The time is now

In recent years, many large pension funds have adopted liability driven investment (LDI) type strategies, seeking to reduce risk within their portfolios by increasing their allocation towards bonds or bond-like assets. However, many schemes continue to run a significant level of short-term funding position risk by investing in balanced funds.

Balanced funds were developed to provide long-term performance by investing most assets in equities for growth and some in bonds for protection. For years, these have been the investment solution of choice for smaller defined benefit schemes.

But recent changes to pension fund regulations mean the likelihood of significant short-term volatility in the funding position. On the asset side, a high concentration of potentially volatile equities and a low exposure to fixed interest is set against scheme liabilities whose valuation is sensitive to interest rate movements.

The values of assets and liabilities are sensitive to interest rate changes. The present value of liabilities is calculated using an assumed interest rate, usually based on long-term gilt yields. If this changes, so does the regulatory value of liabilities. A scheme’s duration is the extent to which the assets and liabilities are interest rate sensitive. For example, if a scheme has liabilities with a duration of 20 years, a 1pc change in long-term interest rates will change the value of liabilities by 20pc.

However, a typical balanced fund only invests a third of its assets in bonds, with an average duration of 10 years. As a result, the same 1pc change in the interest rates would see the assets increase by just 3.3pc.

Also, where a scheme has liabilities linked to inflation, any change affects the value of the liabilities. Equally, rising inflation can erode the value of the scheme’s assets and its income, resulting in changes to its funding position.

An interest rate or inflation rate mismatch cannot be expected to generate long-term additional returns. And though we have seen an equity bull market over the last four years, the impact of unrewarded risks should not be underestimated.

At first, many viewed the move to LDI as merely a shift from equities into bonds, but its scope is now broader. Techniques such as duration overlay, pooled swap funds, portable alpha and diversified beta can help manage a scheme’s investment risks. Schemes can hedge out unrewarded interest rate and inflation risks while maintaining exposure to growth assets.

Most LDI strategies recognise the need to diversify the portfolio’s growth assets. The risk of relying solely on equities was brought into focus by the 2000-2002 bear market. New diversified beta portfolios have been developed, targeting the same long-term returns as equities while diversifying risk across asset classes.

Some asset managers now offer pooled swap funds, meaning swap exposure can be obtained more cheaply than before, and some have developed the modelling tools and framework necessary to assist schemes and their advisors develop an LDI strategy.

Although balanced fund investments have performed well, they can lead to significant short-term volatility in schemes’ funding positions. Product developments mean LDI is now a powerful and flexible framework that can help trustees reduce risk and ultimately deliver their pension promise. Now might be the time to consider using a LDI strategy to reduce the level of short-term funding position risk to which your scheme is exposed.

Neil Falconer is investment director, global bonds and economics, at Scottish Widows Investment Partnership