It is hard to believe that three years ago, liability driven investing, was not even a blip on a fund manager's radar screen. Now it is an embedded entry in the financial service industry's vernacular, especially in the UK, Netherlands and Scandinavia. Regulation and accounting standards have been the main driving forces, although glaring pension fund deficits, ageing populations and volatile markets are likely to motivate the rest of Europe to take a hard look at their pension scheme's assets and liabilities.
As with any new trend, change can be gradual and pension funds across Europe are not only at different stages at incorporating LDI strategies but also in assessing their attributes. Andrew Dyson, head of institutional business at BlackRock in the UK, notes: "Countries in Europe are moving at their own pace and this is true even for those who adopted a LDI strategy. At the moment, there is no pan-European strategy and what is appropriate in the UK is not necessarily going to work in Denmark due to the different regulatory environments and requirements."
According to a recent report on LDI in Europe conducted by JP Morgan Asset Management, a fifth of the respondents across Europe are currently using an LDI strategy while a third are contemplating such a move. Only a mere 10% of those questioned view LDI as the latest fad in the investment world. The countries leading the pack are Denmark, the UK, Netherlands and Sweden. The US-based firm canvassed about 214 pension schemes across 14 European countries representing total pension assets of €750bn.
The common thread among the four countries is regulation that emphasises valuing liabilities using market rates. Denmark was a trailblazer, introducing a so called traffic light solvency system in 2001 which used mark to market values and shock-based risk analysis. Sweden, which debuted its own version in 2006 for its insurance industry, uses three signals - green, yellow and red - to help funds monitor their exposure to different classes of risk - share prices, exchange rates, Swedish and foreign interest rates and credit. The aim is to provide an objective starting point from which to assess a fund's capital funding requirements above its capital buffer.
After much debate and discussion, the Netherlands has finally launched the Financieel Toetsingskader (FTK) this year. It plans to use a mark to market system whereby pension fund liabilities will be calculated using variable interest rates depending on the duration of their liabilities, rather than the current fixed 4%.
The UK pension scene, on the other hand, has been guided more by accounting standard FRS 17, which came into force three years ago, obliging companies to report year-by-year changes in the value of their pension funds as gains and losses, instead of smoothing out the variations over many years. Businesses have to display the shifts in value on their balance sheets, rather than using actuarial predictions of funds' likely positions.
The Accounting Standards Board, the UK's accounting regulator, recently announced a shift to bring the FRS 17 standard more in line with IAS 19, which gives companies a choice between ‘fair value' - a snapshot valuation of the assets and liabilities of a pension fund - or spreading the valuations out over a period of time.
The JP Morgan study revealed that LDI is the most relevant to defined benefit (DC) and defined contribution (DC) plans with a guaranteed element, according to Karin Franceries, head of client solutions Europe, JPMorgan Asset Management. The UK is the most impacted with a recent survey by UK based Alexander Forbes Financial Services predicting that almost half of the UK's defined benefit DB pension schemes (mainly final-salary plans) schemes will close within five years. This is mainly due to the rising cost of working through the red tape of the Pension Act 2004, which is designed to protect members of final-salary schemes.
Ironically, however, despite these findings and the fact that 74% of schemes in the UK are running a deficit - the highest in the JP Morgan survey - the country is the most reluctant to embark down the LDI path. Only 44% of schemes in the UK are using or considering LDI compared to the Netherlands, which is set to be the biggest user, at 66%. Denmark and Sweden, both follow at 53%.
One of the reasons perhaps is that the three other countries have to comply with much more stringent funding requirements. Also, trustees in the UK are more circumspect abut LDI's attributes. "One of the issues in the UK is having to make the case to the trustees, especially those working at the smaller end of the pension fund spectrum. Before they make any decisions, they want to feel comfortable and have a full understanding of the process," notes Francis Fernandes, director and head of pensions actuarial at Citigroup.
Franceries believes, though, that the mood will change in the UK as more schemes realise that LDI extends beyond simple cash flow matching and can help deliver alpha generating returns. This has already happened in the Netherlands, Denmark and Sweden whereby schemes are not only looking at LDI as a fixed income strategy but as part of a risk/return framework. For example, pro LDI schemes in the Netherlands have a marginally lower allocation to fixed income products but are more diversified in their alternatives asset allocation.
Meanwhile, Denmark and Sweden, whereby 92% of respondents were running a surplus, were by far the highest users of derivatives, according to the JP Morgan Survey. Danish schemes were ahead of the pack in their use of swaps and swaptions while Swedish plans preferred options, futures and forwards.
As for the rest of Europe, there is currently no compelling reason pushing them to embrace LDI, notes Joe Moody, head of LDI at State Street Global Advisers. "Unless there is a law, we see reluctance on the part of pension funds to tackle their deficits," he says. This is certainly the case of countries such as Germany and France where state pension funds dominate the landscape and funding requirements are not based on the market value of liabilities in these markets.
Regulators in Ireland and Switzerland are also exploring their options although no immediate action is expected to be taken. The Swiss pension system, however, may feel the heat more intensely. The industry has come under the spotlight recently after Zurich public prosecutors arrested a senior pension fund manager, for allegedly accepting a bribe.
Other pension funds have come under a cloud over the Swissfirst affair, with allegations regarding insider trading.
Industry experts also believe that international accounting standards might act as a spur to raise LDI's profile. Maarten Roest, head of LDI & structuring specialists at ABN Amro Asset Management, adds: "There are certain countries which have different pension systems such as France and Germany and the magnitude of demand for LDI solutions is much lower, but is picking up. International accounting standards apply to all multinationals regardless of where they are based and they generally have large pension liabilities. Moreover, there is Solvency II (which will introduce a new risk capital framework) for insurance companies. As a result, I think these regulations will fuel further demand for LDI products and solutions across Europe."
Paul Bourdon, of Credit Suisse Asset Management, agrees, adding: "There may not be any pressure in general for companies, for example, in Germany or Switzerland, to adopt LDI for their pension schemes, but if they are having to comply with IFRS, it will encourage them to sort out their pension commitments and manage the impact of pension schemes on their accounts. If they do not, then they are at risk of being penalised when investors make comparisons with other