Nearly 2,500 DB schemes are now using LDI to hedge their liabilities, XPS Pensions finds. James Phillips looks at the increased use of the product over 2018.
Hedging of defined benefit (DB) scheme benefits is continuing to pick up pace as the use of liability-driven investment (LDI) has jumped over the 50% mark.
By the end of 2018 there were 2,405 LDI mandates, covering £1,024bn of liabilities, with private sector DB schemes in the UK - a jump of £59bn from the end of 2017, according to XPS Pensions.
The consultant said this equates to 54% of private sector DB liabilities, based on a low-dependency gilts plus 0.5% basis, with the majority using gilts-based derivatives as protection.
XPS' annual survey - LDI: A £1 trillion market - analyses the data of 13 LDI providers, although Legal & General Investment Management's (LGIM) figures may not be accurate as the firm declined to participate. Instead, LGIM's data is sourced from KPMG's 2017 LDI survey and assumed to remain consistent.
In the analysis, LDI is defined as products where managers have cashflow benchmarks and are using derivatives to manage interest rate and inflation risk.
The market continued to grow over 2018, with the £59bn extra in LDI spread across an additional 265 mandates - increases of 6% and 12% respectively.
The average size of mandate therefore is £223m, half the size of the average mandate in 2017, which XPS sees as evidence of a market catering to an increasing number of smaller schemes.
The firm's chief investment officer, Simeon Willis, says that, over the long-term, LDI has become significantly more accessible to a wider range of market participants.
"People have got used to the levels of markets," he says. "People have also got used to the concept and the role it can play in helping risk management.
"Nothing happens overnight in the pensions market so it's taken time for it to feed though. By having products that are made simpler to the user, this has really helped small schemes adopting it."
He believes smaller schemes were previously held back from LDI because of a "knowledge hurdle" and "limited governance time" that meant the issue dropped down the agenda.
The majority, 87%, of the hedged liabilities are in mandates held by just three firms - LGIM, Insight Investment, and BlackRock - although BMO Global Asset Management holds the largest number of individual mandates.
At the end of 2018 BMO had increased its number of mandates by 93 to 537, XPS found, compared to LGIM's 519 based on the 2017 data from KPMG. Insight then held the third highest number of mandates at 312, up 30 on 2017.
These figures also exclude mandates secured through platforms or fiduciary management, which an increasing number of LDI users are accessing.
In comparison, by total notional liabilities hedged, LGIM secured the top spot - based on the 2017 data - with £381bn, while Insight ran LDI mandates totalling £319bn in liabilities. Although BMO held the most mandates, these covered just £36bn of liabilities.
The market is burgeoning, and has done so for a few years, as Willis explains: "A number of years ago we reached a tipping point with the market where people realised that LDI wasn't a solution to a theoretical problem, it was a solution to a real-world problem of low yields."
The lower-for-longer environment has led schemes to seek alternative ways to manage liabilities.
In doing this, schemes have, on the whole, used pooled solutions to access the LDI market. In terms of the number of mandates, 92% of new arrangements in 2018 used this method - and across all mandates currently in operation, 73% are in pooled arrangements.
Yet this method is generally used for the smallest schemes and the bigger allocations access LDI through segregated or bespoke pooled solutions. Around 89% of liabilities are hedged via the latter, despite comprising just 27% of mandates.
"Your default approach would be pooled, unless pooled was unable to provide some aspects that you require and you've got the scale where segregated works," Willis explains. "But it's not the preserve of large schemes.
"In pooled arrangements your leverage is constrained, and the use of growth derivatives is also constrained. If you want to use equity options, for example, you'll need to use a different arrangement."
Bespoke arrangements facilitate combining a collateral pool with a buy-and-maintain corporate bond portfolio, for example, allowing more assets to be invested with a slightly higher level of leverage within the LDI portion, Willis notes.
For any DB scheme, LDI is a useful way of managing the risks that could push up liabilities, particularly in the current uncertain Brexit environment, where the outcome of the negotiations could push interest rates, inflation, and the value of sterling in any direction.
It is perhaps no surprise, therefore, that schemes are looking to hedge more and more.
Ross Trustees has secured investment backing from private equity investor LDC, as it prepares to capitalise on growing demand for professional trustee services.
Lee Sanders says the fast and adaptive market response to the crisis of 2020 has shown how much the financial system has improved upon the credit market liquidity issues that were at the heart of the 2008 global financial crisis (GFC).
Defined benefit (DB) schemes that provide GMPs must revisit and, where necessary, top-up historic cash equivalent transfer values (CETVs) that have been calculated on an unequal basis, a landmark court judgment said last week.
The stabilisation of US economic growth amid unprecedented fiscal and monetary stimulus has raised questions about the likelihood of inflation returning. Global Head of Fixed Income, Jim Cielinski, and Global Bonds Portfolio Manager, Andy Mulliner, explain...