Joseph Mariathasan examines the origins of liability driven investment (LDI) and its role in pension fund management and investment today
The cult of equities introduced into UK institutional pension funds during the 1950s replaced the previous orthodoxy of using bonds as the main investment of pension funds.
Having seen immense growth in equity holdings by pension funds during the next four decades, arguments began to swing back the other way as the implications of turning a pension promise into a legal liability led to the argument that pension liabilities are no different from other corporate liabilities and should be brought onto the balance sheet.
A company's risk should therefore be minimised by matching liabilities with assets that mimic their behaviour as closely as possible. The problem for many pension funds though, is that they have a shortfall between their liabilities and assets, so locking in a deficit through hedging - even if one could hedge out all future risks - then exposes the eventual beneficiaries to the risk that the company may not be able to make up the deficit at some future date.
Given that it is generally accepted that equities should give higher returns over the long term than bonds, both companies and trustees are willing to increase the investment risk in the hope of reducing deficits and potentially creating a surplus, which could even be shared with the beneficiaries.
The implicit assumption behind arguing for matching estimated liabilities exactly, no matter what the current bond yields are, is that bond markets are efficiently priced. Modern portfolio theory starts off with the premise that all investors are rational profit maximisers and therefore all investment opportunities can be analysed on the basis of their expected returns, risks and correlations with the rest of the financial marketplace.
But the real world is more complex, with many players in financial markets who are not driven by trade-offs between total returns and risks, and the global market for bond investments is a case where game theory rather than the behaviour of crowds is more relevant. One of the fundamental problems in implementing liability driven investment (LDI) strategies today is that bond yields are low because bond markets are subject to the twin effects of two key non-profit maximising players, namely central banks and liability matching investors.
A pension fund matching liabilities with long dated bonds or swaps is therefore buying investments whose prices have been driven higher by the behaviour of Asian and Gulf central banks which are buying US treasuries and European bonds for management of their exchange rates rather than maximisation of profits.
The issue for pension funds has been that this has arisen at a time when there was pressure to consider the whole issue of mismatches between pension fund liabilities and assets with almost a doctrinaire approach in many cases to liability driven investment. If an individual were given €100,000 to invest for 30 years for their grandchildren, few would decide to keep it all in government bonds at yields of 5% or so. Yet that is exactly what pension funds with long term liabilities are being asked to do.
Moreover, matching the inflation element of pensions requires investing in index-linked bonds. The fact that there is a strong inflation-linked component to pensions led the UK government to introduce index-linked gilts in the 1980s and they have been followed by a number of other countries. Although clearly designed to fulfil pension funds' inflation liabilities, the limited amount of index-linked bonds in existence makes them expensive and illiquid, exacerbated by the lack of significant corporate issuance.
Whilst theoretically it should be possible to find corporate entities willing to pay out inflation-linked cashflows as counterparties to pension funds wishing to receive them, there has not been much evidence of this actually happening so far and the indications are that inflation-linked swaps have to be hedged using index-linked bonds, making them expensive and illiquid. This is eased somewhat by the fact there is often a capping of inflation-linking in the pensions to 5%.
A pragmatic approach
More pragmatic approaches to LDI accept that it is crazy going for a completely matched solution when a fund may still have 50% in equities, but it may make sense to reduce the mismatches to some extent by a couple of swaps, accepting that any estimates of liabilities beyond ten years in many cases will be highly uncertain, giving little rationale for completely matching a snapshot of a moving target. As Erik L. van Dijk, CEO at Netherlands-based Compendeon Investment Advisors in the Netherlands, explained: "As a more general concept of ensuring that whenever you run your asset portfolio you are always aware of the valuation of your liabilities and take them more seriously than you have done in the past, LDI is very important."
Investment banks have gained notoriety in some cases for pushing swap options and other LDI solutions very aggressively, but even they are finding the market for these has become so commoditised it is no longer seen as a very profitable activity to be in and are looking to create more complex tailored solutions that can offer some advantages to clients. As van Dijk explained: "The LDI products that I would describe as good are the ones that in all cases allow for some flexibility. Obviously flexibility comes with a price of having to look at new derivatives rather than bond indices, so you have to ensure that the flexibility doesn't mean excess risk. If a product is inflexible, but at least being done in a cost effective way, then we will advise the clients not to go all the way, to invest less than 100% of what they had in mind. Normally the flexible ones are slightly more expensive so you have to compare the two."
He went on to add: "There are some tailor-made products in the market. We were talking for a UK client with a US firm [about] an investment banking type solution: compared to the standard products it was slightly more expensive, but flexibility would be built in and our client had a specific problem with liability structure that made it more interesting to go the flexible way. The majority of more flexible structures are the ones provided by investment banks or by asset managers related to insurance companies. A lot of the tailor-made LDI structures won't by nature be very liquid so it's important to build in extra flexibility."
What is becoming clearer is that the rationale for a pension fund contemplating an exact LDI matching solution may well need to be examined very carefully. If the scheme is fully funded and the corporate sponsor seeks to eliminate the headaches of managing investment risks in the pension fund, then the growth of the pension buyout market may offer another alternative that is becoming of increasing importance, particularly in the UK marketplace with an influx of new players and new capital.
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