Real Returns by Dan Mikulskis

The first 12 years of Liability Driven Investing (“LDI”) in the UK have seen remarkable growth in number of mandates (from a handful to over 1,000) and in liabilities hedged (from <1£bn to over £650bn). Overall, as I covered in a previous post I think it’s fair to say from a neutral standpoint that the first 12 years of LDI have been a success.

It’s clear to me (and others) that LDI is central to risk management for defined-benefit pension schemes, particularly as they mature (indeed, I’d go as far as to say you can’t effectively risk manage a defined benefit pension scheme without LDI, just see the evidence from the last decade here). So LDI is here to stay, and it’s spectacular growth likely to continue.

The next question is, what’s going to be important in LDI in the future?

I can see really 4 themes that I think will be pretty key in LDI over the next few years. Some of them possibly receive less coverage than they merit right now, but I predict we’ll hear a lot more about them.

1. Basis Risk
2. Negative Cashflow
3. Deflation Risk
4. Regulation

1. Basis Risk

One issue with communicating about LDI generally is that it is all too often surrounded by acronyms and jargon – and basis risk can easily fall into this camp. However, at a fundamental level basis risk is quite simple to understand: basis risk is about avoiding unpleasant surprises.

Basis risk is about ensuing that your hedge actually does what you want it to, principally it stems from the fact that both gilts and swaps are instruments that can hedge interest rate (and inflation) risks, but in practice they do price slightly differently, and this can lead to their performance differing – possibly by more than you’d think.

Here’s a simple example: at the time of writing (November 2015) gilt yields are actually higher since the start of the year (by around 15 bps) whereas swap yields are lower (by around 10bps). So LDI hedges based on gilts may well have lost money, whereas hedges based on swaps will have gained. Over longer periods of time these differences are likely to “wash out”, and over the entire period to maturity the payoff will be more certain, but it is a reasonable expectation that hedges will work over shorter periods of time as well – after all that’s partly the point about risk management through LDI. to make sure this happens it’s essential for clients and advisers to understand basis risk.

There may well be very good reasons for taking some basis risk (for example, it might enhance returns) but like other sources of return, it is not without risk, so needs to be controlled and understood.

2. Negative Cashflow

The excellent Hyman’s Robertson FTSE 350 Pensions Analysis Report  states that some 50% of UK pension funds are (or will be soon) be in negative cashflow (a position where they pay out more each year in benefits than they receive in contributions) – I must admit I was surprised it was quite this high, clearly this dynamic can have profound consequences for how schemes are managed.

A negative cashflow dynamic presents unique risk-management challenges. The risk of capital loss is that much greater given that recovering significant losses is so much harder when paying out a significant part of a fund each year. For LDI this is likely to affect the amount of leverage taken, and also the availability of liquid assets to post as collateral.

3. Deflation Risk

Deflation isn’t something that pension schemes have tended to worry about too much (inflation being the greater risk historically). However, most schemes are in a position where the benefits paid each year cannot fall (their inflation sensitivity has a floor at 0%) whereas many or most hedge with RPI-linked instruments which do not have such a floor. In theory this could lead to a nasty mismatch between liabilities and hedge if inflation is significantly negative for a period of time.

Fortunately, there are ways to set up and LDI mandate to minimize this risk, we wrote more about that in this paper.

4. Regulation

Let’s face it, regulation is rarely a thrilling topic to talk about, but LDI faces regulatory-imposed changes from two possible sources 1) The European Market Infrastructure Regulation (“EMIR”) and 2) the Basel III regulatory framework for banks.

The trouble with talking about regulation is that all-too-often its tough to say for sure what the consequences will be for clients and be clear about exactly the best course of action. This case is no different, but it seems clear that either or both of EMIR and Basel III could have relatively significant effects on LDI, either directly, or via the prices and terms on which banks are able to provide access to common LDI instruments. As always it’s vital for schemes, their advisers and fund managers to be on top of the issues, and be ready to adjust LDI programs should this be in the best long-term interests of the client.

There we have it, my 4 big predictions for LDI themes over the coming years. LDI has done it’s job well over the last 12 years, subject to these issues being managed there is every reason it will continue to do so over the next 12.