European pension funds failing to implement true LDI, EDHEC warns

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Despite awareness of liability-driven investment (LDI), pension funds are failing to truly adopt the model, with only half operating a split between performance-seeking and liability-hedging portfolios, according to the EDHEC-Risk Institute.

In a survey of 104 mainly European investors, EDHEC found that 80% were fully aware of the LDI strategy.

The institute described the paradigm as creating two distinct portfolios within pension funds, one for performance and access to risk premia and the other to hedge against impacts on liability values.

However, its research found that only half of respondents implement a formal separation of the two portfolios.

It also singled out the UK and Denmark, where most responding pension funds adopted a clear distinction and 44% of respondents said it simplified the portfolio-construction process.

The survey also found pension funds often measure liability risk but do not put in any formal hedges against it.

One-fifth of respondents did not measure liability risk.

“This is still a worryingly high percentage, given that this measurement is an essential part of a sound asset-liability management (ALM) process,” the report said.

EDHEC also found that only two-fifths of respondents align the duration of bond holdings to the duration of their liabilities, which may represent the lack of liability matching.

However, of the funds that do implement LDI, only a third match duration.

“This is surprising, given that duration matching is usually considered the first step towards the immunisation of the funding ratio against interest rate changes,” EDHEC said, while acknowledging it may be due to the lack of available bonds with long maturities.

“Too many pension funds are still more concerned with standalone performance than risk management,” it added.

“Many remain asset-only rather than ALM funds and do not take sufficient account of the impact of their liabilities in their asset allocation policy or risk management.”

With regard to dynamic LDI, which allows periodic revisions to the allocations to performance-seeking and liability-hedging portfolios, a growing split is occurring between Northern and Southern Europe.

EDHEC said that, while 38% of respondents adopted dynamic LDI or are considering doing so, it was limited to Netherlands, Denmark, the UK and Germany.

Readers' comments (1)

  • There is quite a bit of confusion as to what LDI is and the EDHEC study does not seem to have contributed to a better understanding. On the contrary. I am concentrating on the concept of matching the liability and bond portfolio duration (duration matching) which is sheer nonsense. First, it assumes that the whole bond portfolio is invested in bonds, or that the rest of the portfolio has matched the duration of the liabilities already, otherwise, such matching is an empty gesture towards theoreticians. Second, it ignores that the liabilities of an open fund have a duration of 15 to 25 years, so that it is physically impossible to match that duration in the bond market. If 40% of the respondents were able to pull this off anyway, there are some severe definitional problems here. If this impossible task is indeed "the first step towards LDI" it is no wonder that pension funds don't implement LDI.

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