Safe or sorry?
Written by Lynn Strongin Dodds
February 2013
Interest in LDI has fallen lately, but Lynn Strongin Dodds finds that pension funds should nonetheless have an action plan ready
Although enthusiasm for liability driven investment (LDI) strategies has waned due to current market conditions, the strategy remains a firm fixture in the institutional armoury. Pension funds that took the plunge before the financial crisis can sit back but those on the sidelines are advised to develop an action plan so as not to miss out on the next turning point.
In other words it is better to be safe than sorry because fixing a date when that next window will open is not that easy. The bountiful quantitative programmes coupled with greater demand for safe haven assets across the UK and Europe has pushed real yields to new lows. Despite an improvement from the darkest days in 2011, UK 10-year gilts, for example, are currently trading at 2.09 per cent while the yield on 15-year UK index-linked gilts, which would have been the security of choice in the pre-crisis days to match the expectations of liabilities, is now 2.63 per cent.
There was a hope that the Bank of England would not have to dip back into the coffers this year but fears of a triple dip recession may force its hand. Europe’s outlook also remains dim with the European Central Bank having cut its forecast for the eurozone’s growth rate this year to between -0.9 per cent and +0.4 per cent. The result is that long-duration bonds and related derivative instruments used in LDI remain stuck at historically high prices while liabilities have increased.
The latest figures from Lane, Clark & Peacock’s annual analysis of 83 FTSE 100 companies show that their total pension deficit more than doubled over the past year, from £19 billion at the end of June 2011 to £41 billion at the end of May 2012, while their total value of liabilities stood at £447 billion with total assets at £406 billion. Over the past decade the typical FTSE pension fund whittled down its equity exposure from 70 per cent in an effort to de-risk, moving towards bonds. Although the stock prices have recently been on an upward trajectory, the trend is not expected to reverse due to the volatility of equities.
“I do not think there was less interest in schemes de-risking last year but a combination of factors such as the continuation of low rates, the CPAC (Consumer Prices Advisory Committee) consultation on the retail price index and the resurgence of the equity market made trustees and advisers adopt a wait and see approach,” says State Street Global Advisors head of European Strategy and Research Raymond Haines. “It is difficult to predict when rates will rise and the big question for pension funds is how long can they bear the pain or should they do something now.”
Redington managing director, investment consulting Mark Herne also notes that UK schemes were holding their breath in the fourth quarter waiting to see whether the Office for National Statistics would bring the formulation of RPI into line with the consumer prices index (CPI). “The market had expected a change and pension funds were waiting because inflation-linked instruments would have become cheaper if the formulation of RPI was moved more in line with CPI. However, the change didn’t happen and now these instruments are more expensive and trading at the higher end of their historical range. Does that mean pension funds should not hedge? Not necessarily, as it will depend on whether they have embraced risk management as well as their own specific level of funding.”
According to the latest SEI poll, which canvassed 25 schemes in the US, Canada, the Netherlands and the UK with assets ranging from $25 million to $1 billion, usage dipped to 57 per cent last year but “it is important to look at the bigger picture,” says SEI director of European institutional advice Charles Marandu. “If you take the years since we started doing the poll, LDI has more than tripled from 20 per cent to 63 per cent in 2011. What we have seen change is that people are taking a much more holistic approach and looking to build asset strategies that match their liabilities. As a plan’s funding level increases it may make greater sense to invest in portfolios that clearly match liabilities. At the moment, many plans cannot afford to heavily de-risk straight away but can implement a journey plan to reduce interest rate and inflation risk as certain trigger points are hit.”
Erwan Boscher, head of solution management at AXA Investment Managers in Paris, also believes that LDI is resilient. “Firstly, managing balance sheet volatility and restoring funding ratios are still very important objectives, to which LDI contributes. The fact that private companies feel some pressure on their accounts at a time when the international accounting standards are becoming more stringent (revised IAS 19, moving towards more pension mark to market) explains why some corporate schemes still pay attention. Secondly, more generally, we are seeing a new wave of more dynamic LDI strategies that take on board the potential rise in nominal rates, as well as the growing importance of inflation.”
F&C Investment head of global consultants and UK institutional business Julian Lyne agrees, adding: “Pension schemes are looking for flexibility and are investigating a variety of implementation approaches that they can use. We are also seeing more bespoke LDI strategies but the action they take all depends on their funding levels and governance structures.”
Not surprisingly, the larger pension schemes typically opt for more tailored solutions while smaller to medium-sized players are taking advantage of the broader array of tools that are now on offer via pooled funds. “We are definitely seeing a wider set of instruments that include total return swaps, repos and swaptions,” says BlackRock Solutions managing director John Dewey. “This is because pension funds are looking not only to mitigate the risks but also to squeeze out the returns. For example, late last year, we combined conventional gilt repo and inflation swaps rather than index-linked gilts for a client in order to generate the best returns.”
Total return swaps (TRS) have gained a following because they exchange cash flows linked to the return of a gilt or basket of gilts for a set of cash flows tied to a floating rate of interest. Like other swaps, there is no initial outlay to enter the position but they offer institutions additional interest rate and inflation exposure. Repos are also finding a place as they allow pension funds to sell gilts temporarily and invest in something with a promise of better return only to buy the gilts back at a later date. Views are more mixed on swaptions which enable trustees to hedge interest rate exposure at a certain level, but do not oblige them to lock into current interest rates. The downside is that strong govern-ance frameworks are required which is why they are mainly used by the bigger institutions.
They may become more popular in the Netherlands though, due to new regulation. According to Boscher, a smoothing rule as well as a new discounting curve has relieved, to a point, the pressure from live market rates, although LDI is still important. “The potentially higher rates could lead to swaption strategies, the use of triggers or other rule-based strategies to adjust the hedge ratio according to the level of rates and funding ratio. This could result in lower hedge ratios in the short term, but with pension funds keeping their LDI mandate, albeit in a different format,” he adds.
Boscher also believes the new Financial Assessment Framework (FTK 2) for pensions could lead to a switch from nominal to index-linked liability, creating the potential for a ‘second wave’ of LDI, should the macro environment become more inflation prone in future. The more dynamic strategies could also take hold of wider leeway for nominal and inflation hedge ratios, allowing the pension boards to adjust according to medium-term market views.
Written by Lynn Strongin Dodds, a freelance journalist
