Should pension funds rebalance portfolios strictly according to their liabilities? Many have yet to be convinced. But for those choosing to go down the road of liability-led investment, there is no shortage of transport. Asset managers and investment banks are hard at work inventing solutions to the funding problems, and many have created new business units for the sole purpose.
The issue of liability-driven investment has come about, says John Harrison, managing director, UBS Global Asset Management, because the conventional type of approach has had such a tough time in the early part of the
Pension fund trustees are now looking at ways the widespread under-funding can be solved, as are industry bodies and consultants. “At the moment, there is no clear consensus,” says Harrison. “Effectively, most of it comes down to how we use risk and control what the drivers of that risk are.”
Many pension funds are in crisis, says Steve Aukett, director of Strategic Solutions at Schroders. Their assets are simply insufficient to meet their liabilities unless they receive major contributions from the sponsoring company.
Liability-driven investment may be the phrase used for the latest techniques, but Aukett says that pensions investment strategies have to some extent always been liability-driven. “There’s always been a need for funded pension schemes, for those assets to be invested in such a way as to meet the liabilities in due course,” he says.
But apart from the financial position of pension funds, there is now a much higher level of sophistication in the investment world, he says. “There is a much greater understanding of risk… we are talking in a much more sophisticated language now than we were in the 1980s,” he says.
Also, we are now in an era where investment returns will be more modest and potentially more volatile in the short term. “It is no longer possible to rely on the significant returns of the 1990s… therefore funds are having to think much more seriously about how their assets will be chasing returns.”
Harrison says the first type of liability-driven investment strategies that UBS Global Asset Management created involved tactical asset allocation overlays alongside corporate bonds. This method has been very successful, he says.
“More recently, we’ve been looking at creating an RPI targeted return strategy which aims to return 6% a year on top of RPI before costs,” says Harrison. UBS also offers the strategy as an offshore pooled fund. To meet the pension funds with differing liability profiles, UBS has plans to offer other strategies, including Gilt Plus 3. “Pension funds with quite short-term liabilities, say the next 20 years, are probably more concerned with the gilt yield,” he says.
Schroders set up the unit Strategic Solutions in 2001 to provide assistance to clients setting, developing and implementing long-term investment solutions, says Aukett.
The unit has been giving pension fund clients three basic pieces of advice. They should have a better understanding of their risks – so simply think about investment returns in relation to liabilities; they should diversify their sources of return into more assets and reduce their reliance on equities, and they should make their conventional assets work.
The unit’s work is very similar to a service a consultancy might offer. Aukett says there is a place in the market for this type of offering from asset managers. “This used to be the sole domain of consultants, but increasingly there is a demand for fresh thoughts,” he says. This is not a case of asset managers trying to take over the consultants’ role, but rather they are providing an additional view, he says. “Clients are able to seek advice beyond just their consultant,” he says, “and that’s all helping to solve the pensions crisis.”
There is a huge differentiation between pensions clients in terms of what they require, Aukett says. “On the one hand it’s the level of sophistication, but primarily, it is the different financial situations the pension funds are in which
limits the different amount of risk they can take.”
For example, a maturing pension fund would take significantly less investment risk than one that has a large proportion of young active members. The differentiation is there, and it is becoming greater, he says. But apart from bald facts such as these, the tolerance of risk varies.
“Even if two funds were in the same position regarding solvency, you still might get different solutions. This might be because the sponsoring company has a different approach — it might be more or less willing to support the pension fund,” he says.
There is a wide variation in the level of understanding trustees have, he says. The level of expertise in larger funds is often greater, but smaller funds cannot always afford to pay for the advice. However, Aukett points out, whether the fund is large or small, the impact on the individual scheme member is the same.
But certain packaged products will be available for clients seeking to match assets to liabilities, and these could suit funds where the level of expertise is not so high.
“One of the biggest risks that face pension funds is the movement of interest rates and inflation rates. Investment solutions are increasingly improving the way they hedge against adverse movements in interest and inflation.
“That means interest and inflation hedging skills are important in newer solutions that are coming up for funds of all sizes,” he says. Some of these can be packages, but of course, they cannot then be tailored to suit the individual client such an extent.
Gareth Derbyshire, managing director, European Pensions Group, at Morgan Stanley, says that to some extent, it is the accounting changes – FRS17 and IAS19, and the regulatory changes such as those in Denmark in 2001 – that are behind the move towards liability-driven investment. “Combined with the weak capital markets,” he says. “If people were holding healthy surpluses they wouldn’t be anything like as concerned.”
However, even if funds did have surpluses, prudently they should still have been looking out for their liabilities. And to a certain extent, of course, they have. “Funds in the UK have been doing AL modelling for several years,” says Derbyshire.
But funds have not been matching assets to liabilities in terms of using bonds and some of the other ideas that are now out there, for example, portable alpha.
“There have been two problems,” he says. “Firstly, the higher allocation to equities, and secondly, the holding of bonds which were much shorter than their liabilities. As long-bond yields have fallen, that has pushed up liabilities which are now increasingly marked to market.”
Derbyshire acknowledges that the ability and apparent need within some EU member states for pension funds to invest with their liability profile in mind, is different. But this does not mean the problem of under-funding does not exist, and one day the chickens may come home to roost.
“In some countries, from a regulatory point of view, the liabilities may appear to have been fairly static (since they do not have to be marked to market)… but from an economic point of view, those liabilities have still risen substantially,” he says.
Under IAS19, there is a certain smoothing effect, and so from an accounting point of view, it can take a long time for the impact of the current level of liabilities to feed through, he says. But it is still desirable, from an economic point of view, for funds in countries where liabilities are valued based on a static discount rate, to put more money aside. After all, it is only a matter of time before regulation and, or, accounting change forces the full value of liabilities into view.
One of the areas the European Pensions Group at Morgan Stanley is able to help clients in is advice, says Derbyshire. Pension funds, in the UK, have traditionally relied almost exclusively on their actuaries for advice, but banks have a lot of experience and are often better placed to advise the sponsoring company, he says. “We can help look at the bigger picture,”
Derbyshire says. “How does the pension fund fit into their overall business?”
The other side, which is just as important, he says, is in executing these changes. Solutions that pension funds tend to be looking at include duration lengthening using interest rate swaps and inflation swaps.
AXA Investment managers has set up its unit Liability-Driven Solutions to cater for third-party pension funds and insurance clients in their bid to find adequate funding. Vincent de Martel, director at the unit says 2004 was the first year that liability-matching has really been at the top of the agenda.
There is a certain reticence around the subject of liability-driven investment, he says, due to the necessity of using derivatives.
“We would be using derivatives in the strategy, and there’s a reluctance for pension funds to admit that. It’s not socially acceptable to use derivatives,” says de Martel. Pension funds, he says, may feel that if they use derivatives they will attract publicity. “If you are a pension fund, the last thing you need is publicity for your investment techniques,” he says.
Consequently, no one will go on the record, even though AXA says it has had significant volumes of business.
Its approach is to work very closely with the actuaries of pension schemes, and really understand them, de Martel says. All solutions are bespoke, though there are four common elements that are in the mix: bonds, equities, interest rate swaps and
inflation rate swaps. But the changes that are made are implemented as smoothly as possible, taking into account how the fund is already investing and reducing the need for any major transition of investments. “The movement to this strategy is evolution and not revolution,” he says.
The closure of defined benefit schemes is another driver behind the need for liability-matched assets, de Martel says. “The moment you close the DB scheme, it becomes more mature and more exposed to interest rate changes,” he says. “When you’re in a closed DB scheme, you can’t rely on long-term assumptions anymore, and the fixed horizon becomes closer and closer.”
Guy Freeman, vice-president, Insurance and Pension Group at JPMorgan, points out that nearly all bond mandates are benchmarked to bond indices, but they are not matched to the liabilities
of the pension fund. Liability matching is all about how your assets move relative to your liabilities, he says. It is about having your asset manager manage your
solvency risk.
“So it is a more holistic approach, and it should be of interest to many trustees,” Freeman says. It is not that a certain pension fund has to invest in one particular market or another. The starting point is the need to provide for the pension liabilities.
“The thing that holds people back is that invariably these involve the use of OTC derivatives,” says Freeman. Three or four years ago it would have been very rare for trustees to use interest rate or inflation rate swaps, but today it is much more understood and the use of derivatives is now being considered widely by the pension community.
“There’s a familiarity issue which is almost overcome,” he says.
Some managers are launching pooled funds based on derivatives in 2005. But there is still a need for trustees to understand how these funds work, Freeman adds.
Liability-driven mandates are
different from bond mandates, and they call for a different list of questions in the RFP, says Freeman, it is not like just picking a good bond manager. Notably, addition questions need to be posed on the use of derivatives, such as how the counterparty selection is conducted, how collateral and counterparty risks are managed, and how liabilities are built into the performance benchmark.
“There are practical issues for trustees and consultants to address that will aid their understanding of derivatives markets and their use by trustees,” says Freeman.
Asset managers agree that faced with the current investment challenges, trustees have a more difficult job to do. “There is a greater burden on trustees to think about which solutions work for them and their scheme,” says John Harrison. “The degree of complexity is greater and the maturity profiles differ greatly… there are a lot of different factors trustees have to bear in mind.”