LDI has dominated final salary scheme strategies for the past 20 years, but is it time for a re-think? Andrew Holt reports.
Liability-driven investment (LDI) is the bread and butter of institutional investing. It has traditionally been employed by pension schemes as a popular risk management tool due to it focusing on aligning a scheme’s assets with the projected obligations, or liabilities, owed to its members.
LDI is, essentially, all about investments and liabilities moving in tandem. “It’s a framework for assessing risk across the whole balance sheet and deciding which market factors and how much exposure an investor is prepared to take,” says Evan Guppy, head of LDI at the Pension Protection Fund (PPF).
“To do this, investors will need to assess the factors that could cause their liabilities to rise or fall in value,” he adds. “They will also need to determine the size of the sensitivities for each factor and how these might correlate with other exposed risks. Finally, they will need to appraise their appetite for the risk of these factors moving adversely.”
LDI has been one of the dominant trends in UK defined benefit (DB) pension scheme investment for almost 20 years. Moreover, it has been a productive strategy since the financial crisis of 2008, as pension schemes enjoyed a favourable run of market conditions during that time, particularly if using LDI to protect against falls in interest rates.
Amongst historic volatility, LDI returns significantly exceeded expectations, returning between 14% and 17% in 2019, and in the region of 12% to 15% a year later, depending on the duration of liabilities. LDI – along with US large caps – was one of the two consistently strong contributors to investment portfolios.
In addition to positive returns, LDI continued to serve as a hedge throughout 2020 for the present value of pension liabilities. One assessment revealed the impact of the market turbulence brought to light the strong relative performance of LDI strategies and their broader role in portfolio risk mitigation. Within this, LDI-focused pension plans that hedged interest-rate risk with long-duration bonds fared better in 2020 than longer-duration total-return plans with allocations more focused on equities.
Improved funding levels underscore LDI’s effectiveness as a tool to manage portfolio risk and reduce funded status volatility. Consulting firm NEPC tracked the funded levels of two hypothetical pension plans: a longer-duration open plan investing in a total-return portfolio, and a shorter-duration frozen plan that hedges interest rate risk.
And the funded status of a typical LDI-hedged corporate pen- sion plan increased by more than 5% in 2020. In contrast, the total-return approach resulted in lower funded status for the better part of the year, ultimately finishing a less than 1% improvement, despite robust equity returns. While the higher equity allocations of a total-return plan helped o set the increase in liabilities, the rally in long bonds boosted returns for plans incorporating LDI.
“The ultimate aim for DB pension schemes is to be fully funded – that is to have sufficient assets to meet future pension obligations whilst taking minimal investment risk,” Guppy says. “For most, the best way to achieve this is to increase assets in a smooth and steady way relative to its liabilities.”
An LDI approach helps to manage this path, says Guppy, to being fully funded and reducing overall investment risk as it gets closer to that endpoint. “Scheme liabilities are typically long-dated, making their value volatile and thus a key driver of the overall funding level,” he adds.
That said, the Covid pandemic has also brought LDI into sharper focus, with some considering a re-assessment of it as an approach. One asset manager cites pension plans experiencing several challenges during 2021 in and around LDI with an assertion that such allocations now provide limited benefit in protecting the plan from required contribution demands.
Key risks for those using LDI include changes in interest rates and inflation, as well as duration, which is a measurement of how sensitive a fixed-income instrument’s price is to rate fluctuations. All these risks can have some sizable impact on the value of future liabilities. This situation is applicable to the current economic and investment environment.
“Interest rates and inflation are the key factors DB pension schemes focus on when talking about LDI because the value of their pension obligations – the liability side of their balance sheet – rise when long-term interest-rates fall and inflation projections rise,” Guppy says. “So, for DB pension schemes, the adoption of an LDI strategy tends to result in increased allocations to fixed income assets that behave in a similar way to liabilities.”
This in turn though could lead to a re-assessment of LDI. “Investors naturally want to re-assess their strategic and tactical positioning. LDI portfolios are no exception, especially because of their sensitivity to changes in interest rates,” says one asset manager.
“The re-assessment of LDI strategies, as any strategy, needs to have discipline and be holistic, incorporating plan sponsor characteristics, pension-specific factors and market conditions,” he adds. “LDI, appropriately sized and understood, can continue to bene t from LDI’s positive impact on risk-adjusted portfolio performance.”
Going further, Guppy adds: “The first phase of recovery following the pandemic is also sharpening minds regarding the economic scenario which is most concerning for institutional investors: stagflation.
“An environment of low economic growth generally means low returns on most financial assets, whilst high inflation means that the obligations that those assets need to fund are rising at the same time,” he says. “Following an LDI strategy can help to protect investors in such an environment.”
With an average segregated LDI mandate size of £1.3bn, it is clear why this strategy is favoured by larger schemes. But more and more smaller schemes are entering the LDI market.
From one perspective, pension plans are exposed to more risks than perhaps they once supposed, which presents an interesting analysis. “Traditionally pension plans viewed risk as the volatility of their assets. LDI defines risk as the volatility of the funding status,” an asset manager says.
Many elements form a part of this equation, including interest rate risk, inflation risk and market risk. But the risk with the most bite, though, is probably the mismatch in the duration of the liabilities against the duration of the plan assets, particularly fixed income.
And some have commented that the yields on gilts – the main holdings in physical LDI portfolios – have fallen into negative territory on a real, long-term basis. “Historically low yields make it more challenging to explain to people why they should be allocating more of their portfolio to gilts,” Guppy says. “However, thinking of LDI as a framework for evaluating risk, rather than as a prescriptive approach to asset allocation, means its valuable regardless of expected returns on gilts or other asset classes.”
Guppy also put the yields argument into a longer-term perspective. “Over the past 15 years or so since I’ve been implementing LDI strategies, I have frequently been told that yields on government bonds are too low and that investors should allocate less to LDI strategies. My answer is always the same. Yields can always go lower.”
Here Guppy cites the Bank of England expressing its willing to take nominal rates below zero if the economic outlook warranted it. “We only have to look at the German bond market to see that there is plenty of room for gilt yields to fall further. I also ask how much an investor is prepared to be exposed to interest rates?
“An LDI approach helps to frame that question by specifying what a neutral level of exposure would be – hedging ratios in line with funding ratios – and quantifying the impact on overall scheme funding of making the wrong call,” he adds.
Show me the money
On another level, there is a big question mark over how an LDI approach works for those pension funds that are cash ow negative. “A challenge many schemes with large LDI allocations face is how they can increase their funding level whilst their LDI assets match the behaviour of their liabilities,” Guppy says.
To overcome this challenge, Guppy notes schemes need to leverage effectively and borrow money to invest in their LDI hedging assets. “Schemes can manage their net cash flows each year by dialling up or down the amount of leverage they use in their LDI portfolio.”
So, for example, Guppy notes that a scheme that is cash ow negative could fund their pension obligations without impacting their level of investment risk by selling some of their physical gilt holdings and replacing them with derivatives. “In such a case it would be important to have a plan for how the leverage of the LDI portfolio will evolve over time and be managed if it becomes concerning,” he says.
For many investors, adopting an LDI strategy is something of an iterative process, with more than one well-defined step. “We approach the implementation of LDI as a three-step process. First, replace the current fixed income with longer duration fixed income designed to hedge liabilities,” according to an asset manager.
“Second, reduce volatility of the return generation component by focusing more on absolute versus relative return. Third, consider the pros and cons of using leverage to further hedge the liability beyond what can be done with the fixed income portfolio.”
Although one source of hesitation when it comes to LDI implementation is the use of derivatives. The construction of LDI strategies requires derivatives and can be most effective when it involves swap agreements. But, particularly for smaller pension plans, this can be a hurdle that is difficult to address, as they are unlikely to have the in-house expertise in utilizing derivatives.
Although this has been one of the benefits of the pooling system, with smaller schemes being able to exploit approaches, like the use of derivatives, not previously open to them.
“At the PPF, we have just over 50% of our net assets allocated to hedging assets whilst still hedging out all of our exposure to interest rates and inflation,” Guppy says. “We use derivatives to add unfunded exposures into our portfolio to offset the part of liabilities not hedged with physical assets.”
In this way it is the case that LDI may not be the answer for all plans. As each organisation has its own unique set of challenges and circumstances, which evolve and change over time. “This is why we believe it’s vital for liability-driven investing strategies to be flexible by design, allowing for easy customisation and adaptability in the face of shifting internal and external factors,” an asset manager says.
LDI can represent a possible leap in terms of thinking about how to solve a range of issues, if one fully understands what is at stake. “One point to highlight is that the use of LDI and leveraged exposure to manage interest rates and inflation means that an investor is exchanging one risk – rates and inflation – for another: liquidity,” Guppy says.
As a result, it’s vital for any LDI strategy to ensure that there’s a clear understanding and plan for managing liquidity risk. “In practical terms this means spreading out the term of borrowing to create breathing space in the event of a squeeze in liquidity, maintaining a sufficient buffer of collateral to be used to meet future margin calls, and having a clear plan for how to raise more collateral if that buffer is depleted,” Guppy says.