Get to grips with liability-driven investment

Liability-driven investment (LDI) has become an increasingly popular strategy as employers attempt to eliminate inflation and interest rate risks from occupational pension schemes, explains Ceri Jones

Broadly defined, liability-driven investment (LDI) is any investment strategy that benchmarks against a pension scheme’s individual liability profile. The phrase is typically applied to de-risking strategies developed for mature final-salary schemes, using swaps in order to remove inflation and interest rate risk. Swaps are effectively agreements between parties to exchange cashflows of their respective obligations.

Most LDI strategies will try to eliminate a pension fund’s interest and inflation risk. This is because the long-term nature of pension liabilities makes them highly sensitive to movements in interest rates, increasing by about 20% for every 1% fall in interest rates. But 1% change in rates will alter a pension fund’s asset value by just a few percent, depending on the asset mix.

Toby Baldwin, head of LDI at HSBC Investments, says: “Over the last 12 months, there has been greater acceptance of LDI strategies. We are also seeing more interest in these strategies on the part of small pension schemes as the best ideas filter down. LDI is an appropriate solution for all types of organisation. If you can eliminate the inflation and interest rate risks and achieve the same level of investment return, then clearly this is beneficial for every scheme.

“Typically, LDI is adopted where the pension scheme is large in relation to the company and poses risks to the accounting position, particularly where the funding position is not strong enough to allow a full buyout of the scheme.”

According to Mercer’s annual European survey of pension fund asset allocation, published in April, 20% of pension schemes, as listed by asset size, have already adopted LDI. This figure could double this year as strategies become more accessible and businesses consolidate their position on a pan-European basis.

Ability to manoeuvre

One reason LDI has taken off is that accounting standard FRS17 puts a company’s pension deficit onto its balance sheet, impairing its image among shareholders and its ability to manoeuvre in corporate activities such as mergers and acquisitions.

As the liquidity of swaps has improved, so their cost has also become affordable. Very broadly, an interest rate swap now costs about 0.5 basis points (0.05%) a year, while an inflation swap costs about 1 basis point (0.1%) a year. A 20-year inflation swap will therefore cost 20 basis points, but some of that premium will be made back by the higher yields on swaps than on government bonds, or gilts.

Ever since the Myners Code was introduced in 2001, trustees have faced an onslaught of increasingly onerous regulations and codes of practice governing their understanding of investment and the protection of members’ benefits. Charles Cowling, managing director of Pension Capital Strategies, says: “Now both sponsors and trustees are interested in de-risking, so risk management and LDI products are coming to the fore.”

Typically, the liabilities will be matched by using swaps and a portfolio of bonds. Putting derivatives in place can be difficult and costly for small schemes, but investment houses, such as Insight and Barclays Global Investors, offer pooled LDI funds that require less governance and paperwork, effectively allowing £20-30m-sized schemes to put an LDI strategy in place.

The drawback with LDI is that assets put to covering off liabilities will not be available to generate good returns and improve a scheme’s funding position. Any remaining assets over and above those required to match the liabilities will be used to generate the best possible investment returns, often quite aggressively in equities and alternative investments.

One solution that has attracted smaller schemes is diversified growth funds, which offer a cheap means of diversification across a wide range of alternate asset classes, such as currency and commodities. Smaller funds lack the scale to take meaningful positions in some of the most illiquid asset classes, such as property. Malcolm Jones, investment director at Standard Life, says: “When LDI was mentioned in bear markets, it was predominantly based around hedging interest rates and inflation. What we’ve seen is strategies can’t afford to be bond-only, so there has also been growth in diversified growth funds that look to generate cash plus 4%-5% but with a lot less risk.”

If you read nothing else, read this…

• Liability-driven investment is a strategy that benchmarks against a pension scheme’s individual liability profile, usually aiming to reduce inflation and interest rate risk.

• The regulatory environment for both trustees and sponsoring companies is strongly in favour of de-risking pension schemes.

• The drawback of LDI is that assets devoted to matching liabilities, using bonds and swaps, are not available to generate good returns and therefore do nothing to alleviate a scheme’s overall funding position. For this reason, any excess assets are often invested fairly aggressively.