The prolonged low-interest-rate environment is prompting debate about the future of LDI
- Regulation and the maturing of pension schemes have driven the growth of LDI.
- Some experts are sceptical about locking in LDI hedges now because of low rates.
- A growing number of schemes combine LDI with more aggressive investing.
- Some say LDI can make it harder for schemes to meet cashflow objectives.
Liability-driven investment (LDI) has grown rapidly in popularity across Europe as trustees respond to worsening demographics at pension schemes. But this increase has not led to unanimity about its principles and practicalities. Far from it – there is a debate about who needs it, how, and when to apply it.
“I’m not saying: ‘don’t do LDI’”, says Carl Hitchman, head of fiduciary management advisory at Stamford Associates. “But, I am saying that it is not necessarily appropriate for everybody” – or, at least, “some aspects of it”.
LDI involves hedging interest rate and inflation risk to reduce the volatility of the value of assets, relative to the value of liabilities. This can be done through investing in assets sensitive to interest rates and inflation or through derivatives.
In the UK, statistics show how mainstream it is. The value of UK mandates hedged in this way rose by 13% in 2015 to total £741bn (€874bn), according to KPMG.
Richard Wood, managing director, client solutions, at BlackRock, says he has seen interest from two other countries in particular. In Germany, pension schemes are become more concerned about matching their fixed-income allocations to their liabilities. In Ireland, the regulatory framework encourages the matching of assets and liabilities, because a risk reserve is applied to any liabilities not backed by fixed-income assets.
LDI is widespread in the Netherlands, reflecting the conservative approach of the regulator. “LDI hedging is pretty common, especially for the bigger pension funds, whose level of sophistication is high”, says Lukas Daalder, CIO of Robeco Investment Solutions. More recently, he adds: “smaller pension funds have been pushed in the direction of interest rate hedging by the regulator”.
Observers credit the growth in LDI to a regulatory impetus towards mark-to-market valuations for pension funds, which increases the focus on short-term volatility. The maturation of pension funds has also contributed: as schemes shut to enrolment and turn cashflow-negative, they have to disinvest; when disinvesting, they do not want the value of the assets to fluctuate. Advocates of LDI say that by reducing volatility, it assuages these fears.
There is, however, a hitch. “Yields are at historically low levels, which mark less attractive entry points than in previous years,” says Ross Pritchard, head of LDI solutions management at Schroders. By hedging their risk at this point, schemes would have to lock in at historically low rates.
However, Daalder says that the balance of risks has tipped. On the one hand, he acknowledges that schemes have been caught out in the past: “Over the past five years, every time yields went lower there were always people who said: ‘this time we have reached the low point.’ At that point they lowered their interest rate hedge, but it turned out to be pretty painful because yields continued to decline.” However, at the end of 2016, Robeco advised clients that yields were more likely to rise than fall, making it sensible to reduce interest rate hedges.
But even if yields rise in the future, they are historically low and likely to continue so. This means investors cannot rely on government bonds to generate a decent return.
The low level of rates has whetted appetite for what David Rae, head of client strategy and research at Russell Investments, calls “allowing schemes to have their cake and eat it”. That means having “a reasonable proportion of their portfolio in asset classes and strategies that can be expected to generate an attractive long-term return, while at the same time hedging some of the valuation risks around their liabilities”.
Wood says an allocation of up to 75% to “return-seeking assets”, including corporate bonds and equities, is still compatible with an LDI strategy. To do this, the remaining 25% of the portfolio would have to be, as he puts it: “worked quite hard to hedge quite a high proportion of liability risk”. He says this could be done through allocating the 25% to cash and bonds, and using that as collateral for positions in derivatives that leverage the total portfolio’s interest rate and inflation exposure to beyond 25%. “A key feature of LDI is that it doesn’t have to mean low risk,” says Wood.
Never mind LDI. What about CDI, or cashflow-driven investing? “LDI strategies are based on stabilising the volatility in pension schemes’ funding levels,” says Hitchman. “However, rather than focusing on managing short-term volatility, the starting point should instead be to view the liability of a pension fund as its cashflows, unless buyout is a real consideration in the foreseeable future.”
Hitchman advocates earmarking assets to meet cashflow in specific years. His rule of thumb: allocations to cash or cash-equivalents for up to two years ahead, ‘cash-plus’, including short and medium-dated credit, for years three to five, higher-yielding credit for years five to 10 or so, and a mix of equities, alternatives and credit for 15 years out and onwards.
“Every single pension fund in the UK should be looking at CDI,” he asserts.