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The benefits of LDI in changing market conditions

19 Jul 2021

Evan Guppy is head of liability-driven investment (LDI) at the Pension Protection Fund

It has been an extremely challenging year for the management of pension fund assets as market volatility has impacted the way investors have responded to the pandemic. At the Pension Protection Fund (PPF), a key part of our investment strategy is our focus on our liability-driven investments (LDI).

Our LDI strategy has played a vital role in protecting and growing our assets throughout this challenging time so we can continue to provide reassurance to our current, and future, members.

Managing risk appropriately is critical for us, so we have invested 40% of our assets into our LDI portfolio making it our single largest asset class allocation.

Our liability hedging approach protects us against adverse moves in market interest and inflation rates, helping to ensure that we always have enough money to pay our members their promised pension benefits.

Our LDI portfolio proved to be especially valuable throughout the pandemic in 2020. Easing of monetary policy by central banks around the world resulted in sharp falls in market interest-rates and a £2.5bn knock-on increase in liabilities. Our portfolio protected us against this rise and without it, the impact would have been a substantial fall in our reserves.

In order for us to react quickly to market movements, we have fully insourced the management of our entire LDI portfolio. This has given us a unique edge, especially in times of heightened market volatility, because we can adjust our assets as and when we need to, to ensure we have the right mix of interest-rate and inflation hedging assets to match the exposures in our balance sheet liabilities.

Another great benefit of having insourced our LDI portfolio is that we can respond to changes in the market in real-time. In the early days of the pandemic, there were a number of sharp market moves that opened up large gaps between the LDI portfolio and the liabilities it hedges.

Our ability to react almost instantly meant we were able to close the gaps quickly, before they could have any major impact on us. We were also able to take advantage of opportunities to enhance the returns on our portfolio under these stressed market conditions because of our quick response times.

For example, during the first half of 2020, credit spreads widened sharply for even high-quality issuers, as investors sought safer, more liquid assets. To capture these wider spreads, we were able to increase our allocation within the LDI portfolio whilst still retaining more than enough liquidity to meet our own collateral calls.

The combination of loose monetary and fiscal policy, set against a backdrop of capacity constraints in certain sectors of the economy as lockdown ends, means there is a strong possibility of higher inflation rates on the horizon. We are already starting to see this translating into higher prices and higher wages in those impacted sectors.

The question for policymakers is whether this higher inflation is temporary and narrow or long-lasting and broader. Either way, fund managers should be looking at how they can protect their investments during these uncertain times.

Our LDI portfolio means our invested assets are already well protected against any inflationary increases, and our investment strategy has ensured we have been able to provide compensation to our members and remain a safety net to those protected by us, despite the pandemic.

Our members should be assured that our flexible approach to investing means we can continue to respond to any economic challenges that may lie ahead so we can continue to protect their financial futures for as long as they need us.

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