The shape of things to come
Liability driven investment (LDI) has become a high priority in shaping asset allocation for some pension funds in Europe where full-funding is a necessity, but some say there are complicated issues around it.
In many continental European countries, liability-driven investment is less of a driving force within asset allocation than it is in the UK, according to Derick Bader of Pictet Asset Management.
“I don’t see a lot of development in this area,” he says. “I tend to believe it is very much a UK type of view.” LDI has little relevance to many pension schemes in France, he points out, which are largely pay-as-you-go.
“The whole idea of LDI has a few practical issues,” says Udo von Werne, his colleague at Pictet. Not only is LDI intellectually complex and therefore not easy to grasp, but its success also depends heavily on which technical rate is used to discount the value of the liabilities within a scheme, he says.
So LDI can be a rather ‘fuzzy’ science, he says, and it has been used by some investment houses to promote their fixed income sales. But some pension funds certainly have needed to match their assets more closely to their liabilities, particularly in the UK, says von Werne, and this has involved including longer-dated bonds in their portfolios.
“There seems to be a big discrepancy between what pension funds would really like to have as a product, and what investment managers would like to push,” says Bader.
In Switzerland, it is very difficult to create a sound product robust enough for the ultimate investor, says von Werne, because the so-called minimum investment rate is not fixed but ultimately at the discretion of the government.
The minimum investment rate is a legal hazard, says Bader, because of the gap that comes as a result of it, between the actual rate used by pension funds and the capital market rate. “That produces huge inconsistencies,” says von Werne.
People have different ideas about what LDI actually is, says Paul Bourdon, at Credit Suisse. For some, an LDI strategy has more to do with cashflow matching, including some enhanced performance through the fixed income portfolios, he says.
“Whereas the trend I see coming through is to extend it to the whole asset portfolio to diversify against liabilities,” he says.
So far, not many pension funds have included all the asset classes in LDI, but have instead focused on enhancing the bond portfolio against the liabilities, he says. But there could be negative consequences for those who fail to consider all asset classes in this context, he says.
LDI is not really a new concept, says Andrea Canavesio of consultancy MangustaRisk in Rome; it is rather a new name for an old concept. “It just emphasises the role of the liabilities,” he says. “But no trustee will tell you they manage the portfolio without looking at the liabilities.”
The change is mostly apparent in countries such as the Netherlands where pension funds where there is an obligation to be fully funded; these funds are now much more influenced by their liabilities than they were before, says Canavesio. But for funds in countries such as Germany and Italy, which have traditionally invested heavily in bonds, the emphasis on LDI prompts less of a radical change.
Even though some investment managers offer packaged LDI ‘solutions’, considering an LDI strategy does not remove the asset allocation decision from pension fund trustees, Ken Willis, of consultants Lane Clark & Peacock points out. “Indeed, it may mean more discussions and potential difficult decisions,” he says.
But for smaller pension funds, an LDI approach might end up with more of the asset allocation decisions resting with the investment manager, particularly if they decide to use a ‘new balanced’ approach, he says.
“Trustees following such an approach need to understand exactly which decisions they are delegating and the amount of reliance that they may now be placing on the manager’s ability rather than on market returns generally,” he says.
But overall, when funds do use LDI approaches to reduce the volatility of their funding position, their trustees and corporate sponsors should be able to make better use of their risk budgets, he says. And this is likely to lead to an increased use of a diversified range of return generating assets, he says.