Liability driven investment strategies have been around for a couple of years now. Global Pensions puts three product providers in the spotlight and asks what's next for LDI
How are liability driven investment (LDI) strategies going to evolve?
Hugh Cutler: Many LDI strategies are currently focused solely on reducing uncompensated interest rate and inflation risk. However, over the next couple of years, we expect to see an increased focus on managing the compensated risks more efficiently. In particular, building an optimal mix of risk and return sources. This is likely to lead to funds seeking greater diversification, moving away from equities (and in particular domestic equities) to include asset classes such as emerging markets, high yield bonds, commodities, property, infrastructure and private equity. We are also starting to see pension funds making long term plans as to how their strategy will evolve as the membership matures, perhaps contingent on funding levels and the strength of the sponsor covenant. Funds will continue to monitor the market for longevity hedging solutions, although widespread adoption of this type of strategy looks some way away. There will, of course, also continue to be increases in hedging interest rates and inflation. Many funds have already taken an initial step and will increase the hedge dependent on market conditions, while others are still at the planning stage. The trend towards defined contribution (DC) will also continue, and increasingly we will see DC funds embracing highly diversified strategies in the same way that defined benefit (DB) funds are now starting to. We may also see DC funds employing more thoughtful interest rate and inflation hedging to match the cost of buying annuities. However, it is not all one way - the gradual ‘de-risking' of DB funds as they mature looks like an idea learned from DC life-styling.
Dominic Delaforce: Longer term we expect the focus to be on longevity. Increased life expectancy and the accurate projection of it is a big issue for pension funds. We may start seeing new mortality-related instruments that will be able to help pension liabilities hedge this risk alongside inflation and interest rates. Currently, the market to trade in mortality derivatives is very much in its infancy and an increase in liquidity in traded mortality solutions would add to the LDI toolbox and be welcome. At the moment, some schemes currently hedge interest rate risk but not inflation risk. This is a risky approach as many schemes have significant inflation exposure and by entering into an agreement to pay the interest received on cash and in return receive a fixed amount, they have potentially increased this inflation exposure. So we expect more and more schemes to hedge against inflation. Meanwhile, segregated and pooled LDI solutions are already available to meet the needs of the vast majority of pension funds. We expect this market to grow, and for solutions to be increasingly tailored for individual schemes. When it comes to pooled funds, we expect the market for long maturity funds to be a growth area (we have found 50-year maturity funds have proved particularly popular). With developed world pension costs rising as populations become increasingly aged and work forces shrink, there is a need for long dated securities to address the potential asset/liability mismatches of pension funds and insufficient supply of prime quality long dated securities.
Neil Walton: We would expect to see four elements develop further. Firstly, greater use of liability hedging techniques built from interest rate and inflation swaps, possible moving onto options on swaps to retain some upside if yields move in favour of the plan. Secondly, a development of longevity hedging vehicles to fill this gap in the risk reduction tool kit. A third development will be dynamic hedging strategies built into mandates, where an action - perhaps further de-risking - is pre-agreed and implemented when the funding level hits a trigger point. Finally, the return sources used alongside hedging programmes will expand and become more diverse, mixing active or skill-based returns with market exposures.
Will we see the incorporation of stronger alpha capturing elements?
Dominic Delaforce: We certainly will. Schemes are embracing LDI strategies to achieve a closer match between assets and liabilities, but, at the same time, they are becoming much more demanding of their managers and setting increasingly high outperformance targets. Once a scheme's liabilities have been matched - for example by the use of swaps - cash can be invested efficiently by allocating to assets that can potentially provide higher returns, be they bonds, equities, property, private equity or hedge funds. Within fixed income, for example, managers are turning to a broader range of alpha sources to enhance performance in addition to traditional investments. Increasingly, to deliver to our clients' objectives we are adding value in two main ways: firstly, through the use of interest rate and currency overlay strategies; and secondly, by exploiting opportunities in non-core fixed income markets, such as global investment grade credit, emerging market debt and high yield debt. LDI is no longer just about interest and inflation rate management or domestic bonds. Today, pension funds are focusing more on the best opportunities in the different markets.
Neil Walton: Alpha will remain scarce and thus of great value and expensive to access. Some will seek ‘alpha' that is really smart beta, namely returns that outstrip cash from exposure to nontraditional markets coupled with active strategies. In our view, the strongest and most robust alpha comes from a diversified approach.
Hugh Cutler: For most funds, generating excess returns over a liability benchmark is becoming the key focus. Without this excess return, contribution rates for sponsors will be unpalatably high and it will be hard to reach full funding. Generating excess returns can come both from ‘beta' (excess returns from taking on market risk) and from ‘alpha' (excess returns from manager skill). Historically, pension funds have focused the majority of their risk on the markets, with a relatively low allocation to skill-based strategies. However, the proportion of risk and return allocated to alpha strategies has increased recently through the use of hedge funds, high alpha bond mandates, currency and global tactical asset allocation, and more recently partial short ‘130/30' strategies. We expect this trend to continue and LDI strategies will be at the forefront of this as they highlight the sources of risk relative to liabilities and show how powerful alpha strategies can be. However, skill-based returns will remain difficult and expensive to capture, and, given the long time horizons of pension funds, we expect the majority of risk (and return) to continue to come from investing in markets. The bigger trend is likely to be the use of a more diversified range of markets to get the best return for the risk taken.
Will the recent volatility in global markets undermine pension fund confidence in the use of swaps and derivatives?
Neil Walton: I would expect the complete opposite. Those that have hedged their major liability risks and genuinely diversified their return sources will have experienced much reduced pain through the market turmoil. One issue is the increased LIbOr hurdle on swap programmes, which will have caused some difficulties and will be more problematic if it continues. I would, however, check that the collateral arrangements are properly set up and running to ensure that counterparty risk is minimised.
Dominic Delaforce: Certainly, recent market volatility is likely to adversely affect sentiment about all sorts of financial assets and instruments, swaps and derivatives included, but pension funds which have allocated to experienced, wellresourced managers are unlikely to be too concerned. As long as their manager has expertise in the derivatives marketplace and robust systems in place, there should be absolutely no cause for concern. Using a manager with experience of trading in a large volume of these instruments should also give clients confidence - for example, our dedicated Derivatives Management Team traded around £80bn in OTC derivatives in 2006, and as a firm we have been active in dealing and managing swaps for clients since 2001. Given the size of our derivatives activity, we are able to ensure best execution for our clients.
Hugh Cutler: The interest rate and inflation swap markets that are most widely used for the hedging of interest rate and inflation risks have continued to deliver what they promised through recent market events. That is, funds that employ swaps have seen smaller swings in their funding levels than those that have not. Funds that have fully embraced LDI and also built diversified return-seeking portfolios have fared even better, with returns from asset classes such as commodities and emerging markets offsetting the losses in credit markets and some developed markets.
How do you defend LDI against accusations it neglects long term strategic objectives in order to manage short term volatility?
Dominic Delaforce: It's true that swap-based solutions can manage short term volatility and (within current accounting standards) be beneficial for company balance sheets. but setting those issues aside, by its very nature, LDI is about the long term. Quite simply, it is a means of trying to make sure pension schemes have the funds (or even more than enough funds) to meet future liabilities and take those risks that will be rewarded and manage large risks that could endanger the future of a scheme. As mentioned above, among our pooled fund range, long maturity funds have proved particularly popular - highlighting the fact that today's LDI solutions are about long term issues such as increased longevity and an ageing developed world population. Furthermore, as we have also discussed, not only can modern LDI strategies enable schemes to hedge unwanted risks, but they can also generate higher investment returns relative to their benchmarks. So LDI is no longer just about avoiding short term deficits - it is also about securing excess returns for clients, with the aim of investing the proceeds for the future. That said, LDI should be seen as part of the toolkit used by pension schemes, rather than the whole solution.
Neil Walton: We believe that most schemes' long term strategic objective is to stabilise and improve their funding level or reduce their deficit. Inflation swaps can help with long term stability - removing exposure to variation in expected inflation. Where liabilities are regularly valued with reference to market yields, this more short term focus brings in interest rate risk. To some extent, bond assets help reduce this risk, but interest rate swaps are usually more effective and precise and can also free up capital for growth investing. So, by introducing an LDI strategy, trustees can stop worrying about short term liability issues and concentrate on their allocation to long term growth strategies. At present, the issues of reducing unrewarded risks and focusing on growth are too often blurred. removing the short term liability issues frees up time to focus on dealing with growth assets in the most efficient and effective way, which is a key tool to help with long term strategic objectives.
Hugh Cutler: LDI suffers from a lack of clear definition and I believe this underlies many of the criticisms. Switching all assets into bonds or swaps and not taking on any risk could be criticised for being short termist. However, this is not what LDI means. LDI is about understanding the risks you are taking, being clear about your objectives over all time frames and using every tool at your disposal to maximise the likelihood of achieving those goals. In that form, it becomes hard to criticise LDI. Of course, people will not always agree on what the objective are, or what the best way to achieve them is, but that debate is extremely healthy in finding the best outcomes.
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