitored as a first stage against the high level objectives. This invariably places the liabilities at the centre of the monitoring process and then reviews the risks that have been taken and the results of this risk-taking.
The detail of the reporting is not necessarily straightforward and this area does require significant thought. There are three aspects that must be considered in a typical strategy:
• Compare the hedge against liabilities, (i.e. has the hedge reduced the risk to the expected degree?)
• Compare the cash plus and growth assets with their performance targets. This should recognise the cash commitment that a scheme accepts if a swap based solution is used.
• Consider the risk management of the total solution for the pension scheme against the expected levels of risk when the solution was implemented.