Liability-driven investment's (LDI) dominance as a trend in UK defined benefit (DB) pension scheme investment will come to an end by 2021, according to research.
LDI has been used by DB schemes over the past 20 years to reduce the risk that they may be unable to meet future retirement payments, providing protection against unforeseen changes in interest rates, inflation and life expectancy.
However, according to the report published by Hymans Robertson and Nomura, notional interest rates and inflation hedging exceeded 75% of private sector DB assets by the end of March. This is equivalent to around 55% of gilt liabilities, based on ‘working assumptions.'
It added that around £1.2tn of notional interest rate risk is being hedged today and schemes will not materially hedge above asset levels of about £1.5tn. It predicts the current pace of increasing hedging levels can only continue for three more years, at most, and that LDI flows will peak by 2021.
Meanwhile, the firms believe that pension funds have been adding in the order of £100bn of notional interest rate exposure a year for the past two years, based on ‘central assumptions.'
The consultancy reached out to a wide number of UK asset managers in the LDI, to several self-administered pension schemes and to UK life insurers for its research.
Its assumptions were intended to represent the universe of UK private sector occupational DB schemes. This covers 5,588 schemes which are virtually all the PPF-eligible schemes.
Its model treats all schemes as a single fund. It projects the total assets and liabilities year by year, for 100 years, starting from 31 March 2017.
Nomura head of EMEA solutions sales Richard Boardman said: "At the same time as the rise in LDI, over the last 20 years UK real yields have dropped by over 5%. While some of this is due to global trends, UK real yields have fallen by almost 2% more than global real yields and in part this will have been due to LDI activity by DB pension funds.
He added this drop in yields has meant LDI asset portfolios have delivered very strong returns.
"Given that a 1% drop in yields adds around 20% to DB liabilities, these movements in gilt markets have inflated the value of DB liabilities beyond recognition over the past generation.
"The abrupt slowing of pension scheme money flowing into hedging assets could have a material impact on bond yields and as a consequence DB scheme funding levels.
He further stated schemes should take this expected change into account when they are setting their investment strategy and considering hedging decisions.
"Hedging in the UK has been a crowded trade with high demand from DB schemes and seemingly ever lower yields. However, UK yields are driven as much by global moves as by UK specific supply and demand, so holding off from hedging does carry risk and is not a one-way bet.
"There will also be questions for the Debt Management Office (DMO) to think about. The ‘buyers of last resort' are soon to become far more price sensitive."
He concluded that the DMO may need to alter its issuance profile in order to attract buyers of gilts for non-liability hedging purposes.
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