(September 23, 2011) — A new report finds that liability-driven investing has been seriously misconceived among UK pensions.

According to the report by Brighton Rock head of research Con Keating, declining interest rates have been detrimental to pension funds because they increase the present value of liabilities. However, Keating argues that falling interest rates actually increase corporate profitability and strengthen the company’s ability to support the fund. Therefore, LDI increases the sensitivity of companies to declining rates rather than decreasing it, the report says.

“LDI is seriously misconceived but rather more worrying is the fact that though costly it also appears to be ineffective,” Keating tells aiCIO. “LDI hedges interest rate exposures which arise predominantly from the discount rate used for liabilities. The true concern however is with the safety and security of the scheme. The strength of the sponsor company determines this. Companies exhibit higher profitability as interest rates fall but lower discount rates raise the present value of scheme liabilities. There is a natural hedge between scheme and company – which hedging the interest rate sensitivity of scheme liabilities destroys.”

Keating’s report expands on the many possible criticisms of LDI, explaining that the oldest criticism is that the discount rate used to calculate the present value of liabilities is not an accurate reflection of financial exposure. “If you think about it, actual DB pensions…do not explicitly depend on interest rates in any way – they depend such things as length of service, inflation, salary etc.,” Keating tells aiCIO, noting that therefore, what is being hedged in LDI is an accounting metric.

The report – “Don’t Stop Believing: The State and Future of UK Occupational Pensions,” officially published September 28 – also analyzes a number of commonly-held beliefs and asserts that they are unsubstantiated by evidence. For example, the paper claims that pensions are both affordable and sustainable in the public and private sector. “Those Jeremiahs who point to an increasing share of our national output as the cost of pensions exaggerate the position. The fact is that true pension costs are rising less rapidly than economic output. They also fail to recognize that as our output and wealth grows so we will want to spend proportionately more on education, healthcare and retirement,” a summary of the report says.

Additionally, Keating notes that pensions costs have risen dramatically because of increasing longevity. “Pensions costs have risen, but at a rate significantly lower than national output and far lower than private sector earnings. True pensions costs have doubled over the past two decades while the funding cost of pensions has more than quadrupled. This is a result of ill-conceived regulation operating on top of accounting standards which are not fit for purpose and badly mis-state the health of schemes,” Keating notes.

Keating’s worried view on the future of UK schemes and, more specifically, on the impacts of LDI in pension portfolios follows an August poll by SEI — completed by 106 pension executives overseeing assets ranging in size from $25 million to over $1 billion — which revealed that an increasing number of schemes are using alternative investment vehicles as funded status volatility continues to be a primary concern.

“Alternative investments continue to be integrated into pension portfolios as another channel for mitigating risk, while providing additional return apparently. However, ongoing volatility of interest rates continues to put liability risk as a primary concern for plan sponsors,” said Jon Waite, Director, Investment Management Advice and Chief Actuary for SEI’s Institutional Group, in a statement. “The poll results show numerous inconsistencies in the use of various investment strategies, including alternatives, over the past year as plan sponsors appear to be uncertain of what’s most appropriate. This might also explain an increased interest in outsourcing as now, more than ever, plan sponsors need to maximize the benefits of external resources and the expertise they provide.”