Lynn Strongin Dodds assesses the range of liability management strategies available to European pension funds
Pension funds may still be taking only tentative steps towards liability driven investing, but this has not stopped the fund management community from powering ahead with an ever growing product range. Two years ago, the focus was on simply matching liabilities but today managers are developing more integrated and diversified approaches. The bet is that clients will adopt these more sophisticated strategies as they advance on the learning curve.
As Nick Horsfall, a senior investment consultant at Watson Wyatt, notes, "overall, there are about a dozen asset strategies in the marketplace, ranging from equities and bonds to emerging market debt and infrastructure. The most popular are the simple ones that manage interest and inflation risk off the table via swaps and bonds, and include assets such as equities and property to generate added return. This is mainly because trustees understand and are familiar with those assets and are not as familiar with investments such as infrastructure."
So far, progress has been slow, according to a recent survey conducted by SEI, a provider of asset management services and investment processing solutions. The poll, which canvassed 226 pension executives in the more pension savvy markets of Canada, the Netherlands, UK and US, showed that only 20% were implementing an LDI strategy, while 33% were not even considering going down the road.
This is expected to change not only in the countries mentioned in the survey but also in Scandinavia. This is due to a combination of regulatory pressures and accounting standards that have sharpened the focus on liabilities.
In addition, people are living longer and schemes need to be stoked with additional returns. Equally as important, derivatives, and more complex instruments which can be a feature of LDI solutions, are no longer alien to many fund managers in Europe, thanks to UCITS III.
Naturally, LDI providers are more than willing to explain the concept
as well as showcase their LDI wares. Antigone Theodorou, director, investment solutions at AXA Investment Managers, explains, "LDI is not a totally new idea as pensions have always looked at their liabilities, but it is a new approach. It will take time for trustees to become comfortable and to be educated about the different techniques available to them."
One of the misconceptions is that LDI is simply about hedging out the unwanted risks such as interest and inflation volatility. This is not the case. As Andrew Connell, head of LDI at Schroders, explains. "While the name LDI has caught on, it can mean different things to different people. LDI is a framework upon which to base an investment strategy - it places the ability to meet a scheme's liabilities as the yardstick by which investment solutions should be judged.
"Most LDI strategies lower the exposure to risks that are perceived to be unrewarded and this reduces the volatility of the funding level. LDI strategies may also allocate a larger portion of the scheme to growth assets with an improved risk/return which also increases the chances of being able to pay the liabilities."
Vincent de Martel, senior strategist in the strategic solutions group at Barclays Global Investors (BGI), adds: "The industry is definitely moving towards a more holistic approach which incorporates liability hedging as well as investing in multi asset classes.
"In a typical portfolio, the first stage is to move to a portfolio of better bonds which could include government, corporate and swaps without reducing the yield. The next step is to increase diversification in a multi-asset portfolio which consists of emerging market equities and debt, high yield, infrastructure, property and commodities. The objective is to generate a return comparable to equities without introducing risk."
There is no ‘off the shelf', ‘one size fits all' solution as each pension fund has its own risk/return profile. Smaller funds tend to use pooled funds, while the larger schemes typically opt for a component based approach and devise their own solutions. After all, they are equipped with the resources, in-house capabilities and expertise to choose the best of breed.
This is not the case for a smaller fund who may be strapped for time, money and expertise to cherry pick. It is easier, not to mention more cost efficient, to hand over LDI needs to one or perhaps two providers. Regardless of the size, though, devising and implementing a plan is not easy. According to Mike Nolan, head of portable alpha at Morgan Stanley Investment Management, the appropriate solution will depend on the size of the scheme, the strength of the covenant, the funding levels, regulation and the longevity of its members. Ultimately, the trustees and the sponsoring employer will decide the balance they want to strike between risk
While the LDI market may look inundated, products typically come in three flavours - hedging, alpha and diversified growth - for both pooled and segregated accounts. For example, a low risk strategy may encompass managing credit and interest rate risk, while a medium risk LDI course of action might entail a mix of global tactical asset allocation, diversified growth or bond funds comprising of swaps, forwards and credit default swaps. Those willing to tolerate higher risk could choose hedge of hedge funds as well as active currency management.
Breaking it down by age, Andrew Dyson, managing director of BlackRock, explains that the more mature pension funds may adopt a narrow approach and use a bond-based approach including high performance bonds, portable alpha strategies and cash flow or duration matched bonds. A less mature plan, on the other hand, where liabilities are less defined, may select a broader church which encompasses bonds, equities, alternative assets and target return investing.
One of the most popular strategies to come onto the market over the past year has been diversified growth funds, which target LIBOR plus four and aim to offer lowly correlated streams of returns. Many household fund management names either have a fund in their stable or are planning to launch one. They are expected to continue attracting interest in the current market when the diversification argument has been reinforced.
"The benefits of these types of products," according to Mitesh Sheth, investment director in the fixed income team at Henderson Global Investors, "is they invest in a wide range of asset classes and deliver an equity like return with much lower risk. They also enable investors to access new alternative asset classes and strategies that are
coming onto the market such as infrastructure, gold and other commodities and hedge funds. In the future, I expect that timber and renewable energy assets will be added to these funds."
Jonathan Cunningham, head of institutional sales at Baring Asset Management, notes, "We are definitely seeing an increase in the demand for our multi-asset targeted return portfolios funds. We have had 15 new mandates over the last 12 months. The funds invest in Baring funds where we have the expertise but use external managers in areas that we do not have the experience such as structured products and property."
Investors are also looking at fixed income from different angles. Dominic Delaforce, co-head of LDI at Aberdeen Asset Management, notes: "It is no longer just about interest and inflation rate management or domestic bonds. Today, pension funds are focusing more on the best opportunities in the different markets whether it be emerging markets, investment grade or high yield debt. Last year, Aberdeen launched its fixed income alpha funds range - a pooled product - which also uses interest rate and currency overlays to enhance performance."
There is also activity in the smaller end of the market. BlackRock recently launched Liability Plus, an LDI product aimed at small to medium-sized UK pension schemes. It incorporates a two-tiered solution designed to generate returns over liabilities. A pension scheme's fixed and inflation-linked liabilities are matched through a series of swaps while the return portfolio is invested in BlackRock's Target Return fund, which seeks to outperform cash.
Schroders, on the other hand, is poised to launch its diversified completion fund, a pooled fund, which offers smaller pension funds pure exposure to the alternative asset class world.
It already has a diversified growth fund which it launched last year. According to Johanna Kyrklund, head of multi asset at Schroders, the problem with alternatives, especially the more illiquid assets, is that they can be hard to access for smaller pension funds. "Our fund will be an efficient way to access these assets,"