Tales of the expected: the need for a return engine around LDI strategies

5 Jun 2014

Trustees might be forgiven for thinking ‘de- risking’ into liability driven investment (LDI) strategies means they can breathe a sigh of relief. While these strategies will go a long way to removing the interest rate and inflation risks schemes are battling with, other significant risks remain, which can have a material impact on accounting liabilities and which may not so easily be hedged.

“The more you get rid of risk, the more it brings other risks into focus. Even fully-funded schemes that have hedged interest rate and inflation risks still have some unhedgeable risk. They need something to provide a buffer against those risks.”

Tim Giles

According to F&C Investments’ LDI Survey, in Q4 2013 inflation and interest rate hedging truncations accounted for £20.5bn and £20.6bn of liabilities respectively.

Given the average UK pension fund is taking an implicit bet of between 80% and 50%, according to different industry sources, on interest rates, de-risking in this manner makes absolute sense. Nowhere else would investors tolerate such a significant bet on a single theme. However, the process of ‘derisking’ creates some risk in itself and either can’t or doesn’t deal with other risks.

In order to hedge these unhedgable or ignored risks, schemes need to complement their LDI strategy with a return engine or cash kicker.

“The more you get rid of risk,” says Tim Giles, partner at Aon Hewitt, “the more it brings other risks into focus. Even fullyfunded schemes that have hedged interest rate and inflation risks still have some unhedgeable risk. They need something to provide a buffer against those risks.”

Swap-based risk

Under swap-based LDI strategies, a scheme agrees to receive fixed payments based on long-term interest rates and pay a floating rate based on short-term rates, usually six month LIBOR. The fixed leg is based on the long-term average interest rate, which is the swap rate. These contracts are expected to be zero gain – both the fixed and floating rates must be the same or, inevitably, the losing party wouldn’t enter into the contract. Where the risk for pension funds arises is if the interest rates on the floating leg rises faster or more steeply than expected.

Janet Yellen, chairman of the Federal Reserve, proved markets are not always able to predict interest rate moves reliably. Following her press conference on 20 March, where she surprised markets with the scope of potential interest rate rises and the speed with which they might start, short term rates spiked. Furthermore, a reference rate like LIBOR is not immune from spikes because of its inherent exposure to banking credit risk. If any question is raised about the liquidity of the interbank lending market, a spike occurs. One of the main concerns about the LIBOR fixing scandal was it hid the lack of liquidity in this market. With that ‘fix’ no longer active, volatility of the LIBOR rate can only increase, especially as central banks begin withdrawing liquidity.

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