LDI: an imperfect investment solution

A new paper by Con Keating, head of research at Brighton Rock Group, called into question the validity of liability driven investing. But industry experts believe LDI, while not perfect, is one of the best solutions pension funds have. Iain Morse reports

Is liability driven investing (LDI) fundamentally misconceived? So argues Con Keating, head of research at insurance company Brighton Rock Group. Over the past seven to eight years, LDI has become the accepted framework within which trustees for defined benefit (DB) pension schemes and their investment consultants take decisions on asset allocation. “It may sound fine in theory,” warned Keating, “in practice it does not work.”

LDI developed out of ‘immunisation theory’, invented by Frank Redington (1906-1984), a solution to how the value of fixed income portfolios can be immunised against the effects of fluctuating interest and inflation rates. It can be applied in several ways; the most commonly used for DB schemes is duration matching between scheme assets and liabilities or cash flows. Redington originally proposed this be done by using index linked bonds.

Since the end of the 90s, trustees have become familiar with hedging some of these risks by using futures, options and swaps. Over the same period pension schemes have also massively reduced their equity and increased their bond exposure. Some trustees combine both hedging and asset allocation, some have avoided hedging but adjusted their assets and vice versa. This is done to reduce uncompensated portfolio risk, where risk is from any outcome other than liability matching. “Many portfolios have sacrificed the equity risk premium for lower returns from bonds,” added Keating, “all in the name of risk reduction.”

Many schemes are now closed to new members. “The result of scheme closure is to push up the cost of meeting scheme liabilities within an LDI framework,” warned Keating. Closed schemes receive no new contributions from members and their trustees can also place a finite duration on their future stream of pension liabilities. “Trustees and sponsors see closed schemes as a risk to be eliminated,” argued Keating, “the demise of DB becomes a self-fulfilling prophecy.” As a result huge sums have been paid by sponsors as special contributions intended to match assets with liabilities, thereby de-risking schemes and effectively eliminating them as a source of balance sheet risk for the sponsor. Despite this a majority of DB schemes are now in deficit.

“My aim is to change the way we think about both LDI and the future of sponsored pension provision,” said Keating. “The current state of affairs offers little hope of adequate retirement income to future pensioners.”