LDI Survey (June 2007) – An evolving industry

Survey participants

Aberdeen Asset Management
Axa Investment Managers Barclays Global Investors
Credit Suisse
Credit Agricole Asset Management
F&C Asset Management
Goldman Sachs Asset Management
Henderson Global Investors
HSBC Investments
Insight Investment
Legal & General Investment Management
Northern Trust Global Investments
PIMCO
Resolution Asset Management
Royal London Asset Management
Schroder Investment Management
Standard Life Investments
State Street Global Advisors
Threadneedle Investments


Introduction
Of all the countless acronyms that trustees are required to know and understand when presiding over a scheme’s investment strategy, LDI is likely to be one of the most common – and yet also one of the most confusing.

While “liability-driven investment” may certainly constitute an industry buzzword – or more correctly, buzz-phrase – it is far from a mainstream practice. According to a global poll of schemes by SEI, only 20pc of UK schemes are adopting such an approach.

However there is a massive incentive for today’s schemes to run an investment strategy that pays close regard to the liabilities; the perfect storm of declining real interest rates and falling equity markets during the opening years of the millennium, together with stricter accounting standards, has highlighted the negative consequences associated with running an asset allocation policy that fails to do so. LDI providers claim they are addressing this through their solutions, but if only a minority of schemes adopting them there are evidently reasons that are holder schemes back.

One issue the SEI survey brought up was a lack of agreement over how an LDI strategy could be defined – it seems that providers offer varying definitions. This brings us to the first part of our LDI survey: we asked the 19 participants how they would present LDI as a concept and a workable strategy to trustees. The results confirm that while there is much common ground between providers in terms of understanding and perceptions of LDI, there are also a number of differences in how they explain and present the investment strategy.

Bespoke LDI strategies are often only feasible for larger schemes with the necessary resources. It comes as no surprise then that an increasing number of providers are offering pooled LDI products to make the techniques available to smaller schemes.

Section 2 reveals which providers offer both pooled solutions and segregated bespoke mandates, and which offer only the latter. It also shows – where figures were forthcoming – how many schemes invest in a provider’s pooled offering and how many have awarded it a segregated mandate.

The rush to LDI solutions has meant that many investment managers have reorganised their investment teams and launched specialist LDI arms. However it is interesting to see how many individuals work full-time on LDI as opposed to those with other primary responsibilities who might work on LDI solutions on a part-time basis. Section 3 asks providers to reveal how their LDI teams are organised in this way.

Section 4 looks at the respondents’ trustee training and education provisions in relation to LDI. This is very important given the complex nature of the concepts and techniques involved.

Finally, Section 5 gives the providers taking part in the survey the opportunity to talk about the future, where they see the LDI market heading, how they will be refining their LDI offerings and whether they will be launching new solutions or products going forward.


1. Defining liability-driven investment

Aberdeen Asset Management
LDI can be thought of as the use of modern investment techniques to create portfolios with a better balance between market risk compared to scheme liabilities and the returns investment managers are able to achieve. It therefore encompasses a large range of different solutions.

Axa Investment Managers
We believe it is very important to understand what the client wants and how to implement solutions. Our LDI approach is constructed around a dialogue with the pension scheme and the consultant.
LDI should be viewed as a framework for schemes to understand and manage the risks they are exposed to, while taking into account their liabilities. It is a framework to close some or all the unrewarded risks and to deploy the capital to take the risks they want to take or expect to be rewarded for. Thus, within this framework schemes can use their risk budget to invest in return-generating assets in order to close the pension gap.
For some schemes this may just mean monitoring the current situation or modestly rebalancing the asset portfolio in favour of more appropriate asset classes. For others, a simple pooled fund, or derivative-based solution may be appropriate to fully or partially immunise the scheme against unrewarded risks.
We see LDI as a mindset rather than a product that helps pension schemes to meet their promise: pay the retirement incomes to its members now and in the future. We can help them to achieve this aim thanks to a comprehensive range of solutions.

Barclays Global Investors
LDI is about establishing a transparent link between liabilities and assets and minimising uncompensated risks. For schemes looking to outperform their liabilities, a wide range of asset classes and strategies will help get the best return for the risk taken. Schemes with a low risk appetite, and hence lower expected returns, may restrict investments tot bonds and/or swaps; however, for most schemes, LDI will lead to more asset classes and a greater use of active returns. This diversification brings risk reduction without reducing expected returns.

Credit Agricole Asset Management
Any approach to managing assets that takes significant account of the profile of a pension fund’s liabilities.

Credit Suisse
LDI is a framework for managing risk in the context of sound economic objectives. It is about focusing on ensuring that pension investments deliver the results required of them. Specifically, LDI defines portfolios managed with controlled risk parameters that recognise the need to meet defined future liabilities. As the liabilities mature over long time horizons, optimising returns is necessarily a process of continuous attention.
LDI starts with the understanding that a pension scheme has a specific purpose, which is to meet future liabilities. Instead of using a traditional mix of assets, whose relationship to the scheme’s primary purpose is arbitrary at best, a “liability benchmark” is constructed to reflect the fund’s actual obligations. Risk is managed to four events likely to have the greatest impact: inflation, interest rate, investment returns and mortality.
Besides the focus on the actual purpose and “end-use” of the scheme, the critical change to LDI is the use of the variety of techniques and products developed in the capital markets in recent years, broadly coming under the headings of derivatives and alternative assets. They essentially provide an effective means of optimising on investment portfolio, ensuring that risk is properly diversified and rewarded (in other words, properly managed).

F&C Asset Management
Pension funds need to identify the risks to which their scheme is exposed and whether these risks are rewarded or not. The foundation of an LDI strategy is to mitigate or neutralise the risks that are unrewarded. For example, many investors expect to receive a positive risk premium to compensate them for holding equities. This is a rewarded risk. Large exposures to interest rate or inflation risk that are not managed or actively selected are unrewarded risks, as there is no positive risk premium.
Leveraged LDI pools provide a mechanism for investors to eliminate some or all of their interest rate and inflation risk, while retaining an allocation to return generating assets such as equity, property or other alternatives.

Goldman Sachs Asset Management
We believe LDI is the most logical approach to pension fund management, whereby the true economic value and uncertainty of providing pension benefits far into the future is placed within an investment framework that seeks to provide greater assurance that those pension commitments will be serviced. In practice LDI can be defined as any asset management solution that serves to explicitly take account of the nature and profile of the liabilities that we aim to be provided for. In this respect LDI can range from the holding of a few long duration inflation-linked bonds though to a highly customised asset allocation that takes account of all the liability risks in considerable detail.
Furthermore, the LDI solution must also incorporate the “real-life” asset constraint and regulatory requirements that pension plans must adhere to. In this regard the practical LDI solution will incorporate various assumptions of long run asset risks, returns and their diversification properties, as well as the important role that derivatives serve in the construct.

Henderson Global Investors
We define LDI simply as: “managing assets to maximise returns while minimising the risk relative to the projected liabilities”. It involves either maximising the returns on assets in excess of liabilities for a given amount of tracking error or minimising tracking error for a given amount of excess return.
We believe LDI is an important framework for pension schemes, as it gets pension schemes to focus on their liabilities. Even if it is not used as a solution, it is important as a framework to help schemes decide which risks to hedge, and which to manage. In our experience most schemes are now looking at their asset portfolios within this framework, even though many of them may decide not to totally hedge their interest rate/inflation risks.
It is not possible to offer a one-size-fits-all solution given that no two pension schemes are the same – each scheme has a different liability profile, different funding levels, governance, sponsor covenant and risk/return preferences. We expect far greater innovation from the industry in providing different solutions for pension schemes.

HSBC Investments
Although LDI is not an easily defined term, we tend to think of it as: “strategies that are built around, and measured against, a pension scheme’s liabilities”.
By loosely defining LDI in this way we hope to avoid the pitfalls of pigeon-holing LDI as a specific solution, such as cashflow matching or the use of derivatives. It is our opinion that such narrow definitions are unhelpful and have led to a lot of confusion as to what LDI entails. Underpinning this definition, we see several key themes to LDI:
• An ideology encouraging a more holistic view of pension scheme investment.
• A process to facilitate improved decision-making and risk-taking within pension schemes.
• A set of tools that can facilitate risk reduction and enhanced returns in pension scheme investment.
We believe that LDI solutions are by their very nature bespoke, catering to the specific requirements of individual pension schemes. This is because every scheme is unique in terms of its liability profile, funding position, strength of covenant and a myriad of other variables. Hence LDI can, and should, mean different things to different schemes. The one consistent theme being that the liabilities lie at the heart of the decision-making process.

Insight Investment
LDI is a direct response to the experience of the last few years that exposed many of the fundamental shortcomings and weaknesses of traditional strategies for funding defined benefit liabilities. LDI is an approach to pension fund management based on the principle that the benchmark for any final salary pension scheme should be its future liability cashflows. These cashflows, together with considerations relating to a scheme’s funding status, maturity and strength of its sponsor, should directly drive its target investment return and desire to take risk relative to its liabilities. LDI does not claim to remove all investment risk, but rather to minimise unrewarded and unintended risk.
An LDI approach will ensure that any active investment risk taken is done in the context of the return a scheme needs to meet its liabilities, versus the traditional approach of measuring performance against a market index that has little relevance to a scheme’s liability profile. Investing in this way prioritises, as its principal investment objective, the promises a scheme has made to its members while retaining the flexibility to add value, thereby reducing the expected cost of delivering these promises to the sponsoring employer.

Legal & General Investment Management
LDI is an approach that aims to increase the chances that changes in investment conditions will have a broadly similar effect on the value of the assets and on the value of the liabilities – thus reducing the volatility in the scheme’s surplus or deficit.
LDI is not something new. Pension schemes have long sought to match investments to their particular liabilities. Thus, for example, equities were often chosen on the basis of their potential to provide returns that would match the salary growth of active members. LDI should be seen as part of a holistic approach to controlling risk and not simply focused on reducing interest and inflation risk. In this context the uncertainty surrounding liabilities generally limits the attractions of close cashflow-matching solutions.

Northern Trust Global Investments
We believe LDI is inevitable for every listed company in every country in the world with a DB pension scheme. LDI involves characterising the scheme’s liabilities in terms of inflation, interest rate sensitivities and increased longevity. Assets are then invested in order to mirror those sensitivities, taking into consideration the scheme’s risk/return requirements.
LDI is therefore a means to measure, manage, and monitor the inherent investment risk-return tradeoffs of the scheme’s portfolio – in the context of its underlying liabilities.

PIMCO
New accounting standards in the UK (FRS17) require assets and liabilities to be valued on a mark–to–market basis and scheme surpluses/deficits to be recorded on company balance sheets, thus placing pressure on pension funds to match more closely their assets to their liabilities.
As interest rates have fallen over the long-term, this has had the effect of increasing the size of scheme liabilities – often exacerbating the mismatch between assets and liabilities. This inflation rate/interest rate mismatch is a critical issue for both members and sponsors alike, and, quite sensibly, companies are now looking for approaches that enable them to reduce the volatility of their assets and liabilities. This is where LDI comes in.
LDI is essentially about schemes considering the appropriateness of assets relative to a liability benchmark rather than indices unrelated to its liabilities. Ultimately, planned sponsors would like to remove unrewarded risks and be compensated for risks they have intentionally targeted. Whereas some risks cannot be removed from schemes – equity, demographic and active management risk. Other, unintentional risks – namely interest rate and inflation risk – can be reduced through LDI.

Resolution Asset Management
We believe the fundamental target of LDI is to have a mechanism by which the risks being run by a scheme can be measured and a framework within which it is possible for the trustees to determine what level of reward they should expect in return for these risks.
We measure the total risk being created by the asset/liability mix within a scheme and decompose this into specific risks. These risks are commonly nominal rates, real rates, credit, equity and property. We do this using an industry standard Monte Carlo simulation package created by Barrie and Hibbert, which utilises multiple economic variables to build the simulation set. The returns are based on some of the targets within the mandates that Resolution currently manage.

Royal London Asset Management
In essence, LDI is a very simple concept – it is the management of a pension scheme’s available assets in a way targeted to meeting the scheme’s known liabilities.
LDI is not a new concept: pension schemes have been managing assets vs liabilities for many years. RLAM believes that an active approach to LDI is crucial, extracting the greatest possible performance from the scheme’s available assets to add incremental value at each stage. A wide range of sophisticated tools are now open to fund managers and a strategy that combines as many appropriate tools as possible is likely to deliver sustained performance for the client.
Schroder Investment Management
We see LDI as a broad framework within which pension scheme assets and liabilities are managed together. This framework covers both liability-focused assets (bonds, interest rate and inflation swaps) and growth assets (equities, property, alternative assets). The mix of these assets and how this mix changes through time needs to be aligned to the scheme’s return objectives and risk budget and ultimately to the delivery of pensions and other member benefits.
LDI is a framework to understand asset and liability risks and allows an investment strategy to be developed to meet requirements.

Standard Life Investments
A practical approach to LDI should comprise two complementary investment strategies: risk mitigation and return-seeking.
The role of risk-reduction strategies is to help scheme assets to match their liabilities, stabilising future funding levels. Precise cashflow matching of future liability forecasts ignores the reality that forecasts are likely to be wrong, as there are many factors that can alter estimates of future pension scheme payments. Consequently, an approach that is too precise will result in frequent asset adjustments and additional costs. We aim to produce effective risk reduction strategies that deliver maximum effectiveness for minimum cost.
However, many schemes also need to address the headline-grabbing deficits that have come to plague many pension funds in recent years. Effectively addressing these shortfalls demands an investment approach with the ability to deliver returns over and above those needed to simply meet liabilities. Our belief is that a well diversified investment strategy, targeting levels of return above cash, is the most effective strategy to deliver the additional required return.
A focus on real returns can also benefit schemes without deficits, enhancing member security by responding to the real economic risks faced by schemes with an open salary component in their liabilities.

State Street Global Advisors
LDI seeks to position a pension scheme’s assets so they match (to varying degrees) the behaviour of scheme’s obligations – or its liabilities. In doing so, LDI seeks to mitigate the unrewarded risk inherent in all portfolios from inflation and duration mismatch.

Threadneedle Investments
LDI is a way of thinking about the risks that apply to both a pension scheme’s assets and its liabilities, and working out how to bear those risks to maximum advantage.
In practice, this tends to mean that schemes seek to minimise the unrewarded risks that are associated with liabilities (typically interest rate risk and inflation risk) and they seek to bear investment risk in respect of their assets as efficiently as possible, so as to deliver the optimum returns for the risks being run.


2. Bespoke and pooled solutions
We asked companies if they provided LDI on a segregated bespoke mandate basis only, or whether they provided pooled LDI solutions as well.
The table below shows the number of LDI mandates currently being run.


3. How many staff work on your LDI team? How many work full-time on LDI?

Aberdeen Asset Management
Derivative overlay portfolios are managed by our experienced six-strong derivatives management team, led by Bob Guzman, which traded around £80bn in over-the-counter derivatives in 2006. We believe the experience of this team benefits LDI clients from an execution perspective.
Additionally in the UK the following members of the client management team have an LDI focus: client director and co-head of LDI Dominic Delaforce; client director Natalie Winter.
To provide comprehensive LDI solutions, the individuals named above work with the UK fixed interest team which typically manages the physical assets within LDI mandates.

Axa Investment Managers
Our team has an extensive experience of designing and implementing LDI and works with DB schemes and insurance companies based both in Europe and in the US.
In total, 12 investment professionals are dedicated to LDI.
The team is part of our Investment Solutions department and is divided into three areas:
• Pension Group (four people)
• Portfolio Engineering (four people)
• Insurance (four people)
In addition, a product specialist team combined with our UK institutional team is in charge of selling our LDI expertise globally.

Barclays Global Investors
LDI mandates are managed by the strategic solutions group at BGI. There are currently 11 team members dedicated to LDI. In addition, the team uses products and expertise from other groups around the company.

Credit Suisse
We are able to call upon a wide range of resources from across the bank with which to deliver solutions required by pension schemes. This includes: investment managers; investment strategists; risk analysts, product specialists and pension specialists. As such, specialists will form part of a team delivering a solution as needed. It is difficult to define a core team, although it should be noted that we have a range of experts from whom guidance can be sought around the globe, including London, New York and Switzerland.

Credit Agricole Asset Management
Two portfolio managers, backed by 15 other investment specialists (not full-time).

F&C Asset Management
The asset liability management team work full-time on LDI strategies. The ALM team is supported by our 47-person global fixed income team, and our derivative development group and investment risk team.
Goldman Sachs Asset Management
Our global fixed income team, with over 100 professionals located in New York, London and Japan, has the skill and scope to set the strategic direction of clients’ portfolios, utilising fixed income swaps and derivatives. Our global investment strategies team, with over 90 years of combined investment experience, develops strategic allocations and constructs liability-sensitive investing solutions. The team performs situational analysis on specific plans to determine an optimal asset/liability growth mix.

Henderson Global Investors
We have nine specialists within the fixed income team who spend a large proportion of their time on liability-driven mandates. We do not separate our LDI team, but greater synergies and resources were put in place when the fixed income investment team was restructured in 2005 to contribute to liability-driven and absolute return mandates.
We have brought together the skills and capabilities of our retail, structured product and hedge fund teams with those of the institutional team to establish a disciplined and flexible investment process for LDI. We have a number of different alpha teams (interest rates, credit, currency, emerging markets, asset allocation, etc.) that generate ideas in an unconstrained and diversified space. To this extent, the entire team is focused on delivering active returns for LDI clients. The specific LDI funds are run by portfolio managers within the sterling fixed income product team whose job it is to bring together as many ideas generated by the alpha teams in to different client portfolios subject to guidelines and constraints.

HSBC Investments
Our LDI team currently employs four members of staff dedicated to LDI:
• Head of LDI
• LDI quantitative specialist
• LDI solutions specialist
• LDI solutions analyst
In addition to these four dedicated professionals, we have the support of an integrated team operating in wider roles which is closely aligned with the core of the LDI team. These include:
• Derivatives execution team – 11
• Strategic asset allocation team – four
• Financial engineering team – eight
• Global investment solutions – 15

Insight Investment
The financial solutions group has 15 members with a skill set and experience that includes risk management, fixed income and equity management, the full range of financial derivatives, index replication and actuarial and quantitative analysis. All team members work full-time on LDI assignments.
The FSG’s role encompasses developing strategic funding solutions, modeling schemes’ projected liability cashflows, structuring the required hedges, as well as execution and ongoing management. The team is supported by market-leading systems for risk analysis and management, collateral management and decision support tools, including optimal counterparty selection for best execution.
Insight has an ongoing programme to recruit high calibre individuals to meet the changing resource requirements within FSG during this period of strong growth in the LDI market and our business.

Legal & General Investment Management
We have a dedicated structured solution team of seven investment professionals.

Northern Trust Global Investments
NTGI has a global team with a global approach to LDI. A number of people from across our organisation are working on our LDI solution – some of them exclusively, others as part of their wider roles and responsibilities. This includes experts from the areas of product, portfolio management, operations, investment risk and analytical services, sales, legal, compliance, pension actuaries and business unit leaders.

PIMCO
PIMCO employs three full-time product managers dedicated to LDI. In addition, two portfolio managers are dedicated full-time to managing LDI portfolios and an additional five portfolio managers spend a portion their time managing LDI mandates.
These people are supported by our worldwide team of 92 portfolio managers and 52 analysts. Of these 52 analysts, we have a team of 12 full-time financial engineers who use proprietary analysis to analyse a pension scheme’s liabilities.

Resolution Asset Management
Resolution has a dedicated LDI team with full-time roles in the design, construction and implementation of LDI solutions. We also have support and experience from across the group to manage all aspects of implementing an LDI solution.
Since LDI solutions leverage off fixed interest skills it is important that any provider has good bond management skills. We are backed by an experienced, well-respected and award-winning fixed interest team. In addition, we have developed bespoke systems used by LDI, fixed interest and risk management teams to enhance our product offering.
A diversified fixed interest portfolio is a key part of any LDI solution. The experience and expertise in both constructing and managing these portfolios is provided by our strong and stable fixed interest team. We can also provide access to another 55 investment professionals who can play an active role dependant on the client specific strategy andor performance objective required.
Royal London Asset Management
Head of derivatives Paul Doran oversees RLAM’s strategic development and implementation of LDI solutions. Paul has 22 years’ investment experience spanning quantitative research, portfolio risk management and the development of derivative strategies.
Doran is supported by RLAM’s eight-strong fixed income team and a further nine people dedicated to quantitative analysis. RLAM’s fixed income fund managers and credit analysts each specialise in different areas of bond markets, ensuring that an optimal mix of asset management techniques can be brought to bear on each client mandate.

Schroder Investment Management
Our team comprises a full-time equivalent of seven people. A wide variety of individuals are involved in the matching plus product. Curt
Custard, as head of multi-asset solutions, and Paul Duncombe, as head of matching plus, have overall responsibility for the product.

Standard Life Investments
Euan Munro heads the investment team responsible for both absolute return and LDI mandates. The multi-asset investing team is responsible for the management of over £4bn in multi-asset LDI and target-return mandates.
The multi-asset investing team draws on the expertise of all the asset desks across Standard Life Investments, including the Treasury banking, equity and the fixed income teams.
State Street Global Advisors
SSgA’s 28-strong LDI team is highly skilled in structuring and managing innovative solutions incorporating inflation swaps, total return swaps, equity derivatives, and alpha strategies. We have developed experience working with many different sized pension schemes and advisors to create tailored, efficient and transparent portfolios for hedging liability risk. All team members are backed up by significant additional resources in their particular area.

Threadneedle Investments
We do not have a team which works only on LDI-related mandates. Within our existing organisational structure, we have fund managers who manage LDI-related investment portfolios, we have people within our quants and risk management teams, who design and illustrate possible portfolios for clients and for prospective clients, and we have people within the institutional business who can provide information on the subject to consultants and scheme trustees.


4. What LDI education and training provisions do you offer trustees?
Aberdeen Asset Management
Having developed modelling tools to help us and our clients understand the interest rate, inflation and yield curve risk of their liabilities, we have the ability to work closely with clients and their investment consultants to evaluate liability streams and develop an LDI benchmark.
Given that many clients find the learning curve associated with LDI quite steep, Aberdeen is committed to helping with the education process. We organise regular trustee education days, designed to meet the needs of a wide range trustees. Included in these days are specialist sessions on LDI.