Liability driven investment (LDI) for pension funds in Europe and the US has been driven by the notion that the legal liability of companies to support their defined benefit (DB) pension schemes leads to the argument that pension liabilities are no different from other corporate liabilities and should be brought onto the balance sheet.
Accounting standard boards such as FASB and IASB in the US and internationally have forced companies to move pension fund liabilities onto their balance sheets. Companies are then faced with guaranteeing the liabilities of their DB pension schemes which has led to the conclusion by many that their primary objective should be to minimise the volatility of the mismatch between the value of the pension fund assets and that of their pension fund liabilities. This can be done by matching liabilities with assets that behave in a similar manner.
No risky assets
Pension fund liabilities have elements of both nominal and inflation-linked cashflows, although there is an element of uncertainty arising from changing mortalities. In Europe and the US, the most dogmatic proponents of LDI argue the pension fund liabilities should be completely matched by combination of conventional and index-linked bonds, while the risks of changing mortality should be hedged away through a “mortality swap” with an investment bank. Risky assets such as equities would have no part to play in such an asset allocation.
There are two ways of going down the extreme LDI route: The first is by having a portfolio of conventional and inflation-linked bonds that matches the liabilities exactly; the second is by undertaking a swap arrangement with an investment bank to pay out cashflows that match the liability stream, while investing in assets that produce a floating rate returns that can be used to pay the floating rate side of the swap.
Investment banks at least prior to the 2007-08 financial crisis, were keen on developing their capabilities in “pension advisory” work which invariably focussed around selling derivative strategies for LDI hedges. Pension funds were encouraged to invest in absolute return portfolios pay out the floating rate leg of swaps transactions used as part of a LDI approach. But the experience of the credit crises has brought a very sour taste to many such strategies as institutional investors found that the supposedly risk free or low risk assets used as collateral to support the swaps suffered heavy losses.
Matching assets and liabilities
Asia came out of the financial crash relatively unscathed in general and if pension funds had utilised derivative based LDI approaches requiring absolute return funds, they may have found themselves in more difficulties. But how much applicability does the philosophy of LDI have in an Asian context? The 2011 Pyramis Asian Pulse Poll which surveyed 95 institutional investors in Japan, South Korea, Taiwan, Hong Kong, Singapore and China, revealed that when institutions were asked what is their greatest challenge in managing their portfolio - 25% said matching assets and liabilities according to Stephen Benjamin, VP Market and Business Intelligence at Pyramis Global Advisors. What does that mean in terms in specific activity? The short answer would be very little outside Japan where 42% of the Japanese institutions surveyed were considering LDI: “DB does not have a big role in the Asia-Pacific region ex-Japan, apart from the national social security funds” says Yvonne Sin, General Manager, Risk and Financial Services, Mainland China and Taiwan at Towers Watson.
Some commentators have seen possible usage of LDI by the large sovereign wealth funds in Asia. As well as the pension reserve funds, the other major class is the foreign reserve funds such as CIC in China, GIC in Singapore and KIC in Korea. The Edhec Business School argues the endowment stream of the foreign reserve funds is linked to the current account surplus of the corresponding economies and their objectives should be to hedge away the factors behind the commercial surplus. Another objective may be to generate higher returns than local sterilisation bond costs related to the issuance of sovereign debt aimed at reducing the monetary base expansion caused by capital inflows. But Sin argues their liabilities are not something that you can use LDI to hedge and most of the time, they do not practise LDI per se, but rather have an absolute return objective.
The national social security funds, do have elements of DB within their liabilities. But adopting LDI strategies in the manner used by European and US corporate pension schemes is not likely to be an option in the near future as Sin explains: “To undertake LDI, you need to have a detailed understanding of the pension fund liabilities. But a lot of state social security funds have no idea of their liabilities. They do not have accurate data or indeed, data management systems so it is easy for them to hide behind the excuse ‘we don’t have the data so we can’t manage our liabilities’!”
But even if they did have accurate data, most of the funds are not fully funded and as Sin points out, the size of the liabilities dwarfs the size of the assets. For them, what they need to be able to do is grow their assets at an acceptable level of risk. The task is made easier by the fact that they do not have the same accounting standards as corporates and are therefore less concerned about the volatility arising from mismatches between assets and liabilities.
For Asia, potential users have to be aware that, as Sin argues: “LDI is a nice idea in theory, but it goes back to what price are you paying to hedge out your liabilities and what is the opportunity cost that is being incurred? How much risk can actually be tolerated if it reduces the eventual costs?”
Mismatch between risk and portfolios
Even in the markets of Europe and the US, a rigid doctrinaire approach to LDI is highly controversial. One of the problems that exist in deciding how to match liabilities is in deciding what the minimum risk portfolio would actually be. A portfolio of conventional and index-linked bonds is generally seen to be the closest theoretical construct, but there are a number of dangers with adopting this route. First of all, the error margins in the calculation of liabilities need to be assessed since without an idea of how accurate the figures actually are, it makes little sense to even attempt a level of precise matching using what are often overpriced government bonds.
Secondly, while a benchmark of liability cashflows can be constructed, they can involve cashflows going out to 80 years in the most extreme cases. There are few bonds over 30 years and while it is possible to trade nominal swaps out to 70 years, liquidity reduces after the 30-year mark and for inflation-linked swaps, 40 years is the absolute maximum.
Constructing a benchmark minimum risk asset portfolio that does not adequately match cashflows beyond 30 years needs to be handled with great care if it is not to confuse trustees even more by giving a misplaced sense of objectivity and security. It also raises the issue as to whether it is possible at all to construct a matched portfolio of fixed interest and index-linked bonds that is the theoretical minimum risk portfolio.
What was not always understood prior to the financial crash is that achieving the floating rate of a swap agreement is not risk free and incorporates both credit and liquidity risk. Absolute return bond funds as a class failed miserably during the global financial crash. The underlying cause was of course, credit, and the fact that many strategies turned out to be nothing more than leveraged positions on credit spreads.
Many, though certainly not all, absolute return bond funds, had heavy exposures to credit. Many US firms in particular, prided themselves on their large credit research teams built up to manage investments in the large US corporate credit and asset backed securities markets. The advent of absolute return strategies enabled them to transport this expertise onto strategies aimed at beating non-US benchmarks through combinations of swaps and absolute return bond funds.
Sophisticated managers realised that they had the building blocks to deliver LDI. They could match the liabilities with swaps, so they just had to generate the floating rate leg tied to LIBOR. But many absolute return strategies went wrong in 2008 and 2009. The most obvious lesson to be learnt from the experience is the mismatch between what investors were expecting in terms of risks, and the actual nature of the portfolios.
Clearly, with hindsight, many products were totally unsuitable for the purposes they were being put to. But more significantly, many managers had products that were essentially taking credit spreads which require no manager skill, and could therefore be regarded as beta positions in credit, and effectively claiming fees for alpha. If the credit teams had a 50/50 benchmark government/credit, they would go overweight credit say 70/30 in favour of credit, so it was a credit beta play.
Investing in ABS at the time enabled funds to outperform the index benchmarks by moving away from the index universe. Perhaps it is not surprising that, as Sin points out, key elements of LDI strategies such as the use of swaps and other derivatives are not even permitted for pension funds in China and elsewhere.
Where LDI in some sense does play a more recognisable role in Asia is with insurance companies: “No one perfectly matches assets and liabilities but the key is managing the volatility” says Sin. In Singapore, Hong Kong and South Korea, there is a lot of investment grade long duration bonds issued by banks directed at insurance companies according to Christopher Wilder, portfolio manager at Stoneharbor Investment Partners: “They come at tight spreads and the risk/return trade-off is not attractive to us.”
They are however, exactly the kind of investments that life insurance companies would be seeking and they are directed at local players of this type, rather than global EMD fund managers. The extent of adhering to ideas of LDI does vary significantly across insurance companies within the region: “Some insurance companies do need to apply some level of LDI, especially subsidiaries of European and US firms that are subject to the Solvency II regulatory environment. But local and regional insurance companies are not subject to Solvency II and can therefore be more lax” says Sin.
More attractive route
While formal use of dedicated LDI strategies in Asia is not present, that does not mean institutions are not concerned about their liabilities. The Pyramis survey revealed the top three concerns on investment were risk management, volatility and the low return environment.
“There is little doubt the financial crisis of 2008-2009, and more recently the Eurozone sovereign debt issue, has forced institutional investors to identify better strategies for managing volatility, especially on the downside,” says Young D. Chin, CIO at Pyramis Global Advisors. “While risk management remains a top priority, the low return environment is driving more investors to also look for ways to enhance returns by deploying timelier, more dynamic asset allocation strategies that can exploit market dislocations.”
According to the Pyramis survey, many institutions in Asia reveal they will consider uncorrelated or less volatile asset classes as a risk management technique for managing volatility. But two of the top three ways to control volatility were to adapt an LDI approach and increase allocation to fixed income.
The evidence suggests it is diversification across asset classes rather than LDI that is the more attractive route for Asian institutional investors. When asked to think longer term, 20% of respondents saw “significant shifts to fixed income and/or immunized strategies” as the most likely future of asset allocation according to Benjamin.
But the Pyramis survey found institutional investors in Asia believe that ten years from now, investment portfolios will be more global as well as including heavier weightings in alternatives as well as fixed income. Asia ex-Japan investors say the greatest change to asset allocation will be a shift to more global investments (28%) – both equity and fixed income.
“Through portfolio diversification, institutional investors in Asia can mitigate volatility by broadening asset class exposure,” says Chin. “They are increasing allocations to strategies such as real estate and private equity with a view to enhancing returns while balancing those investments which often require extended time commitments with more unconstrained strategies like equity long/short and global macro, which provide more portfolio diversification and liquidity.”
Perhaps the diehard LDI enthusiasts in Europe and the US should take note.
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