The past 10 years have seen substantial growth in hedged UK pension liabilities. Starting from a low level in 2004 it now stands at £500bn in 2014, based on KPMG’s 2014 LDI survey. The evolution of the pension scheme funding regime has contributed to this growth, with trustees disclosing deficits to members and increased scrutiny by equity analysts of reported deficits on company balance sheets. This has led to short-term risk management against Gilt referenced liabilities, a landscape where LDI has proved invaluable.
As the industry developed, the number of LDI managers grew, although it soon consolidated into a ‘big three’ – Legal & General Investment Management, Insight and BlackRock – plus a handful of medium-sized players.
The nature of mandates has also evolved. Early adopters focused on segregated execution-only swap mandates but as the toolkit widened there was an increase in sophisticated discretionary solutions. Many of the techniques in the segregated arena are possible for pooled clients, with any hedging strategy possible for schemes.
The latest development has been the use of LDI to manage and gain access to other risk exposures, such as synthetic equity and credit overlays – for example, writing equity total return swaps under existing legal documentation. Pension schemes have used this to get more bonds into the portfolio without giving up long-term investment returns from the equity and credit markets, a ‘win-win’ under the current funding regime.
It has not been plain sailing, though. The credit crisis tested the veracity of derivative contracts, leading to an ever-tightening regulatory environment.
The announcement of the move to centralised clearing for swap contracts triggered the winding down of some LDI products that were backed by more esoteric assets such as credit, diversified growth funds and hedge funds.
For an asset class that was expected to be static and long-term, the journey has been eventful. However, trustees that have taken the LDI route will be pleased with the ride.
LDI: the next 10 years
I believe that in the next decade there will be significant changes in the LDI market, driven by the changing needs of schemes. Growth will continue, but as investment strategies change to reflect the needs of maturing, well funded schemes, LDI will need to respond. The dynamic of the market participants could shift from trust-based DB schemes towards insurance companies and DC investors.
There is still appetite from DB schemes to de-risk further and LDI remains the best tool to achieve this – there are only 825 LDI mandates in place, against more than 6,000 DB schemes. In particular, the small to medium-sized schemes appear to be the least exposed to LDI. So growth from here may come in bite-sized pieces rather than the raft of gigantic mandates seen to date. A further source of growth will be the 30% of mandates with triggers to extend should yields relax in the future.
As schemes focus on reducing uncertainty and moving towards self-sufficiency-type strategies, it is likely that investment portfolios will transition towards contractual income-generating assets such as credit, property and infrastructure. LDI will continue to have a role as the tool to ‘mop up’ any residual interest rate, inflation and term risks not covered by physical assets.
This would lead to an LDI industry with three main roles:
• Engineering solutions: high-margin derivative structuring. An area traditionally filled by investment advisers, LDI fund managers and fiduciary managers;
• Execution: low margin, volume business relying on sophisticated risk systems and deep and experienced trading platforms;
• Physical asset management: high margin differentiated products designed to deliver the diversified income generative portfolios that drive the underlying return of the portfolio using a range of specialist fixed income and other contractual assets, listed and non-public.
If the industry does move in this direction, distinct leaders will emerge in each role. Alternatively, we could see LDI managers leverage their low-margin, scale-execution business to gain traction in the other higher-margin sectors, creating a ‘packaged complete solutions’ offering – akin to diversified-income funds but with bespoke liability benchmarks.
For execution, it is not hard to see the main players continuing to dominate due to scale, expertise and reputation. There is a chance that a handful of the smaller players that have already bulked up their teams will join the existing pack, but I fear that, despite their best efforts, some newcomers will have a strong push into LDI but ultimately retreat after failing to hit critical mass.
Over the longer term, there is an inevitability that all schemes – bar a few large DB schemes – will look to the insurance industry to exit as and when it becomes affordable. This could stem from a cheaper bond market, returns from the risk assets within portfolios or ongoing company contributions eventually bridging the gap. As more and more assets (and liabilities) are transferred to insurance companies, the main consumers of LDI will shift from DB schemes to ever-growing mandates with a handful of insurers. This presents a challenge for LDI fund managers who will face a narrowing client base towards a small minority of hugely influential buyers.
In terms of regulation, the current direction is towards greater transparency, liquidity and increased collateralisation in the derivatives market via centralised clearing. I envisage no change to this and would not be surprised if further developments are proposed.
A Solvency II-type regime for pension funds would take this to a new level and LDI would have to adapt as de-risking programmes are accelerated.
While DC is a growth area, the scope for LDI is less clear. Even when annuity purchase was clear for target, a job ideally suited to LDI, it was not clear how LDI strategies could be sold to a disinterested end consumer. Changes in this year’s Budget question the relevance of the annuity target. LDI does not seek to preserve capital value, so the role of LDI comes into question where capital preservation is a key objective. I believe LDI will feature in the future of DC, but this is perhaps 10 years away.
What does this all mean for LDI? The future is bright, with more schemes adopting LDI, reducing uncertainty and maintaining return expectations. The investment management industry will need to evolve to cater for the types of portfolios pension schemes and insurers will want in the future, and LDI mandates will need to adjust. LDI managers have proved themselves to be adaptable in the last 10 years, and there is no doubt they will continue to adjust over the next decade.
Barry Jones is head of LDI at KPMG in the UK