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.

Features

Schemes which entered into swap contracts over a year ago may now find themselves locked into what feels like a bad deal as the margin between what they receive and what they pay becomes increasingly squeezed. In time, the risk is schemes end up either paying away gains sooner than they expected, having to post more collateral against their swap positions or taking a hit by renegotiating swap agreements and paying the cash penalties associated with doing so.

“A lot of schemes haven’t hedged this risk yet because they are so dominated by the bigger risks they can hedge,” according to a senior industry expert.

Longevity risk

Perhaps more obvious than swap-based risk is longevity risk, which remains unhedged for many investors.

Although increased life expectancy is good news for a population, it increases the financial strain on those tasked with providing benefits for those members. Before IAS19 came into effect in 2005 there was very little transparency around mortality assumptions. In the period since, the allowance made for increased longevity has grown materially.

LCP’s 20th annual survey of FTSE 100 companies’ pensions disclosures showed the _ average assumption in 2005 was a male retiring at 65 would live for a further 19.8 years. By 2012, the same male was expected to live on for 22.8 years, an increase in life expectancy of three years. In other words, companies’ assumptions on how long former employes would live on average increased by over five months every year between 2005 and 2012. Over this period alone, which notably also included a very significant financial crisis that plunged many schemes deeper into funding deficits, the increase in longevity assumption pushed accounting liabilities up around 8%, or a combined £40bn for the FTSE 100.

Yet longevity hedging remains expensive and largely out of reach for many smaller schemes.

According to Howard Kearns, head of LDI EMEA at State Street Global Advisors ( SSgA): “Longevity hedging is still preserved for larger schemes and no one has yet found a good way to apply it to active and deferred members.”

Although longevity hedging is beginning to become more available, the risks associated with increased longevity on accounting liabilities remains very real for many pension schemes, including those that have ‘de-risked’.