LDI Debate (August 2007) - Right on target

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.

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.

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.


A recent survey found only 20pc of UK schemes are using liability-driven investments, while 33pc are not even considering doing so, despite 72pc of (global) respondents indicating they wanted the asset pool to provide some level of support to their scheme’s liabilities. Would you agree this highlights a confusion and/or a lack of agreement as to how an LDI strategy can be defined?

Guzman: It is slightly surprising that it was not 100pc of respondents who wanted the asset pool to provide some level of support to their scheme liabilities, since that is exactly what the assets are there for. In the UK, “LDI” is commonly used to describe a risk budgeting approach that recognises that it is appropriate to reduce the excessive interest rate and inflation positions historically taken by most pension schemes, typically with swap instruments. There is resistance to this by pension schemes for a number of reasons – for example, a failure to understand the severity of these risks, a lack of familiarity with the instruments or strong views on the direction of interest rates combined with a willingness to tolerate the risk, because much of the “peer group” is still doing so.

Walton: I suspect it highlights a lack of agreement over the meaning of LDI. The low response in terms of those using LDI possibly reflects a narrow definition based on using interest rate derivatives to hedge liability risks. If 33pc of schemes have no regard to their liabilities, then their membership may question what the investment policy is aiming to achieve. The interesting figure is the 72pc looking for greater liability support. I am sure that many of these pension schemes will follow an LDI route to achieve this aim.

Bourdon: We agree there is some confusion. Understanding the nature of liabilities and their associated risks is fundamental to understanding why a liability-driven approach to investing should be adopted by pension schemes, irrespective of their funding position.
Some trustees take the extreme view of LDI as being a synonym for interest rate hedging using derivatives. We see LDI as a conceptual framework to manage pension plan assets in the context of a complex set of objectives and within a wide range of possible investment solutions.


“Controlling year-to-year volatility” was the most common primary goal of an LDI strategy among global schemes (79pc), while a quarter of UK schemes cited it as “progressing the scheme towards termination”. Is it possible to adapt LDI to different objectives or is there a fundamental aim it should always seek to achieve?

Guzman: It is right that some schemes target a buyout of their liabilities while others may, for reasons of staff retention and recruitment, wish to keep their schemes open. There can clearly not be a one-size-fits-all. The scheme that is targeting buyout and is reasonably well progressed towards closing its buyout deficit should hedge interest rate and inflation risk on a buyout pricing basis. The open scheme may wish to hedge, say, 50pc of these risks on a funding basis to introduce some stability of company contributions as calculated in a triennial valuation.

Walton: LDI remains a broad framework to develop an investment approach that directly reflects a scheme’s objectives and reflects the fundamental need to deliver the future benefits. The detail of these objectives will differ from scheme to scheme and hence a wide variety of approaches should be expected.

Bourdon: The fundamental aim of any investment strategy is to create value within an appropriate risk budget. We believe it is possible and critical to have a framework for designing and implementing strategies combining different objectives.
Controlling year-to-year volatility has an impact on corporate transactions, the level of the PPF levies and other areas involving real cashflows. However, the decision-making regarding deficit financing and investments may be based on a longer time horizon with the ultimate objectives to secure pension benefits with an external insurance company. We do not see inconsistency between these two objectives and think there are a number of ways to achieve them.


Can LDI strategies be tailored to reflect the risk appetites of individual schemes? If so, how?

Guzman: Of course! An LDI strategy can be thought of as a benchmark based on the expected scheme cashflows – managing against these cashflows is much like managing against any bond-based index. Active risk from the cashflow benchmark can be taken in the same way. For example, typical bond decisions such as views on the direction of interest rates (a duration position) or the future shape of the yield curve can both be implemented against an LDI benchmark; credit (corporate debt exposure) can be introduced to the portfolio to enhance yield and other “off benchmark” positions can be taken (such as allocations to emerging market debt or other asset classes). LDI therefore embraces strategies with, say, liability benchmark plus 0.5pc through to plus 4pc or so (using a multi asset portfolio targeting LIBOR plus with a swap overlay).

Walton: This is the whole point. The main lever to control risk is the extent to which the uncertainties over the future liabilities are managed, reduced or hedged. The key liability uncertainties are future inflation (higher inflation leads to higher benefit payments), long-term interest rates (lower rates require more assets now to accumulate to the required amount), and longevity (pensioners living longer leads to a longer stream of pension payments). We can add to this the uncertainty over the returns from risky assets, such as equities and from active management.
The development of a liability-focused approach will consider the potential impact of these risks and, in combination, identify acceptable levels of risk or uncertainty, and this allows the construction of an investment policy that is aligned with the risk appetite.

Bourdon: Today, trustees and sponsors have significantly more information on the nature of liabilities than in the past and they are therefore able to focus more clearly on setting performance targets. The problems associated with attempting to accommodate both liability matching and active management in one process have encouraged fund management groups to look for alternative solutions.
Once the scheme has agreed what risk level is appropriate, we can establish a suitable investment objective. The investment objective will have the liabilities as part of the benchmark, whatever the level of risk. We can then manage the risks using bonds and derivatives, and introduce returns through a combination of passive and active funds across a well-diversified portfolio. Essentially, you will have a risk managed portfolio alongside a suitable return-seeking portfolio.
We have a number of solutions aimed at combining a long-term performance target with controlled balance sheet volatility. For example, the growth of the derivative markets and alternative asset classes allows separation of core market risk (beta) from the manager’s skill performance (alpha) and expertise in niche areas.
How can trustees decide whether a segregated mandate or pooled approach is appropriate to the scheme? Should they be concerned that if they can only access LDI through pooled funds it might compromise their needs for outperformance?

Guzman: Trustees should certainly not consider LDI in a pooled fund as compromising needs for outperformance – Aberdeen offer a pooled LDI fund range that targets plus 2pc over fixed term benchmarks. Pooled solutions are often considered the only approach available to public sector schemes, smaller schemes that cannot access a diversified return seeking portfolio without pooling and those for whom a segregated swap overlay is not cost effective, given the associated fixed costs.

Walton: Pooled or segregated is a marginal point, balancing the control and bespoke nature of a segregated approach with the additional legal, administrative and governance burden of building a segregated solution. Pooled is often easier to implement and usually accurate enough, particularly when we remember how difficult it is to forecast long-term future pensions with accuracy, or consider that in many cases only a proportion of the scheme’s liabilities are covered by the interest rate or inflation hedge.
Trustees should be very worried if LDI pooled funds compromise their need for excess return and outperformance, as this doesn’t need to be the case. At Schroders we believe in the separation of the risk reducing element (liability hedging) and the return-seeking element. This allows very flexible and genuinely bespoke solutions to be created that are exactly aligned with a scheme’s need for outperformance and risk appetite. Importantly, this flexible approach allows the asset mix and hedging strategy to be managed through time as conditions and funding positions change.

Bourdon: The pooled funds provide an efficient way (for example, in terms of cost and simplicity) for the smaller funds to manage their risks. Provided the pooled funds allow manager flexibility and limited constraints to deliver performance, then the scheme needs should not be unduly compromised. Having the right benchmarks and risk control strategies are the critical factors for meeting the objectives.