To view this article in digital magazine format, click here.
On a spinning globe, you have to keep moving just to stand still; so it is in the world of liability-driven investing (LDI).
Since LDI’s first iteration of using government bonds already held in institutional portfolios, the industry has developed by using diverse asset classes and derivatives to offer a large range of options for hedging out pension funds’ unrewarded risks.
It has not been a smooth ride. In recent years, investors and their service partners have had to cope with stubbornly low interest rates, seemingly un-curbable liabilities, and an uncertain outlook. These factors have combined to start investors thinking—or in some cases removing—options they had relied on in LDI and coming up with new ways of carrying out the process.
The different maturity levels of LDI around the globe have allowed those a little late to the party to learn from the trials and errors carried out by early adopters.
So what is in store for investors?
Consultants are busy creating and refining new ideas for the LDI sector. Some of them are still on the drawing board. Some of them may remain there. Some are proactive, some are reactive—but change is happening.
Firstly, the triggers that many European pension funds put in place after interest rates were reduced to historic lows have had a makeover. Many of these trigger points were arguably meant to have been hit by now. Interest rates were not meant to stay this low for this long.
“There has been a general trend away from target triggers—interest rates at 5% or 1% real yield, for example—and more of a move towards affordability or funding as being the key,” says Kenny Nicoll, director in manager research at consultants Redington. “The logic is that if your return-seeking assets double in value, then why wait for interest rates’ yields to rise another 10 basis points? If you can lock in, you should do so and recognize that portfolio performance is more important than the straight rates level chosen.”
For many pensions, this new set of triggers makes sense. Most of the largest LDI markets have been told that their nominal interest rates are not going to go up for many months, so with the recent market rallies increasing portfolio valuations, this seems like a natural development.
Interestingly, the US—a market acknowledged as being slightly behind its European cousins on the LDI-adoption curve—has already cleared this hurdle.
Just 5% of funds employ triggers that are linked to interest rates, according to Chris Levell, partner at NEPC. The rest use funding ratios as the prompt.
There are further echoes of the financial crisis causing headaches across the wider system, and investors are indirectly affected.
Repo has been European pension funds’ hedging instrument of choice in recent years, but as central banks are asking the sell-side providers to reduce their balance sheets, they are becoming less keen to participate in the trade.
“The leverage ratio, which limits the amount of leverage in a bank’s balance sheet, will potentially limit the amount of repo business—particularly in low-margin business like gilt repo—that they are willing to do,” says Nicoll.
Every bank is different, but regulations are uniformly strict, so Basel III and various international post-crisis legislations are likely to have an impact across all the bulge-bracket institutions that offer repo.
“We expect to see banks wanting to offer repo lines with greater optionality and certainty attached—and margin,” Nicoll says. Higher margin for the banks means higher costs for pension fund hedges, and there could be an additional problem: They might have to take a step back in time. “Running a repo desk is dependent on volume,” says James Fermont, partner at LCP. “When some banks retreat from the market, pension funds will have to revert to swaps—something many trustees may not feel comfortable with.”
Pension funds may face internal issues due to post-crisis regulation, according to Mark Davies, investment director at PSolve Asset Solutions. “Central clearing regulations in Europe may push pensions away from using derivatives,” he says. “They may decide that the price they have to pay is just too much for taking off the risk it removes. An extreme case might be to switch over portfolios to use physical assets for LDI and employ synthetics in actual investment portfolios due to increased costs.”
Innovation—or enforced change—does not have to come in the form of tools, gadgets, or products created by asset managers and investment banks, however. Ideology is also shifting. David Rae, head of LDI Solutions for EMEA at Russell Investments, believes people thinking about how to actively manage LDI assets and integrate them into an overall strategy will change the landscape.
“It’s time investors were compensated for what they are holding in a proper fashion, rather than measuring it against an arbitrary benchmark,” says Rae. “There is a natural nervousness to enter a deal where you won’t know if it has been successful for several years, but if investors understand the rationale behind it, they can witness it coming through.”
PSolve’s Davies agrees that most major changes to LDI are likely to come through implementation. “It’s a way off, but it will happen: Providers will be able to use straight-through processing to access member-specific data to design portfolios,” he says. “Providers are technically infinitely better than they were five years ago; they have more accurate data and can use this to eliminate the gaps.”
In the US, where advisers have been watching European struggles and successes with interest, pensions are continuing to embrace the glide-path technique of LDI. “Glide paths have been a way for decision-makers to agree. They can say, ‘Well, we’re not fully funded now, but we will be in X years,’” says Levell at NEPC. “In the UK, investors didn’t have enough duration in their bond portfolios, so they used derivatives—we are going straight to this second step. Real assets are rarely used as any kind of hedge for LDI in the US due to the governance structure. Many corporate sponsors are not keen on illiquid assets as they may want to get rid of the plan, and illiquidity makes it harder to do so.”
Rae at Russell says an evolution from general, non-specific LDI portfolios to much more tailored hedging strategies is underway. “Schemes in the US have taken the first steps of recognizing the true nature of their liabilities and extending duration using relatively simple techniques. Much of current work with clients has been on building a more detailed and customised strategy that is a better representation of the liability. The development of indices and products has assisted with this next stage.”
Not all US pensions have bought into the LDI story, however, mainly due to one large risk-management option.
“Pensions are generally eschewing LDI for risk transfer,” says Jeff Leonard, managing director at Wilshire Associates. “Many are getting their house in order to transfer the risk to an annuity provider rather than look at an asset allocation that would make sense for them long-term.”
All agree that pension funds have become keener to monitor their matching and growth portfolios, with increasingly frequent checks—often daily—becoming common. This may be, Leonard suggests, because they want to know how ready the fund would be at any given moment to buyout—should the occasion arise.
Regardless of geography and chosen path to a desired outcome, Davies at PSolve says there is one issue that needs to evolve. No matter how complex and sophisticated solutions may become, one of the biggest changes has to be a deeper delve into risk management. “Only one-third of all UK pensions hedge all their liabilities, according to KPMG. We are worrying about the nitty gritty when a bigger issue is still getting pensions to engage.”
Fermont at LCP agrees that focusing on potential new bells and whistles means drawing attention away from more central issues: “New approaches? Pensions first need to make sure that the LDI approaches they already have in place are going to withstand the rigours of new regulations—which were made with the best of intentions.”