At a time when many corporate sponsored pension schemes face deficits and funding gaps, liability driven investment has gained in popularity. As an investment strategy that aims to match and outperform a pension fund’s liabilities, it can enable pension funds to manage a number of uncompensated risks, such as interest rate and inflation risks, and reduce the volatility of pension liabilities on the balance sheets of scheme sponsors.
What is LDI?
Liability Driven Investment (LDI) is an alternative method of investment now increasingly used by pension funds. Historically, the performance of pension schemes was evaluated by means of a peer group comparison before benchmark-linked performance targets, such as the outperformance of specific market indices, became more popular. These benchmark-driven investment strategies focus on pension-fund assets rather than the consideration of a fund’s liabilities.
However, a pension plan is only successful if it can meet the cash payments promised to plan members. In recent years, more and more pension funds have encountered a deficit as funding gaps have appeared between the assets available to them and their liabilities in terms of due cash payments.
LDI aims to establish a link between assets and liabilities, by making the liabilities themselves the benchmark for a pension scheme’s performance and risk management.
Matching their assets and liabilities enables funds to hedge uncompensated risks, such as exposure to interest rates and inflation, in whole or in part, by using either bonds or swaps. This enhances the overall risk/return position of the fund and aims to ensure that the fund’s benefit payments can be met and that any additional contributions by the plan sponsor are kept to a minimum.
Schemes with a higher risk appetite aim not only to meet but to outperform their liabilities – for example to close a funding gap. They are, as a result of LDI, in a better position to invest effectively in riskier asset classes, such as commodities, equities, private equity or hedge funds to generate a potentially higher return.
Why did LDI develop?
Institutional funds, such as pension funds, exist to ensure a stream of cash payouts. In the case of a pension fund, these liabilities are the benefits that have to be paid to current scheme members. Some of these benefits may be fixed, for example as a percentage of the final salary, but the majority of pension fund liabilities are linked to an inflation-index and increase in line with inflation.
The sponsors and trustees of pension plans are primarily concerned with the ability of a fund’s assets to meet future obligations, rather than the value of the assets as such. The sponsor of a pension plan will want to ensure that liabilities can be met under various scenarios for investment return, interest rates, retirement ages, longevity and inflation.
In recent years many pension funds faced the problem that their asset growth was no longer in line with the liability growth and consequently funding gaps appeared. Such funding gaps exist when the net present value of liabilities exceeds the net present value of assets. This was due to a number of factors including:
Lower returns in the equity market.
Historically low interest rates.
Underestimations of the longevity of scheme members.
The net present value of pension fund liabilities is sensitive to changes in interest rates and inflation. Pension liabilities react in much the same way as bonds to interest rate changes, that is if interest rates fall the net present value of liabilities increases and vice versa. Changes in market rates therefore create a certain degree of volatility, which is amplified by the long-term nature of pension liabilities relative to the more short-term assets held by most pension funds.
Pension fund liabilities tend to have a higher duration than pension fund assets. Duration is a measure of sensitivity to changes in interest rates. Duration calculates all cash flows related to a pension scheme (or financial instruments) and determines the weighted average maturity of these flows expressed in years. The higher duration of pension fund liabilities means that, when interest rates fall, the value of liabilities rises faster than that of pension funds assets because the liabilities’ sensitivity towards interest rate changes is greater.
At the same time liabilities that are linked to an inflation index will be sensitive to expectations regarding inflation.
Changes in the regulatory and accounting framework have led to a more prominent role for LDI strategies in countries where accounting regulations demand that pension schemes must value their liabilities in accordance with market rates at ‘fair value’ and any changes are recorded in the Profit & Loss account of the pension plan sponsor.
The net present value of a fund’s liabilities is determined by discounting the future cash flows using current market rates as the discount rate. Any fluctuation of market interest rates and inflation will therefore be reflected on the balance sheet of a pension plan sponsor. In other words, potentially significant interest rate and inflation risks, resulting from a mismatch between assets and liabilities in their exposure to interest rates and inflation, become visible. These risks are generally not compensated in terms of higher risk premiums and return.
LDI strategies enable fund managers to isolate and hedge risks that are not expected to contribute to a higher return, in particular interest rate and inflation risk, and thereby reduce the effect of the volatility of pension liabilities.
How does LDI work?
LDI covers a wide range of different investment techniques. However, in all LDI strategies, assets are managed by establishing a transparent link to the liabilities as a basis for the investment strategy. Once this has been achieved risks can be hedged more effectively and potentially more risky investment techniques can be adopted to outperform the liabilities.
This means that a part of the fund will be used to match liabilities and minimise uncompensated risks, while the remainder of the portfolio can be invested into return seeking assets in correspondence with the overall risk strategy of the fund.
There are many possible approaches to LDI depending on the size, funding level and risk appetite of a fund. In practice any LDI solution needs to be tailored. The main elements of a LDI strategy can include:
Analysing the liabilities and establishing a benchmark.
Setting a risk tolerance against the benchmark.
Creating a portfolio of both matching assets (to remove unwanted risks) and return seeking assets (for additional asset growth and return).
Liability matching portfolio
Based on accurate cash flow forecasts a fund’s annual liabilities and their sensitivity towards interest rates and inflation will be assessed. A scheme will seek to invest in assets which display similar sensitivity to interest rates, inflation and other variables as the liabilities, in order to avoid any risks resulting from a disparity between the two. One asset group used to achieve this is bonds.
By using government, corporate and index-linked bonds a portfolio could be structured in such a way that asset and liability cash flows are matched so that cash flows are produced when they are required. This strategy based on the increased use of bonds, which is also known as a ‘narrow’ LDI strategy, is able to reduce much of the investment risk.
However, in practice the use of conventional fixed-income and index-linked securities is limited by the availability of appropriate bonds. Pension fund liabilities are very long dated and often linked to inflation. Corresponding long-dated bonds are not always readily available and very few inflation-linked bonds exist. In addition it is difficult to produce superior returns just by using bonds and the diversification of the fund remains very limited.
In an alternative approach it is possible to structure a solution based on swaps, which allows a better match to liabilities, both in terms of interest rates and inflation.
Swaps are derivative contracts between two parties who agree to exchange (swap) single payments or a series of payments in the future based on a notional amount of funds. For example, in a fixed-for-floating swap agreement, one party will make a payment based on a fixed interest rate, while the other party will make a payment based on a floating interest rate (such as EURIBOR or LIBOR).
There are many different swap structures available depending on a scheme’s individual needs. A pension scheme could, for example, choose to receive fixed payments to meet its fixed liabilities and pay floating rate payments based on a money market rate.
As pension liabilities are also sensitive to inflation, swap agreements in which the pension scheme receives variable rates linked to an inflation index are also an option to meet these liabilities.
Swap-based solutions can come in the form of overlays, when an existing bond portfolio is supplemented with a swaps portfolio alongside it to extend the term and smooth the asset income. At the same time the risk/return profile of the fund is enhanced as unrewarded risks are hedged with swaps.
Alternatively a set of interest rate swaps, inflation swaps and credit default swaps could be used to create a synthetic portfolio which displays exactly the same exposures as a conventional portfolio. The main advantage of this more sophisticated or ‘broad’ LDI solution is added flexibility and the fact that interest rate risk throughout the term of the liabilities can be immunised by using only a portion of the fund’s assets.
This frees up capital which in turn provides better opportunities for asset diversification as it can be invested into higher return assets such as hedge funds, structured credit, commodities or private equity.
Caveats of using swaps
It is important to consider that the management of swaps requires specialist expertise in terms of derivatives management, systems, market access and counterparty risk management.
In addition using swaps can become extremely costly and a complete shift towards a portfolio of swaps may well be inefficient.
There is also no protection from swaps against longevity risk.
This all makes it difficult, particularly for smaller funds, to adopt a swap-based LDI strategy. These funds have the option of gaining access to the diversification benefits provided by LDI by using pools. Some asset managers offer pooled derivatives-based solutions, which minimise operational costs and make them available to a wider range of investors.
Setting the risk budget
By matching assets to liabilities LDI creates a benchmark that will react in the same way as the fund’s liabilities when interest rates or inflation expectations change. If a fund’s performance meets the liability benchmark the return will be sufficient to pay all liabilities. Some LDI strategies focus on the pure matching of assets and liabilities in order to improve the balance of risk and return from investments relative to the liabilities. Other LDI strategies are looking to match assets and liabilities whilst at the same time providing opportunities for added return.
By setting the risk budget the level of risk taken against the liability benchmark and target returns can be determined. The level of risk will depend on the risk appetite of the scheme as well as the financial strength of the scheme sponsor, ie the ability to make additional contributions to the fund if needed.
It must also be decided where this return should come from. Different schemes will choose different ways to generate additional return, by opting for either a higher exposure to market risk (beta) or an increased active management risk (alpha).
Selecting a portfolio of return seeking investments
Traditionally investments have needed to both match and outperform the liabilities. This limited the asset allocation to investments which displayed a similar behaviour to the liabilities. In LDI, matching and return seeking assets can be separated. When swaps are used to take over the matching function and hedging of interest rate and inflation risks, a wider range of investment opportunities, irrespective of their sensitivity to interest rates, inflation and other variables, can be considered. As a result pension funds may invest in less correlated, higher return asset classes.
Additional outperformance may come from active management of the portfolio. LDI provides the opportunity to manage portfolios in a dynamic way by taking into account changing market conditions as well as realised returns and funding levels.
For pension schemes the implementation of an LDI solution may lead to a change in asset allocation and to the introduction of new types of asset vehicles. This cannot always be achieved quickly and timing issues and size constraints may require a transitional approach, for example by introducing swaps first to isolate uncompensated risks. With a more complex investment strategy and higher risk levels, an even closer governance and detailed understanding of the investment techniques will be required from trustees.
Arguments against LDI
It should be noted that LDI has its critics. They argue that, as a result of LDI, funds may select asset allocations that are too risk averse or a protection against risks that would be too expensive. According to this opinion, particularly for funds with a funding deficit, LDI strategies would lock in the deficit and restrict the ability of the scheme to reduce the funding gap.
It is true that not all LDI solutions are appropriate for all pension schemes. For example, an LDI strategy that ties up a large portion of a fund’s assets to match liabilities may be a suitable option for funds that are fully funded, but a scheme that is underfunded would be limited in making its assets work to close the funding gap. However, the use of swaps in particular has the advantage that only a portion of a fund’s assets are needed to match liabilities whereas the remainder can be invested in return seeking assets.
Irrespective of the funding level, another danger of LDI is that assumptions made by actuaries when projecting the cash flows, for example regarding longevity or salary increases, could be locked into the investment strategy.
LDI can include a wide range of investment techniques. Depending on the size and funding levels of a fund and the financial strength and risk appetite of the plan sponsor, many different solutions displaying various risk/return profiles are available.
LDI is typically used by pension schemes with a low risk appetite. LDI will not be able to remove all the risks (eg longevity risk) and variables faced by a pension scheme, but it can address certain large, uncompensated risks resulting from a mismatch between assets and liabilities which were previously ignored. It also allows a closer management of assets and liabilities and reduces the volatility in the funding levels of a fund. In addition LDI may provide access to a wider, more diversified and dynamically managed range of investments.
We would like to acknowledge the assistance of Paul Harrison, State Street Global Advisors Limited, in the preparation of this article.