I recently had the pleasure of attending a roundtable discussion on Liability Driven Investing, hosted by Pensions Expert.
the group covered the following four questions :
- How do you approach LDI with schemes that do not already have it in place?
- Once an LDI programme is in place, does it get more sophisticated as it progresses?
- What assets have been substituted for low-yielding gilts in LDI programmes?
- What innovations are currently being seen in the liability-driven investment market?
1. How do you approach LDI with schemes that do not already have it in place ?
read the full set of answers to this question here
I opened the answers to this key question by re-iterating the basic reason why schemes look to put an LDI strategy in place:
“The fundamental reasoning for implementing liability-driven investment within most schemes is to ‘right-size’ the risks being run by addressing interest rate and inflation risk. You tend to often meet with misconceptions saying, ‘Rates are low, surely they can only go up and surely I am only going to lose money in this approach.’
There are responses to that – LDI is not focusing on short-term rates. We are looking at longer-term rates which are currently building in significant interest rate rises. People are quite surprised when you explain how steep the interest rate curve is and also the extent to which carry and roll-down affects their liabilities as well.
The fundamental way it is approached has really remained exactly the same as always although the challenges evolve, given the market environment that we are in.”
Steve Barker made a very interesting point regarding the appetite of smaller schemes for LDI :
Something that has surprised me is how open-minded trustees are about LDI, particularly the smaller schemes that I deal with. Eight or nine years ago when pooled LDI funds became available – which made LDI a discussion that was worth bringing up for small schemes – I thought, ‘Brilliant, this is a solution that really works well and it should be a no-brainer,’ but I was a
bit sceptical about how easy it would be to explain how they work.
But I have only had two clients that we have ended up recommending using pooled LDI funds [that] have decided not to because they were scared off.
2. Once an LDI programme is in place, does it get more sophisticated as it progresses?
Marian Elliott made a very good point about the difficulty trustees face in assimilating all the different information and advice they receive at different points in the year:
“That [communication from their providers] can be a problem for a lot of trustee boards – they get some information from a covenant provider, at a different time of year they get some information from their investment consultant about an investment strategy, and then later an actuary takes a different approach and tells them, ‘Sorry, actually this is the different hole that you have to fill’. Trying to get those lined up can be very difficult for trustees.
The regulator’s latest statement on defined benefit funding is very positive in reinforcing the need to look at all of those three things together, and that will cause advisers very much to have to up their game in terms of presenting some coherent strategy to a trustee board rather than, ‘This is my piece of advice, do with it what you will.’”
I highlighted the changing use of different instruments as markets have changed
You have to react to events as they occur. When the early adopters put liability-driven investment programmes in place in 2004 and 2005, it was all around swaps and cash. The swap curve was higher than the gilt curve at that point, so there was a strong case for using swaps.
People did not foresee the fact that those curves were going to move around a lot and then it would become beneficial to have the flexibility to move in and out of gilts and swaps – on both nominal and inflation – at different points in time.
So I do not think you necessarily plan for things to evolve in a particular way, you just want to have the flexibility, and that is one thing we have learned.
3. What assets have been substituted for low-yielding gilts in LDI programmes?
Some interesting points were made highlighting the use of illiquid forms of debt such as infrastructure debt or social housing debt, but the participants were careful to highlight the fact that these substitutes might not be a precise hedge for liabilities.
Marian Elliott: This is where you see a lot of interest in infrastructure projects coming in – anything expected to generate a relatively predictable stream of revenue, which ideally would be inflation-linked. The thing trustees need to guard against when they are investing in proxies to hedge their liabilities is that it is not a direct hedge; they need to be aware of the risks that still remain.
Also, some of these asset classes are very different to anything they would have invested in before. It is therefore important that trustees make sure they really understand the nature of the asset they are buying and the potential impact on the funding position under a range of possible economic scenarios.
Richard Butcher: The other one is social housing. Any proxy is a compromise. There are going to be additional risks that go with it.
4. What innovations are currently being seen in the liability-driven investment market?
There was a very wide-ranging conversation on innovations in DC, I highlighted the general need for more hedging among pension funds, and the coming of central clearing for interest rate derivatives such as swaps:
“Most schemes out there are dominated by interest rate and inflation risk, and the challenge is really trying to increase that basic level of hedging along the way.
The challenge of central clearing – of interest rate swaps, and possibly, in the future, inflation swaps – this year will be a big development. We are yet to see exactly what the effect of that is going to be.”
There was then a very interesting debate around the applications of LDI to DC schemes. This conversation took place before the announcement by the Chancellor in the budget of 19th March around the increasing of flexibility in DC schemes, and therefore focused significantly on the idea of buying annuities in DC schemes (which up to that point was the expectation, in most cases).
Steve Barker: One of the most interesting changes is a move into defined contribution. Fifteen years or more ago you had LDI used for large segregated defined benefit schemes. Then we had pooled funds set up so that smaller schemes could use LDI. The smallest client we had using pooled LDI products was a £1m scheme. I think there is scope for using those same ideas for DC.
Richard Butcher: DC is an interesting one for me. I am not sure I have seen LDI yet in DC and the reason for that is very few people are actually recognising their liability. At the moment we focus on contributions and investment returns, rather than what we are trying to achieve with those contributions and investment returns. I think it will come, but I do not think we are there yet.
Elliott: Sooner or later that has to take hold, and there are enough people who think that way for there to be a general groundswell that we need to be communicating this in a much better, more sensible way to members and providing them with guidance about the likely outcomes in retirement. The problem around LDI in DC is who pays for it.
Barker: There are two main challenges – one is how you package it up so that it can be delivered in small enough parcels. The bigger issue is communication, because you have got to communicate to members that there is a liability. It is not about building up your pot as big as possible; it is about what you can afford to buy in terms of the annuity at the back end of it.
And if annuity prices fall through the floor, and their assets fall through the floor, how do you cope with disgruntled members of a scheme that, on the face of it, look like they have lost a lot of money?
Brown: In terms of solutions that are out there in the market already, if we think that the liability for DC ultimately is purchasing an annuity – which I suppose it is – some providers have pre-retirement funds which allow you to move towards an appropriate asset allocation that actually matches the annuity pricing of the top three annuity providers. So there are those kinds of products out there; I know there are not so many at the moment, and obviously continued innovation and competition will be useful.
Conclusions
A lively discussion then, with most participants agreed on the basic reasons for implementing LDI within a DB pension fund, and a variety of ideas put forward in terms of changes and innovation we may see in the near future. The budget announcement has clearly shaken up the DC angle but I’m sure we’ll read plenty more on that too.
thanks to Pensions Expert for inviting me and hosting the discussion.