Coming To America

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Can you hear that distant rumble of hooves, bugle calls, and battle cries? It’s Europe’s biggest liability-driven investing (LDI) providers—and they’re charging towards the US.

America currently has corporate pension liabilities totalling $2.3 trillion—almost twice the size of the UK market. And that’s before you consider the public sector pension market, which has another estimated $3.5 trillion. There’s a lot to play for.

BlackRock, Insight Investment, and Legal & General Investment Management (LGIM) dominate the UK LDI market. Collectively, the three firms manage 90.9% of the liabilities hedged with these strategies. LGIM takes the crown with 43.3% of the market, according to KPMG’s last LDI report.

These champions of LDI’s round table have overseen its evolution in the UK. No longer is it just a way of matching assets to liabilities: Today, LDI is a more rounded framework for working out the risks. It hedges out the ones you don’t want, and makes sure the risks you choose to retain pay a good premium. It’s about making your assets work harder, not locking them in.

In the US, meanwhile, LDI has started to gain traction. After years of talking about it and putting plans in place, mandates are accelerating. As they are predominantly corporate bond management strategies, most of those mandates are a simpler form of LDI than the British would recognize.

And this is where the UK’s shining LDI knights want to shake things up: The US is ready for LDI 2.0, and they believe they’re the ones to provide the LDI of the future.

BlackRock and LGIM first established their LDI businesses in the US in 2006, but it’s fair to say take-up had been slow until recently. Insight Investment began having conversations with plan sponsors six years ago, but only this year that has it opened a New York office with plans to offer LDI to a US market in the next 12 months.

So why are they crossing the Atlantic now? In short, because two big chickens are coming home to roost. 

In 2006, the US underwent two major changes. First, FAS87—the long-standing accounting measure—was abandoned in favor of Corporate Balance Sheet 158, meaning companies recognized the dollar value of pension fund deficits and were forced to calculate liabilities on a mark-to-market basis. In turn, this limited companies’ abilities to borrow money, as well as make some other business decisions, putting pensions at the top of chief financial officers’ to-do lists for the first time.

Secondly, the Pension Protection Act was introduced, bringing changes to funding rules and contribution requirements. In a nutshell, deficits had to be made good in a seven-year period, and while an element of smoothing has been allowed due to the financial crisis, today’s landscape has a much clearer view of the value of assets and how they and pension fund liabilities dictate contribution requirements. Both of these changes are only now really starting to have a profound effect on US pension funds—and these funds want help.

“When these things happened, that gave the impetus for de-risking and LDI,” says Andy Hunt, head of US LDI at BlackRock. “There was lots of planning and preparation, but it’s only now that people are pulling the trigger.”

Andrew Giles, CIO of solutions at Insight Investment, agrees that going out to the US market six years ago was tough. “They told us: ‘We did all this in the 1970s, and it was expensive—and we missed out on a big part of the equity rally’, and they weren’t very keen,” he says.

But after the credit crunch, everything changed. “In 2006, everyone was talking about it, and there were conferences held on it, but in 2007 the cash crisis crept up, and then you had the credit crisis and the full-blown economic crisis. And then funding levels fell off a cliff,” Hunt says.

LGIM’s Global Head of Solutions Aaron Meder believes the economic crisis kick-started interest in LDI, with the first steady flow of assets coming in around three years ago.

“During the credit crunch, credit spreads blew out to record levels, giving plan sponsors an opportunity to invest in long-duration corporate bonds at an absolute yield of 7% or 8%. That was the first time that opening had come since LDI opportunity had taken place,” he says. “The second reason is that the credit crunch was the second, if not the third, time that decade that pension funds had seen significant drawdowns as equity markets fell. Interest rates also fell, and there was this realization that there’s a lot of risks in these pension funds.” What happened next was a raft of fixed-income managers offering LDI solutions for an American audience—long-duration credit, in some cases actively managed, to match the liabilities.

So why does America need BlackRock, Insight Investment, and LGIM?

“If you asked any fixed-income manager in the US if they do LDI, they’d say yes. But we think there’s a big difference between long-duration fixed income and managing the physical securities and/or derivatives relative to a liability benchmark and being accountable for performance and reporting attribution,” argues LGIM’s Meder. “That’s where you need to invest in a dedicated LDI team, and there’s very few people in the US that have invested in that. Fixed-income managers have been able to get away with that so far, and there will always be a demand for just long-duration fixed income. But over time there will be increasing demand for customized management against liability benchmarks. Those true LDI providers will become increasingly separated from those managers who just ‘do’ LDI.”

Others are less aggressive about their competition in the US. BlackRock’s Hunt believes there’s room for everyone. “We talk about there being a quarterback role, or a completion manager role,” he says.

As up to 80% of an American pension fund’s assets could be in corporate bonds, it’s rare to select just one manager. Many pension funds have three or four to spread the manager and alpha risks. “That means there’s an increasing need for one of those managers to act as the hedging manager and provide the coordination, running overlays across all of the portfolio, and possibly providing an aggregation of reporting data for the plan sponsor,” Hunt explains. “Fixed-income managers are a part of the solution, but they’re not enough on their own.”

Insight Investment, meanwhile, believes its more holistic attitude to LDI merits a push across the Atlantic. “We differentiate between liability risk management and LDI, which is as much about the asset side of the balance sheet as it is about the liabilities,” says Giles. “One of the things that has worked well for clients in Europe is to separate the decisions into ‘What do I want to hedge?’ and ‘How much risk do I want to take on the asset side of my balance sheet?’” He continues: “The beauty of using the UK approach with derivatives through overlays is you can hedge whatever you want, but what you do with your assets is a completely different decision, driven by how underfunded you are and how much risk you want to take.”

There are a number of obstacles for these European gallants to overcome if they’re to make it big in the US market. Fundamentally, the two types of LDI (European and US) are different—largely because the liabilities, and the way they are discounted, are different.  

In the UK, liabilities are inflation-sensitive, and matching assets tend to be long-duration gilt-type bonds. Liabilities have durations of around 20 years, and UK-based plans hedge on an economic basis using a combination of derivatives, including swaptions and overlays.

In the US, duration is shorter—more like 15 years—there is typically no inflation-linking, and discounts are calculated using corporate bond yields. Their primary concerns are hedging interest rate and credit spread risks.

Financial markets are different, too: There’s a much deeper long-duration credit market in the US and a relatively liquid traded derivatives market. In the UK, gilt futures are not as liquid, and there’s not much around that is longer-dated than 10 years, forcing investors into over-the-counter derivatives for synthetic exposure to interest rate and inflation hedges.

The big shift, therefore, will be to convince a US market that it wants to move away from simply actively managing corporate bonds and towards taking those long-duration securities and adding in derivatives, a liability benchmark, and possibly overlays.

There is evidence that this starting to happen. At LGIM, Meder says his US clients are currently split: 65% opt for the simpler LDI, and 35% choose the derivatives and benchmark variant. He predicts that will move closer to 50:50 in the medium to long term, and that the majority could even reverse.

Insight Investment is trying to encourage the US market to synthesize elements of the portfolio outside of the credit portion in order to free up other assets to invest in return-seeking strategies.

Another major difference, and potential setback, is the lack of consultant influence in the US compared to the UK market, the managers say. Insight’s Giles is the most candid: “Consultants’ influence is less pervasive in the US than in the UK, which complicates the problem for us. In the UK, we can talk to a relatively small number of people and gain a huge market coverage. In the US, it’s more dissipated.”

The only way “in” will be to build a personal rapport with the CFOs, plan sponsors, and investment committees of those US pension funds. Having a well-known parent company (Insight’s BNY Mellon) or a well-known brand (BlackRock) will open some doors, and having existing LDI business with US companies’ UK or Dutch arms will also help (all three).

Staff on the ground will be crucial, however. All three now have offices in the US, although Insight is a relative late-comer, moving in just this year. All three plan to recruit domestically—while the risk management and tools imported from the UK are useful, they know the implementation doesn’t necessarily translate.

BlackRock arguably has the strongest presence, with a reported $220 billion global LDI book, $48 billion from 161 US clients. That compares to £82 billion in the UK and £36 billion for 32 European ex-UK clients, predominantly from the Netherlands.

LGIM has $40 billion in US LDI assets across roughly 60 to 70 clients, while Insight Investment has no clients in the country, as of our print date. In Europe, its liability hedging book tops £205 billion, more than half of which comes from the UK.

The one advantage these heavyweights have over their US counterparts is the length of time they’ve operated in LDI. LGIM transacted the first LDI strategy with UK pharmacy Boots in 2002. With all of that knowledge, they should be able to spot the future trends of the LDI market and where it will go when the corporate defined benefit books are sewn up.

All three are adamant there are no fat ladies singing in London: There are still plenty of UK LDI mandates. “Even those pension clients which have implemented hedging strategies may only have a hedging ratio of 40%,” says Insight’s Giles. He also thinks the public sector market in the US is worth considering at a later stage.

BlackRock’s Hunt thinks the next evolution could see other institutional funds with softer liability pledges adopting LDI. “LDI as a broad concept is totally applicable,” he says. “It works for endowments or foundations which have a desire to pay for future uses of money. If you have a spending pattern and want to commit to a certain amount of money, that becomes a stream of income, and you could argue that you could match your assets to naturally pay those payments when they fall due.”

Defined contribution (DC) funds are another fertile ground for LDI, Hunt continues. “DC isn’t just a wealth accumulation fund, it’s a provision for retirement. The needs of retirees and what income they can draw for their healthcare and cost of living is a structured need.”

And it doesn’t stop at the US. Up next: investors in Canada, Japan, and Australia. The knights have you in their sights.