UK: No more ‘set and forget’
Gill Wadsworth examines current practice among UK pension funds and their trustees in the management of liability risk
Initially branded a fad and regarded with suspicion by many UK pension fund trustees, liability-driven investment (LDI) has come to transform portfolios.
Liability risk management typically returned 20% to UK schemes in 2011 against a WM defined benefit (DB) average of 3%, according to analysis conducted by the risk management and fiduciary management specialist Cardano, and is now seen as best practice.
When LDI first entered the investment lexicon some ten years ago, it was structured around basic principles: liabilities are linked to Gilt yields and there are inherent risks within an investment portfolio that need to be managed.
The LDI pioneers bought bonds to match assets and hedge out unrewarded inflation and interest rate risk. Most strategies involved nothing more complex than a pure vanilla interest rate swap, while swaptions and other advanced derivative instruments were yet to make it as far as DB funds were concerned. Glide paths to full funding were set, hedges put in place and trustees were free to focus on other things.
Fast forward to 2012 and LDI strategies include more exotic instruments born out of the unprecedented market conditions that have turned accepted investment theory on its head.
No longer is LDI considered a ‘set and forget’ strategy, says John Belgrove partner at investment consultant Aon Hewitt. Instead the mechanisms put in place must be dynamic, sophisticated and able to respond to hitherto unknown economic environments. LDI is alive; it is real time. We have a much broader toolkit and opportunity set to work with.”
Since interest rates plummeted to historic lows - 10-year Gilts yields hit a historic low of 1.44% in early August - pension funds have been unwilling to commit to hedging strategies that represent poor value. Instead, they favour putting in place triggers that tell the LDI manager to take action when rates rise. Then, should they fall back again, the LDI manager will be automatically authorised to reverse the decision.
The 2012 Mercer European asset allocation study found that more than half of schemes using LDI had implemented trigger-based policies that prompt an increase in bond allocations as yields rise and funding levels improve. Of the schemes surveyed, around 15% have LDI strategies in place to address funding risks and 57% of this group use triggers.
At the same time, the instruments with which managers construct hedges have gained complexity.
Gilt repos, total return swaps, synthetic bonds, gearing and forwards are all typical in the more advanced LDI programmes being rolled out across UK pension funds.
Insight Investment secured a number of new LDI clients in 2012, but the greatest level of activity the manager saw centred on extending existing clients’ mandates by a further £13bn (€17bn).
This has been in extensions to existing interest rate and inflation hedges and increasingly in areas where schemes wanted to tap into some of the more advanced strategies available, such as using swaptions.
Steve Aukett, director of financial solutions at Insight Investment, says pension funds are typically looking for techniques that improve capital efficiency and make assets sweat.
“Clients are not running for the hills in terms of the use of derivatives because, net of any cost that we see in the system and net of any collateral demands, derivatives offer clear benefits in gaining capital efficiency,” Aukett says.
Ignis Asset Management is another advocate of the more sophisticated investment strategy, choosing as it does to use Gilt forward rates for its LDI strategy, which covers some £25bn in assets, including its own in-house pension scheme.
It seems only right that LDI should evolve in line with changing markets, and few could argue with the performance of the new generation of strategies, but there are questions over the level of governance required to run them.
It is one thing to expect pension fund trustees to understand a matching strategy involving gilts and bonds with the odd swap thrown in, but it takes a lot more to get to grips with some of the techniques employed today.
Belgrove says that while governance requirements have increased for all trustees, those using LDI have witnessed even greater demands on budgets. “There is more complexity involved in some of these investment instruments, and a lot more jargon and terminology for trustees to get their heads around,” Belgrove says.
This view is echoed by Ian Mills, partner at consultant Lane Clark & Peacock, who says pension funds are undoubtedly tempted by the 25 to 30 basis points of extra yield that can be garnered from using Gilt repos, for example, but there are aware this comes at a price. “More sophistication definitely has increased the burden on pension schemes, particularly those that look to do this kind of thing themselves,” Mills says.
Some investment managers running more complex LDI strategies claim trustees have no problem getting to grips with what is involved. Helen Farrow, head of institutional business at Ignis Asset Management, says forwards are intuitive and trustees can understand them. “If I told you that the three-year interest rate was 3% that tells you nothing about the path of rates; it’s just an average over next three years. Trustees can understand that we are getting underneath those averages and that concept is not a difficult one”.
Even where LDI tools and strategies cannot be explained simply, trustee boards have spent the last decade investing in training, as well as employing more expertise. Belgrove says he has seen a marked increase over the last decade in the number of trustee boards that are ‘upskilling’, in other words bringing in more talent and allocating a greater amount of time to training and education.
The role of independent trustees, too, has been vital in helping some schemes climb up the knowledge ladder enabling them to take on more complex LDI strategies. Mark Ashworth, director at independent trustee firm Law Debenture, says: “The motto is train, train and train again, and train specifically about what is proposed. Trustees must understand the mechanics and the risks and costs implications across the whole strategy.”
Managing trigger mechanisms also requires a level of dynamism that was largely unrequired for the LDI strategies of old. Such time-intensive monitoring demands do not sit well with a trustee model founded on quarterly or, at best, monthly meetings. However, Belgrove says there have been marked improvements here too, with trustees meeting more frequently and creating investment sub-committees to take on some aspects of portfolio management.
The scheme sponsor can also play a visible and proactive role in the setting of LDI strategies, taking positions in joint sub-committees or joint working groups. Raj Mody, chief actuary at PricewaterhouseCoopers, says: “The corporate sponsor can bring expertise to the joint committee through its treasury function, so even if you don’t have massive expertise on a trustee board it can come from the sponsor.”
Of course for many schemes, notably those of the smaller and medium size, there remains a governance budget deficit when it comes to taking LDI strategies to the next level. Predictably, investment managers are keen to ensure this does not preclude smaller clients from taking advantage of the complex tools on offer.
Insight’s Aukett says more than half of its LDI clients by value are run on a delegated basis with the fund manager taking a fiduciary role in terms of running the mandate. BlackRock launched its WayPoint service in June which offers daily portfolio monitoring aimed at schemes with less than £500m in assets.
Advances in LDI continue to push schemes towards healthier funding positions and while they come with additional governance demands these need not be a deterrent.
Investment managers, investment consultants, independent trustees and even scheme sponsors are available to help trustees put these new tools to good use and while they undoubtedly constitutes hard work, the rewards may prove worth it.