When the deputy governor of the Bank of England (BoE) touted the possibility of negative interest rates, some alarm spread across the investment community, not least among those advocating greater liability hedging.
“If LDI is a governance hurdle then certainly swaptions are another couple of steps up on that governance scale. It’s about investment of time.”Julian Lyne
While Paul Tucker’s proposals may not have related to the BoE’s base rates, the mere suggestion of negative interest rates in any part of the financial process could be enough to impact markets and send gilts yields falling even further than the lows of last summer. Economists have since dismissed the prospect of negative interest rates, but the renewed focus on one of the key risks threatening pension scheme funding levels served as yet another reminder of the relative merits of hedging strategies. Liability driven investment (LDI) has become a cornerstone of UK pension fund portfolio management based as it is on removing unrewarded risks and better matching assets to liability cashflows.
However, LDI has moved on from its initial incarnation which used straightforward gilts and simple swaps to match pension payments. Today it calls on a whole host of complex derivative instruments better able to keep pace with the current challenging economic environment. As gilt yields plummeted and prices rose trustees needed to thinksmarter about traditional matching strategies, and derivatives in the form of gilt repurchase agreements, or repos, became popular. These instruments allow pension funds to sell their gilts with an agreement to buy them back at a later date, thereby benefiting from the inflated price without losing the hedge.
Simeon Willis, principal consultant at KPMG, says: “Using gilt repos is a good alternative to swaps; they reduce risk while doing it in the most efficient way. In a lot of ways repos are simpler [than swaps] and they are proving a popular approach.” So far so accessible, but LDI refuses to stand still and as it evolves so its components have gained sophistication.
Not an easy swaption
Swaptions, for example, offer investors a chance to hedge without locking in to today’s unappetising rates. However, their relative complexity precludes some investors from taking advantage.
As with traditional options, swaptions offer investors willing to pay a premium the right but not the obligation to enter into a swap at an agreed point in the future. This should be an attractive proposition to pension schemes that want to hedge now but believe rates will rise in the future. However, while European schemes – which are often larger than their UK counterparts and have the governance budgets to match – have taken to swaptions with enthusiasm, UK pension fund trustees remain cautious.
Tim Cook, senior consultant at Russell Investments, says: “It’s a complicated area and [managing an LDI strategy] is not a trustee’s day job. Unless they’ve got an internal expert they won’t have the time to fully engage with LDI so there is a high level of distrust of derivative products even where they help the scheme hedge in a more efficient manner.” And it is not just governance hurdles which must be overcome. Since swaptions demand bespoke tailoring to match the particular circumstances of an individual scheme they can only be set up on a segregated basis, thereby effectively excluding many pension funds without the requisite assets.
Julian Lyne, head of global consultants and UK institutional at F&C, says: “[Swaptions] are not like other strategies where we can take some reasonably complex solutions and deliver them in a pooled fund. Swaptions have to be bespoke and so there is a hurdle in terms of size.”
In spite of these obstacles Lyne says there is a growing interest among UK trustees to embark on a swaptions-based strategy. However, he notes significant education is needed. “If LDI is a governance hurdle then certainly swaptions are another couple of steps up on that governance scale. It’s about investment of time; we have a number of clients in the UK who have put swaptions strategies in place and it is about doing the hard miles of trustee education and training,” Lyne says.
Alongside swaptions, fund managers have developed other sophisticated strategies to bypass trustees’ reluctance to get involved with LDI at today’s prices. Notably the use of gilt forward rates has started to take hold as managers look beyond the low yielding shorter durations towards the more ‘normal’ longer rates. Managers such as Ignis Asset Management, which uses forward rates for its own £1bn in-house pension scheme, are stripping out the first five years of low yield which drags down the performance of a longer duration bond, allowing pension fund investors to hedge based on rates past the early years.
KMPG is in the final stages of collating its 2013 LDI survey and Willis says more pension schemes are turning to this kind of strategy. “Pension funds have been looking at hedging the longer term rates while not removing the exposure to the shorter term yields, but it’s hugely complex. It introduces lots of uncertainties in terms of how the hedge protects you against changes in bond prices. It’s both complex to implement and understand. We have been seeing it but it’s at a relatively low level,” he says.
Of course, the vast majority of UK schemes do not share Ignis’s £1bn in assets nor boast its army of internal LDI specialists. So how can the mid- and smaller-tier funds take advantage of LDI’s new wave of solutions? The obvious answer lies within pooled funds and a growing number of options are available. F&C launched its Dynamic LDI funds last year which are able to invest in a range of derivatives including futures, repos and swaps with the asset manager choosing which instrument is most efficient at any given point in the market.
A survey of pension schemes with assets between £10m and £500m undertaken by Aon Hewitt in the summer of last year revealed two-in-five planned to increase allocations to LDI solutions using tailor-made funds.
Richard Dowell, head of clients at Cardano, says trustees should still expect to encounter additional costs and demands when using pooled funds but ignoring them on that basis could prove to be a false economy. “The opportunity costs of not hedging can be significant. If you look at our client portfolios that were hedged back in 2008/09, their funding position is much stronger than the average pension scheme,” Dowell says.
Delegation’s what you need
Alternatively pension schemes lacking the requisite governance budget to manage LDI themselves can call on fiduciary managers. Russell’s Cook says: “There is inertia because [the trustees] don’t understand all the solutions available. There should be a level of delegation of either the governance budget or the implementation of the different tools. A liability hedging manager and the fiduciary manager can discuss the options available and put forward a solution that works.” But handing responsibility to a third-party requires something of a leap of faith for many trustee boards, not to mention a potential increase in fees and additional fiduciary manager monitoring requirements.
Dowell maintains the benefits should outweigh the costs, adding: “You have to trade a balance between paying the fees [for a fiduciary manager] versus the benefits it brings. You can’t always see the benefits on a day-to-day basis but schemes will see it over time as their funding ratio becomes much more stable.”
How far has LDI left to go? KPMG’s Willis likens its future to the smartphone: complex technology hidden beneath a simple interface. “There is still a requirement for complicated LDI arrangements for big schemes, but for smaller schemes there will be greater choice and simpler structures that make it easy for trustees.”