Is liability driven investment (LDI) being hyped? "Yes, is the short answer. The term is bandied about too much," says Chris Lewin, co-author of the Deregulatory Review of Private Pensions, and former chief investment officer of Unilever's defined benefit scheme. LDI gives consultants something new to talk about as well as often necessitating the re-engineering of a scheme's investment strategy and risk budget. This activity is fee generating - resulting in new mandates which must be filled with beauty parades and selections. Furthermore, investment banks also like LDI because they manufacture the swap overlay products increasingly employed in its implementation.

 

 

"There is nothing really new about LDI. What has changed are the instruments available with which to implement liability matching," says David Morgan, who recently retired as CEO of Coal Pension Trustees.

 

 

"The direct relationships between some of the banks and pension schemes may seem like a small change to established practice but is potentially very important." In essence, LDI consists of matching as closely as possible the asset flows in a scheme portfolio with the liability flows and swaps can be used to facilitate matching.

 

 

"LDI is the fashion of the moment and fashions change," warns Robin Ellison,  former chairman of the NAPF. Everyone agrees that LDI using swaps is a valuable addition to the trustee's armoury, but not that it is a panacea.

 

 

"The fact is that promoting LDI is good for business both for the consultants and banks," says Lewin. Furthermore, while LDI promises to reduce and perhaps eliminate some important sources of risk, notably those from inflation, interest rates, markets, currencies and perhaps longevity, it may also introduce new forms of risk. Projections of the value of future liabilities are friable and have often been proved wildly inaccurate by events.

 

 

"Suppose the projections are under estimates but meeting the cost of the overlay has taken the scheme out of equities and into bonds, giving away the equity risk premium," conjectures Lewin. In this situation, using overlays could prove more expensive than staying in equities.

 

 

This is because the cost of running the swap programmes need to be paid to the swap providers on a recurring basis. The consequence is that the benchmarks for scheme assets are set on an absolute rather than relative return basis.

 

 

"Maintenance of hedging becomes more important, this is never a fire and forget strategy," warns Paul Bourdon, head of the European Pensions Solutions Group for Credit Suisse Asset Management. As a result, funds must diversify their portfolios into low and uncorrelated sources of return. These can include infrastructure, commodities , hedge funds, global tactical asset allocation (GTAA) strategies and more. "The goal here is to reduce funding volatility but this can have unforeseen consequences," says Paul McGlone, a senior consultant at Aon Consulting.

 

 

The most significant of these is any sacrifice of equity exposure in favour of other assets which often results from the portfolio diversification required to pay for swap overlays increasingly used in the implementation of LDI.

 

 

"A 1% fall in bond yields can mean a 20% increase in the cost of scheme liabilities," warns McGlone. Pension schemes that go into bonds to match liabilities still face huge market risks and there are also regulatory issues at play.

 

 

"Trustees don't want surpluses. The irony is that this can make embarking on LDI seem more attractive than would otherwise be the case," notes John Broome Saunders, actuarial director at BDO Stoy Hayward. There are also hidden risks in the unknown future costs of rolling contracts that expire before the relevant liabilities have been met.

 

 

The pricing of swaps is opaque, a major source of profit to the same investment banks which already furnish them to Europe 's burgeoning hedge fund indus-try. Despite the claims made by some consultants to have a more or less clear view of swap pricing, the process by which banks compete for this business does not support these claims.

 

 

The swap programmes are often bespoke, over-the-counter, providing scheme specific risk reduction. From trustees' points of view there may be  no ready means of comparing their cost. In practice, when consultants are involved in selecting a bank to provide swaps they do so by organising an auction. This invariably goes to the same very small group of banks, including such as JP Morgan, Goldman Sachs, Barclays, Deutsche Bank, BNP Paribas and several more.

 

 

The asset management companies owned by the banks are also entering this market with suites of so-called bucket funds which contain swaps of different  durations.

 

 

The funds are pooled, creating economies of scale for both investors and providers. Not surprisingly, the consultants are strong advocates of the bucket funds - they are more transparent but also allow the consultants to recover their role as intermediaries in this market.

Patchy and incomplete

 

 

How widely is liability driven investment being practised by pension schemes in the ? Despite the extensive commentary on the subject the answer is that we simply do not know. not even approximately. of course, much depends on how LDi is understood. if it means using current and future scheme liabilities as a benchmark for asset returns and for measuring their relative volatility  then all schemes practise it, with the important caveat that some do so better than others. But LDI is usually understood to include the use of swaps to facilitate implementation. Here the evidence of use is patchy and incomplete.

 

The best, most recent data we have on swap use comes from Mercer Human Resource Consulting's "survey of pension Financial Risk" of June this year. of the 100 respondents to this survey of FTse 350 companies, 17.5% said they use used interest rate swaps, 16.5% used inflation swaps, only 5.8% use credit protection swaps but far more, some 28.2%, use currency swaps and forward contracts. These levels of usage may seem low but they have tripled over the past year and there are no reasons to believe that this rate of growth will slow.

 

Behind this sits a sea change in attitudes to the treatment of pension risks. no less than 33% of board directors and senior managers rate the issue as much more important than a year ago, a further 31% as at least slightly more so. over half of schemes had made special contributions, 30% for general risk mitigation, 31.7% against strengthened mortality assumptions and 3.3% against credit rating downgrade.

 

There is also surprising evidence on the route by which trustees buy their swaps. Almost two thirds of those hedging out interest and inflation risks used derivates  purchased directly, often from banks, while the remaining third bought via so-called bucket funds.

 

"This is significant because it shows that trustee are more comfortable with derivative documentation and the process of collateral management," notes Richard Giles head of longevity at Mercer Human Resource Consulting. The use of derivatives is becoming more general as a means of gaining exposure to alternative asset classes. no less than 22.3% use swaps and futures for currency exposure, 9.7% for commodity exposure and 7.8% for other strategies such as corporate exposure, and asset allocation. none of this is conclusive but it deserves to be taken as strong circumstantial evidence that LDi type strategies using swaps and swap-based pooled funds are on the rapid increase. some of the early adopters of LDi type investment strategies, like the Boots pension scheme, have been forced into partial reversals of policy, selling bonds to buy back equities. other schemes, such as that of BAe systems have undergone more recent and complex re-engineering.

 

Last year, after lengthy consultation, BAe systems agreed a package of changes intended to reduce the scheme's £3bn (€4.4bn)  liability. some £446m of this came from increased employee contributions, £642m from the employer's contributions, over £1bn from a one-off top-up, salary sacrifice of £126m but also £770m of benefit reductions.

 

A key element on the benefit reductions was pricing in the costs of increased longevity and adjusting future accruals and benefits accordingly. This is a means of reducing longevity risk without relying exclusively on swaps or other structured products supplied by the banks and may find wider use as pension schemes look to reduce risk.