There is a great deal of discussion about what liability-driven investing is exactly. So what clear advice is there for the investor? Lynn Strongin Dodds reports
The pension fund community may be taking only tentative steps towards liability-driven investing (LDI), but there is no shortage of advice. Managers are deluged by investment consultants, asset managers and investment banks eagerly ready to lend a helping hand.
The marketplace is getting crowded but initially competition is likely to be between firms in the same field as LDI solutions often require a collaborative effort.
Despite the hype, though, many institutions are just at the beginning of the LDI learning curve which explains why most of the conversations taking place revolve around education rather than pure advice. LDI is not an easy concept to grasp and the confusion is compounded by the various definitions being touted in the marketplace. One common misconception is that LDI is simply about hedging inflation, interest and longevity risks. However, it can also entail absolute return targets and a diverse set of asset classes within specified return and risk parameters.
Andrew Drake, an executive director, currently oversees Morgan Stanley's UK pensions business, describes the phrase LDI as something of a red herring: "It is also sometimes perceived as a term to push products. However, pension funds have always been liability driven. It is the way in which they think they should match liabilities that has changed. LDI should be seen as a framework whose objective is to better match a pension's funds assets to its liabilities. We have lengthy conversations with the trustees and plan sponsors to ensure that they understand the mechanics and different characteristics of the LDI solutions they choose."
Al Pierce, global head of SEI Investment's advice team, says: "One of the biggest obstacles is the ability of pension fund trustees to understand what is proposed and how to implement it. They have to be able to navigate through the different disciplines and integrate all the advice that they may receive."
Unsurprisingly, different countries are moving at their own pace depending on regulation and accounting practices. A recent poll conducted by SEI, which canvassed 226 pension executives across Canada, the Netherlands, UK and US, revealed that only 20% were implementing an LDI approach while 33% were not even considering such a strategy. The Netherlands is leading the charge with 43%, followed by Canada at 21%. The UK and US lagged behind with 19% and 17% respectively.
Advisers think it is only a matter of time, though, before LDI becomes an integral part of the investment blueprint. They are gearing up for business now in anticipation and are tailoring their advisory offering according to a country's particular culture and legislation. For example, Dutch schemes are increasingly adopting a fiduciary management approach whereby an asset manager typically oversees the whole investment programme, including the LDI piece. Generally, this means advice on the asset allocation and risk management component as well as taking responsibility for manager selection, monitoring and tactical asset allocation.
Also, as Catherine Claydon, managing director Lehman Brothers points out, some of the industry-wide schemes in the Netherlands and Nordic region have built their own internal resources to design and implement their own LDI roadmap. They will choose advisers as well as product providers depending on their skill set in a particular region, asset class or instrument.
By contrast, in the UK, investment consultants have traditionally been the first port of call for pension funds. Their role has been to advise on asset allocation and to hold beauty parades to find the best in class managers.
However, consultants have come under heavy criticism for not being up to scratch in risk management and LDI skills. Clients had become more demanding forcing consultants to justify their hourly fee. They could no longer rest on their laurels and had to reconfigure their operating structure. Not only were there competitors encroaching in their space, but it was thought that the big three - Mercer, Watson Wyatt and Hewitt - were facing unprecedented cost pressures as their bread and butter advice was not generating the necessary revenue.
The result has been a more proactive and dynamic model. For example, Mercer recently launched an outsourced liability driven investment solution, which combines the firm's consulting advice with implementation, via selected specialist managers. Its global research team has added a new range of funds to its roster including a diversified alpha fund, a UK high income fund and a European property fund-of-funds. They as well as their investment consultants have poached talent from investment banks and asset managers to plug any gaps.
Mick Moloney, head of Mercer's European financial strategy group, believes that investment consultants have strengthened their proposition. "If you made the criticism that consultants were not up to speed two to three years ago on complex risk transference products I would have agreed. Everyone, though, has since run up the learning curve. For example, our financial strategy group, which was launched in May 2007, has brought people with different quantitative backgrounds within our business together under one roof to focus on how we can bring complex solutions to both trustees and corporate treasurers. We have hired in additional investment banking, asset management and credit skills to offer a comprehensive service."
Although investment consultants will continue to play an important role, Andrew Dyson, managing director at BlackRock, notes: "If you went back three years, the consultants were often in pole position but I think trustees, particularly in the larger schemes, have become more receptive to different providers and solutions. We are also seeing more treasurers and finance people becoming involved because of the accounting angle and a knowledge of risk management is needed. Ultimately in the UK and Netherlands, due to their fiduciary responsibility, the trustees have the final decision as to who to use."
Never one to miss an opportunity, the investment banks have jumped at the chance to show off their derivative and risk management skills set. They already had a foot in the door due to their relationships with the finance teams, which now oversee pension issues. In the not too distant past of balanced mandates, the human resource department was in charge.
Many of the larger banks such as Morgan Stanley, Goldman Sachs, UBS and Lehman have built pension and advisory groups although they are often accused of being too transaction orientated. The advice may be free but it is often based on their internal product range.
Rupert Brindley, managing director, life and pensions for the investment bank at UBS, believes that "the criticism of banks is often baseless, particularly as markets have become increasingly transparent. Banks often excel at assembling the components of a solution in an effective way. We develop investment roadmaps to ensure that a client's overall risk policy is continuously aligned to the objective of fund deficit elimination."
Gareth Derbyshire, a managing director in Lehman's European pensions advisory group, adds: "We do not see ourselves in competition but in offering complementary services with the investment consultants. If we were only providing advice based on our product range, then that would impact our integrity with clients. It is fairly understood in the market that if you do not come up with good ideas, then you will compromise your relationship, which does not serve the firm well."
Asset managers have also come under fire for being too focused on their own branded goods although some have adopted an open architecture platform offering third party LDI products. Many have not only set up dedicated pension groups but they have also created a whole new generation of LDI solutions which include both hedging instruments and alpha generating assets.
Andrew Connell, head of liability-driven investment at Schroder Investment Management, says: "There is an increasing overlap between the services offered by asset managers, investment banks and consultants. Fund managers' strengths are in market expertise and the long term nature of the solution, as a result we are well positioned to offer LDI as a core service in our existing relationships"
While the mainstream providers may dominate the LDI scene, new players have also come onto the LDI scene. Cardano, the Dutch group, recently set up shop in the UK while Redington Partner which is filled with ex-Merrill pension experts, also opened its doors this year. Their unique selling point, of course, is their objectivity in terms of products and advice. Dawid Konotey-Ahulu, partner of Redington Partners, who previously was head of Merrill Lynch's insurance and pensions solutions group (Europe, Middle East and Africa) notes: "Trustees are looking for variety and impartial advice. The inherent difficulty with the investment banking model is that they are selling their in-house products as solutions. We work closely with both investment banks and asset managers to develop the best framework but we offer independent advice as well as monitoring of the strategy."
For now, despite their differences, most advisory groups tend to work in a collaborative rather than confrontational manner. This may change going forward with trustees outsourcing different components of the LDI solution to the various providers. Phil Page, client manager at consultant Cardano, says: "There will be competition for different parts of the pie with the main rivalry being between those wanting to implement the strategy and those offering advice. Our offering is different in that we offer advice as well as implementation of both the assets and risk management pieces."