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Looking to LDI

Written by Lynn Strongin Dodds
June/July 2014

Although liability driven investing in Europe is making a comeback, activity is still mainly the preserve of the larger UK, Dutch and to a lesser extent German, Irish and Danish pension schemes. The landscape is expected to change thanks to regulation, shifting market conditions and demographics but it is unlikely to permeate the entire region.

In many ways it is not surprising that these Northern European countries are at the forefront. They are home to some of the world’s largest defined benefit corporate pension schemes, all of whom are subject to international regulation and are looking to manage the end game.

“LDI is driven to a large extent by the nature of the pension market and that varies completely from country to country,” says F&C Investments head of LDI Alex Soulsby. “Holland is a long way in front in terms of the take-up while the UK has been gaining momentum as an increasing number of schemes have realised the importance of looking at risks in terms of liabilities. These two countries though are fairly similar in the way they implement a strategy.”

LDI had lost its shine in the post financial crisis era of prolonged low interest rates, but as Mercer’s recent European asset allocation study discloses, there has been a slight uptick over the past year as stock prices have recovered. The survey, which canvassed 1,200 schemes in 14 countries revealed a 3 per cent rise, from 26 per cent to 29 per cent, in the proportion of plans following a LDI path.

LDI adoption

Market participants believe that the trajectory is likely to continue upwards, albeit gradually. “Many trustees are cautious on allocating a large proportion of their assets to an LDI strategy with yields at low levels,” says Mercer European director of strategic research Phil Edwards. “However, we are definitely having more conversations with trustees around liability hedging strategy as the management of interest rate and inflation risks remain a high priority. In addition, many schemes have implemented trigger-based approaches to increasing their hedge ratio as rates rise.”

Healthier funding levels on the back of higher government yields and robust returns on growth assets will also be an impetus. Industry figures indicate that at the end of 2013, the average funding ratio of Dutch pension funds jumped to 111 per cent - the highest level since 2011 - and a three percentage point hike from the levels in September. Meanwhile, a separate study published last year by Aon Hewitt noted that their UK counterparts narrowed their deficits by over £100 billion to under £300 billion.

“In the Netherlands, for example, pension funds have come back to a decent funding level from being under-funded and sponsors are looking differently at risk management,” says BlackRock head of continental European institutional business Peter Nielsen. “They are looking at taking risk off the table and adopting an LDI strategy.”

Regulations

Another factor is regulation, which on the global front includes the revised international accounting standard (IAS) 19. It has not only eliminated the so-called corridor or smoothing opportunities that US GAAP provided for pension sponsors but it also modified the way investment return on assets are reflected in the annual pension expense. The result is that corporate pension funds have more of an eye on de-risking than just generating higher returns in their portfolios.

On the domestic side, companies are grappling with different rulebooks. This is particularly true in the Netherlands where the new version of the financial assessment framework (FTK) is promising a major overhaul of the pension system by 2015. It aims to place a pension fund’s coverage ratio at the heart of the measurement criterion and to change the level of funding to the average of the forward curve of the previous 12 months, discounted against the “stable and realistic” ultimate forward rate (UFR), to prevent funding volatility, according to the regulators.

“What we have seen is that corporate schemes want to mitigate the effects of the IAS 19 due to the removal of the corridors which has increased volatility,” says AXA Investment Managers in Paris head of solution management, Erwan Boscher.

“As for the Netherlands, there is a lot of uncertainty and everyone is waiting for the confirmation of the new framework. However, the pension market is changing and we are seeing some schemes looking to move to a buyout, which is a new phenomenon in the country, or alternatively merging with larger schemes.”

Consolidation has been a long running theme in the Netherlands but the pace has accelerated. Over the past 20 years, the number of pension funds has been whittled down from over 1,000 in 1992 to the current 382 today and it could fall below 300 in the next few years, according to estimates from the DNB, the central bank. The regulator is actively encouraging mergers and has written to 60 small and medium funds urging them to examine the sustainability and long-term viability of their business models.

LDI is likely to be part of the toolkit of those that remain but as Edwards notes: “There is no one size fits all LDI approach. Pension schemes in Europe will build a strategy that fits their own circumstances, beliefs and risk tolerances.”

Variations

A recent survey of 104 European pension funds by Edhec Risk Institute reflects the variations. It noted that while 80 per cent were fully aware of LDI, only half actually implemented a formal separation between the performance-seeking and liability hedging portfolios. The exceptions are the UK and Denmark.

In addition, it found that pension funds often measure liability risk but do not put in any formal hedges against it, while only two-fifths of respondents align the duration of bond holdings to the duration of their liabilities.

“This is surprising, given that duration matching is usually considered the first step towards the immunisation of the funding ratio against interest rate changes,” Edhec said, although it did acknowledge it may be due to the lack of available bonds with long maturities.

The institute also voiced a concern over pension funds’ focus on standalone performance rather than risk management and the insufficient attention paid to the impact of their liabilities in their asset allocation policy or risk management.

“Size and the governance structure is definitely a factor,” says Russell Investments head of liability driven investment solutions David Rae. “Larger schemes are using much more sophisticated hedging strategies and also have the flexibility to execute specific strategies. We are also seeing them adopting a much more holistic view to consider for example, the interest rate risk to the overall portfolio.”

Those in the larger camp have also opened their LDI armoury beyond the traditional swap market to include asset-backed securities, repos, total return swaps, options and swaptions, which gives a party the right - but not the obligation - to enter into a swap at a price agreed with the seller when the swaption is purchased, not when it is activated. The downside is that it requires stronger governance structures than many other instruments.

“LDI has become much more dynamic than in the past due to the interest rate environment,” says Boscher. “Before, it had been quite static but market conditions forced schemes to take more medium term tactical views and to adjust their hedging strategies accordingly.”

Insight Investments head of European distribution Olaf John adds: “We have clients who start hedging passively but then wanted to pick up extra return and are being more active to take advantage of the inefficiencies in the market. Our clients are also looking at the interaction of various risks – the interaction between nominal and real rates, longevity, interest and inflation rates – in a more integrated way and not in isolation.”

Although it is likely that larger schemes will continue to lead the way, smaller schemes - particularly in the UK - are increasingly getting in on the action via pooled funds. “They do not have the same resources but we are seeing them implement a version of what the larger schemes are doing,” says State Street Global Advisers head of LDI EMEA Howard Kearns. “It provides them with access to the same sophisticated and accurate hedging strategies. Overall, the trend is moving towards matching liabilities but the rate of LDI adoption will depend on the funding levels.”

Lynn Strongin Dodds is a freelance journalist



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