UK: Challenges ahead
Pete Drewienkiewicz outlines the broader range of tools available to pension funds to hedge liability risk
The last decade has brought dramatic and lasting change to the pensions industry; accordingly, the definition and practice of LDI have evolved alongside the ailing patient. From the bond-driven solution put in place by John Ralfe and the Boots Pension Scheme as early as May 2000, through to the first derivative-dependent full LDI solution executed in 2003 by the Friends Provident pension scheme and up to now, the LDI toolkit has constantly expanded in response to client demands for more dynamic solutions.
A few themes have developed as LDI managers struggle to combat the dual threats of ‘lower-for-longer' interest rates and widespread quantitative easing - namely extending the LDI toolkit, making matching assets work, and taking an alternative view.
Expanding the LDI toolkit
In the mid-2000s as LDI gained popular acclaim, swaps and bonds were the instruments of choice. Since the credit crunch and the persistent cheapening of Gilts over swaps, Gilt repo and total return swaps (TRSs) have become accepted ways to access "unfunded" exposure to gilt yields; swaptions, too, have made an entrance. They are an option to enter a swap, and constitute a valuable tool that can help trustees hedge some of their scheme's interest rate exposure without having to fully "lock into" low real interest rates.
One of the most common structures involves a pension scheme selling the right to pay fixed on a swap to an investment bank, at an above market rate. The pension scheme receives an option premium in return for a commitment to transact at a rate at which it would be content to lock into interest rates. The current attractive pricing on some swaption structures means that, in some cases, schemes have been able to transact structures that offer interest rate protection, and a better payoff than a straight swap in almost all scenarios, taking into account the premium paid for the swaption. Schemes able to take advantage of these opportunities are those whose governance structures allow a small, well informed sub-group to make timely decisions, as the timeframe for taking advantage of the pricing opportunities can be weeks or even days. The decision-making committee must be nimble.
Making matching assets work
Another key theme in the development of LDI has been the revelation that matching assets do not need to be as lazy as they once were: pension schemes have a uniquely long-dated investment horizon that is valuable in the marketplace. They can afford to give up liquidity in their asset portfolios. Liquidity swaps, along with the purchase of long-dated illiquid assets are two methods by which pension schemes have begun to exploit that characteristic effectively and change the way LDI is defined.
In a liquidity swap, a pension scheme agrees to transfer its Gilts (or index-linked Gilts, or other eligible collateral) to a bank for a set period of time. In return, the bank transfers a portfolio of less liquid, capital intensive assets to the pension scheme. The less liquid assets are haircut appropriately and regularly to ensure that the pension scheme remains over-collateralised, and the bank will pay a quarterly premium to the pension scheme for providing this collateralised lending and for providing the means by which the illiquid assets can be removed from its balance sheet.
Aside from liquidity swaps, the purchase of long-dated illiquid assets also provides a means by which pension schemes can exploit their unique position. We call these flight-plan consistent assets (FPCAs), because they help the pension scheme reach its long terms goals. They are typically long-dated, deliver consistent returns that are both liability-matching and high enough to resemble growth assets, and can help pension schemes avoid significant reinvestment risks implicit in most credit-based assets. Social housing, infrastructure debt and secured leases are all examples of FPCAs that match liabilities but do not require the pension scheme to surrender access to attractively priced credit spreads.
Taking an alternative view
Many schemes are unsurprisingly resistant to hedging at current market yields. Regarding the markets in different ways, though, can make hedging look more appealing. Consider the combination of a 20-year real rate hedge and a 15-plus year corporate bond. In 2007, real yields were higher (133bps versus -7bps today) but credit spreads were also tighter (60bps versus 195bps today). Hedging a 20-year liability to LIBOR in 2007 and then holding a 15-plus year corporate bond against it would have yielded a spread of 193bps. Today, the same process yields a similar spread of 188bps. Stepping away from LDI and returning to a holistic ALM process in which a scheme's assets and liabilities are considered simultaneously is thus valuable.
Again, taking an alternative view of the market, schemes have begun to focus on forward rates. Although forward rates are implicit in the par swap rates, which we as consultants routinely monitor, some LDI managers have found clients willing to hedge using, for example, a two-year-into-28-year swap, carrying a higher coupon than a straight 30-year hedge. This is not voodoo - there is no free lunch in forward rates. By surrendering the high carry implicit in an interest rate swap's first few years in a steep curve environment, a scheme is compensated with a higher coupon further out, which is often more palatable for an investment committee. Taking this process a step further and looking at individual annual forward rates has another benefit: it allows identification of the cheapest, or most efficient, points on the curve to hedge liabilities. This has been a significant theme in the development of the active LDI proposition.
As the definition of LDI develops it is natural to look critically to the past. It appears that, as the early adopters of LDI embarked on their pioneering journeys, many simultaneously built large exposures to one manager; therefore, lurking in the background is a vast (and currently unfulfilled) requirement for proper monitoring and management of LDI manager activities. A number of pension schemes are moving away from a single manager structure in order to diversify operational reliance on one LDI house, but as we look to the future we question whether this is the most effective approach.
The spectre of central clearing rears its head. Although European pension schemes have secured a 3-5 year exemption from many related regulations, it seems unlikely that investment banks will support a bilateral system for long. Although its benefits are clear, central clearing also brings a number of challenges: higher collateral usage, greater reporting requirements and potentially a requirement to re-hypothecate assets in order to free up cash to post to the CCP.
The definition of LDI has evolved as the markets have changed and pension schemes' circumstances have developed; the trend looks set to continue. There is no doubt LDI will remain an elevated item on pension schemes' and their advisers' agendas, given that not even 50% of the industry's potential liability hedging has so far been carried out, but the shape that LDI takes is up for debate. Its greatest challenge is taking on a robust form that accommodates the low rate environment of today, as well as in the stormy market environment that presents itself as the new norm.
Pete Drewienkiewicz is head of manager research at Redington