With a potential Brexit in sight, Carlo Svaluto Moreolo asks whether the assumptions underlying liability-driven investment (LDI) need to be reconsidered 

At a glance

• DB liabilities soared after the Brexit referendum.
The outlook has changed but LDI managers will stay on course.
Dynamic strategies may come under pressure due to heightened volatility.
Pension schemes should review their LDI strategies and managers.

There is an increasing anxiety over the £2.3trn (€2.8trn) of liabilities that UK defined benefit (DB) pension schemes hold, as measured by the consultancy Hymans Robertson

In the aftermath of June’s Brexit referendum, UK bond yields fell to record lows, causing the deficits of many DB pension schemes to increase sharply. The subsequent decision by the Bank of England to cut interest rates for the first time in seven years pushed deficits higher. Hymans Robertson also estimates that deficits have reached an all-time high of £1trn (figure 1). 

Trustees, corporate sponsors and policymakers are debating how to tackle these deficits in an economic environment that could deteriorate further during Brexit negotiations. There have been calls to ease regulatory funding requirements, but now pension schemes should arguably focus on liability-driven investment (LDI). 

The good news is that the LDI sector can meet growing demand from pension funds. The consensus is that the sector will grow and that hedging strategies are unlikely to change. Brexit potentially makes matters worse in terms of DB funding, but it should be possible to manage interest rate and inflation risk. Experts have noted how, after a brief period of market stress, liquidity in the sector returned to acceptable levels.

UK pension fund deficits

Robert Gall, head of market strategy within Insight Investment’s financial solutions group, says: “As the practicalities of leaving the European Union begin to be realised, markets may become more volatile, but the nature of the risks pension schemes are hedging is unchanged. This might change the pace at which pension schemes implement hedging, but the techniques will stay the same.” 

But with Brexit negotiations potentially looming, many of the questions surrounding the sector will be tested. 

First, why have so many trustee boards resisted LDI, and is this going to change? There are more than £1trn worth of unhedged DB liabilities, which should make LDI a priority for many. Yet these schemes have made decisions to maintain exposure to interest rate risk and inflation risk. 

This is based on a view that interest rates must revert to their historical mean, a view that has consistently been proved wrong. Schemes that did implement hedging strategies naturally benefited from the recent falls in Gilt yields. 

John Belgrove, senior partner at Aon Hewitt, believes that trustees’ reluctance to act is due to behavioural factors. “Loss aversion, reputation effects, herding, biases all play a part in trustees’ decisions not to bite the bullet and buy into LDI. On top of that, many market commentators have been wrongly predicting bond yields to rise more than the markets have been predicting. But all the noise makes it difficult for trustees to act,” he explains.

There are, of course, more objective reasons to refrain from hedging, adds Belgrove. He says: “Proper fundamental analysis makes LDI look like a costly strategy at current yields. There is also complexity in the mix: using leverage can be part of the solution of the hedging problem, but it is difficult to grasp.”

The first line of advice from LDI practitioners is to hedge out unnecessary exposure to those risks, notwithstanding one’s views on interest rates. Dan Mikulskis, head of DB pensions at Redington, says: “Over the past six years, the level of interest rate hedging has been the most important determinant of DB pension schemes’ performance. We encourage our clients not to try and make calls on the many macro factors influencing long-dated interest rates.”

Mikulskis recognises that the dialogue with trustees could become challenging. “Schemes that did not hedge to an adequate level might think that they have missed the boat. And it is a reasonable argument. I don’t think it is unreasonable to think that interest rates are going to be higher at some point. But, LDI is the answer to a risk management problem that faces pension schemes in the short to medium term,” he says.

In recent years, life has been easier for pension schemes that did implement LDI strategies compared to those that did not. But that is not to say that pension schemes can relax once an LDI strategy is in place. 

UK Gilt and swap curves

For most schemes, liabilities have been going up faster than assets, slowing down progress towards full funding. When that happens, trustee boards must assess whether the LDI strategy they chose is correct. 

This can be a difficult task. LDI, in theory, is just a risk management strategy. But it is also a complex solution to a straightforward problem. LDI strategies can therefore accommodate little input from trustees in terms of market views or implementation. Consultants and managers hold the steering wheel for the majority of the way. Due to the technical nature of LDI, they are often left to their own devices when it comes to choosing the right hedging instruments and strategy. 

The upshot is that LDI practitioners have strived to achieve outperformance relative to their benchmark just as any asset managers would. Outperformance is often achieved by taking tactical overweight positions in different hedging instruments. This practice is referred to as ‘dynamic’ LDI management.

However, it is hard to take winning tactical positions on a regular basis. Underperformance can and does happen, and even in an LDI context managers may expose clients to undue risks. For instance, certain strategies have underperformed their benchmarks recently, putting clients at risk of their funding eroding. 

The culprit, in this case, is a dynamic LDI strategy that many managers have employed with success, attracting growing interest from clients. By this technique, known as the z-spread trade or asset swap trade, managers dynamically switch between Gilts and swaps to take advantage of the yield differential (figures 2 and 3). However, higher than usual volatility in the spread between Gilt yields and swap rates has started to affect returns negatively. 

30-year Gilt yields and swap rates

Howard Kearns, head of LDI for EMEA at State Street Global Advisors, explains that dynamic LDI strategies based on the Gilt/swap differential worked well when the spread was moving around a 20-40bps range, but came under pressure as the rate widened. “Managers were heavily investing in Gilts in expectation that the z-spread would narrow and Gilts would outperform swaps. It just did not happen and the z-spread continued to widen out as far as 90bps. So the large Gilt portfolio managers were holding performed in line in Gilts, which underperformed swaps”, explains Kearns. 

Andrew Connell, head of portfolio solutions at Schroders, says managers have been running more risk versus their benchmarks than expected, as a result of running positions. “When volatility in the market changes, particularly if positions are so large they cannot be unwound quickly, clients’ portfolios can suffer,” he says.

To avoid these situations, he says, it is paramount for trustees to pay attention to how LDI benchmarks are constructed. Benchmarks need to reflect the end goal, be it self-sufficiency or buyout. Then, it is of course important to monitor how LDI managers propose to manage risk relative to those benchmarks.

SSGA’s Kearns adds that LDI strategies that propose to outperform Gilts and swaps may be too risky. More importantly, clients might want to ask why they are trying to achieve outperformance in their LDI portfolio. “It’s better to take your risks in your growth assets,” he says.

There is another opportunity emerging in the inflation swap market. Note that the term ‘hedging’ is used to describe both interest rates and inflation hedging, but the two are distinct tasks. Most importantly, inflation swaps have historically been less liquid than interest rate swaps, even though the underlying instruments are correlated. 

Connell explains that the UK break-even inflation rate (the difference between nominal bond and index-linked bond yields) has been trading below the historical standard of 3% . This is where managers are looking to take tactical positions. “We need to be cognisant that the pound dropped significantly post-Brexit. That normally is an inflationary impulse in the economy. A lot advisers are thinking whether that offers opportunities to take inflation risk off the table,” says Connell.

This could be the result of unusually low liquidity in the inflation swap market, according to William Parry, investment consultant at Xerox HR Services. Parry says: “It may be that the market is not operating completely efficiently. This is not common, as the interest rate and inflation swap markets are usually highly liquid. In such conditions, managers may be looking to add value by trading in the inflation swap market.” 

Parry, on the other hand, says that the use of active management to add material value is less prevalent in LDI. He says: “The aim of managers is not to deviate away from their central allocations. It is rather to make sure they are tracking the cashflow profiles in place for each fund. But the recent underperformance of some managers is not necessarily a sign of a storm brewing in the sector. I don’t think managers have been taking undue amounts of risk within what is primarily an implementation asset class.” 

It is reasonable to assume that the markets will show increased volatility in interest rates and inflation during the Brexit negotiations. LDI managers will see this as an opportunity. But it is fair to assume that risks will be higher, at least in the medium term. Does this ultimately call for a re-think of LDI strategies?

Either way, as the UK heads towards Brexit, there is an urgency to manage DB funding risk more effectively. One direction pension schemes are taking is to introduce illiquid assets within LDI portfolios. Insight’s Gall says that as the LDI sector matures, more experienced pension schemes will look to introduce more advanced LDI strategies involving these assets. He says: “True LDI is well established. Some trustees have got comfortable with it and are thinking about the evolution of their LDI portfolios. Pension schemes that introduced LDI early on may have freed up room within their governance budget to take on these more advanced types of LDI.” 

Gall points out that this development is not related to Brexit so much as to the maturity of the sector. Yet, the Brexit process could force DB pension schemes to slow down the pace towards full funding.