Ever since performance measurement became a feature of the pension fund investment industry in the 1970s, the idea of relative performance has dominated thinking. Fiduciaries have concentrated on monitoring the performance of their fund relative to the average, or of their mandates relative to the market. Investment managers have concentrated on providing products which are peer group and/or relative return based, and consultants have facilitated the relative return obsession.
More recently the belief that consideration of liability features should have much greater weight in devising strategy has gained ground and few fiduciaries can now be unaware of the term liability driven investment (LDI).
Whilst there is now familiarity with the term LDI, there remains a lack of clarity in many peoples’ minds as to what exactly LDI entails.
Indeed, many fiduciaries in Ireland remain sceptical as to the merits of an LDI approach and some are cynical as to the motivations of providers and consultants suggesting new solutions. This is not surprising since LDI means different things to different people.
There is a spectrum of definitions which can mean anything from business as usual through to the use of structured products like swaps combined with a highly diverse portfolio of alternative assets and mandates.
Crucially, LDI encapsulates a mind-set in which strategy and the implementation of investment structure are more heavily influenced by features of and sensitivity to liabilities (and measures of liability) than has been the case in the past.
LDI does not mean that relative return considerations are abandoned but rather that their suitability (along with other alternative solutions) is decided in the context of their expected behaviour within an overall strategy measured relative to the liabilities rather than relative to the market or to other pension funds.
As mentioned above, this could easily mean that a business as usual solution is adopted.
Where an LDI approach does involve some change in strategy or implementation, it will usually involve, in the first instance, the removal of unrewarded risk from the portfolio. For example, euro government fixed income securities (or bonds) are commonly seen as a matching asset for Irish pension funds.
However, the duration (average time to payment) of pension fund liabilities is typically much longer than the duration (average time to receipt of returns) of bonds available in the market.
To counter this, the LDI products being introduced typically involve the use of financial derivative products, such as interest rate or inflation swaps. Using these instruments enables managers to create pooled investment vehicles of longer duration, with inflation and/or interest rate characteristics, that are not generally available from physical securities in the market.
These are the most commonly referred to LDI solutions in the Irish market and when trustees hear of LDI in the Irish market this is most likely what is being considered.
Whilst the use of such LDI funds may be eminently sensible, there are several considerations for trustees to bear in mind:
❏ Thought needs to be given to what exactly is the “liability” - this is not as obvious as it sounds. The liability is primarily a set of (uncertain) cash flows. In addition, accounting measures or the minimum funding standard can be considered to be the liability.
An investment which matches one measure will not necessarily match another. Reducing volatility relative to IAS 19 may not reduce volatility relative to solvency. The liability measures to which the fiduciaries and the sponsor are most sensitive should get the greatest consideration.
❏ Some LDI funds will offer specific duration - does this duration stay fixed or does it reduce over time? Either way, the strategy will need close monitoring. Ongoing transfer from one duration bucket fund to another may be necessary - what are the costs and implications of this?
❏ The skill set required to run long duration bond-like LDI funds is very different to operating in the traditional physical market. Fiduciaries need to be satisfied that the providers have the necessary expertise and operational structures to do this successfully. There could be significant value loss to the fund if best execution is not achieved.
For the above (and other) reasons, the take up of long duration LDI funds in Ireland has been slow, but seems to be accelerating. Smaller funds have started to use the pooled long duration funds set up by some of the managers in the Irish market.
Larger funds will tend to implement bespoke solutions and may adopt tailored derivative strategies. The technical issues regarding swaps agreements combined with limited familiarity and natural conservatism will see slower take up of such bespoke strategies in Ireland compared to such jurisdictions as the UK and the Netherlands.
However, our firm has already advised on the implementation of bespoke derivative based solutions to some larger funds in the Irish market.
LDI does, of course, mean more than just using better matching (or even just more) bonds. In the mind set where it is the volatility of the total asset portfolio relative to the liability measure that is important, the traditional model of a high equity weighting in the strategy with a “sit back and wait for the long run” approach becomes significantly less attractive from an investment point of view. Much more attractive are policies which combine a number of the following:
❏ Better matching assets (see above)
❏ Alternative assets (hedge funds, private equity, long/short, timber, commodities, property, TAA, high alpha bonds, EM debt etc)
❏ Absolute return mandates.
The overlay of derivative strategies combined with much greater diversity and successful selection of manager skill can very significantly improve investment efficiency. For example, volatility relative to liabilities can be significantly reduced without sacrificing expected return (or expected return can be increased for the same expected level of risk). In order to do this successfully, very significantly more focused and better resourced governance is necessary. The continuing use of lay trustee boards or even of better but not sufficiently resourced investment committees will hamper the development of full on solutions.
Some providers are offering all-in solutions targeting specified return and volatility targets relative to the liabilities. These are best suited to small and medium sized funds but are generally very expensive by conventional standards. Of course, if they deliver the desired outcome efficiently, net of fees, the price is immaterial.
Such an approach will not necessarily allow access to “best in class” for each element of the solution as it is effectively a one-stop-shop. Larger funds are generally better served to implement diversity and liability driven strategies on a bespoke basis.
The governance requirements for this to be done properly can be daunting and may require significant enhancement of existing levels. For this reason development has been slow to date, but we are beginning to see movement. It cannot be over-emphasised that key to getting such solutions right will be the governance.
Whatever the eventual take up of swaps, long duration funds and diversity, there is one thing of which we can be sure: from now on liability measures will feature large in the minds of fiduciaries deciding on investments. Long live LDI!
Joe O’Dea is head of investment practice at Watson Wyatt in Dublin