Growing pressure from national regulations and international accounting standards is forcing European pension funds to look more closely at their liabilities and the extent to which these are covered.
It is argued that pension funds’ traditional method of aligning assets and liabilities by means of asset liability modelling and strategic asset allocation may no longer be enough.
Pension fund managers need to match their investment strategy to the profile of their funds based on the expected future cash flows – what needs to be paid out as pensions.
The post bear market message is that pension promises must be properly protected in future. There must be no pension losers. All must be winners.
As a result, there is a growing interest in liability matching, often with the use of derivatives, and liability driven investment (LDI) strategies.
LDI is attractive for two reasons. Pension funds see it as a way of delivering their pension promise at a reasonable cost, while asset managers see it as a new service to offer to clients who may be disillusioned by active equity management
But how significant is this change in approach? Is liability matching and LDI merely a passing asset management fashion, like the move from balanced management to specialist management?
Or does it represent a permanent change in the way pension funds and their asset manager manages pension assets in order to be able to deliver their pension promise?
The pension fund managers and administrators who responded to our survey generally support the
second proposition. Overall, the feeling is that liability matching and LDI represent a real change, or rather development, in pension fund thinking.
Inevitably responses were coloured by the pension systems in the different countries which IPE’s readership reside. One Belgian pension fund manager points out that “In DB schemes the benefit is irrevocably linked to the final salary, which is linked by law to inflation. Here the only liability matching asset is the inflation-protected bond, whose availability and return are not really impressive.”
Opinion is fairly evenly divided over the question of whether pension funds should match their liabilities before they do anything else, with a slight majority in agreement. However, there are concerns that liability matching is too limited a response. The manager of a Dutch pension fund says funds should “look for total solutions”.
A large majority – four out of five – agrees that pension funds’ adoption of LDI strategies is a sensible response in today’s regulatory and investment climate. Some, though, say that cost is an obstacle.
Perhaps LDI is simply reinventing the wheel? It could be argued that almost any pension fund investment is, in a broad sense, ‘liability-driven’. Again opinion is evenly divided over this question, with only a small majority agreeing. “Many did it before – but many didn’t,” one manager observes.
However, the manager of a UK pension fund is sceptical that traditional pension fund investment strategy is liability driven: “You cannot claim to be ‘liability-driven’ with a highly disproportionate part of assets in equities if your fund is mature. This is just playing with words. Perhaps risk-related rather than liability driven would be a better test.”
The manager of a Belgian pension fund suggests that it is a matter of size “Large and medium sized pension funds that can afford ALM type studies tend to be_liability-driven. Small funds tend to have an ‘asset only’ view.”
This is one of the objections to LDI. It may be a good idea, its critics say, but it is too costly for small pension funds to implement. Our respondents do not see this as a problem, though. A clear majority – two in three – disagrees and thinks that it should be possible to adapt LDI to smaller schemes.
Cynics may suggest that LDI strategies are simply another way for asset managers to generate income. Yet this suggestion is rejected by a clear majority of our respondents. “It is much less profitable than active management,” one pension fund points out. Yet there is no doubt LDI is a useful sales platform for asset managers. “Some managers are certainly using the concept to sell high cost products” one respondent says.
There is strong disagreement with the suggestion that liability driven investment is just a fad or asset management fashion. Most feel that the need for it is real. The manager of a Benelux pension scheme suggests “the rationale behind it is the tightening of the control authorities, accounting standards, and growing risk awareness”.
The flight into fixed income is one of the consequences of pension funds’ need to match liabilities. But is it wise to buy bonds, regardless of price, to immunise long-term liabilities? Opinion is divided on this. Some pension fund managers see it as a regrettable necessity. “Accounting standards drive most companies and funds down this route.”
Others wonder whether buying bonds will actually do the trick. One manager warns: “It must be recognised that bonds may not exactly match liabilities For example bonds linked to price indexes will not match pension liabilities for active members. So a fund with such liabilities will need to preserve the ability to generate additional returns, probably by holding equities and property, unless the funding gap is to be bridged by a higher contribution rate.”
Another points out that “liabilities are not bond-like. They are much less like bonds and much more like equities than many now think.”
It has been suggested that the increasing use of derivatives, such as swaps, may be behind the growing interest in liability matching. There is limited support for this suggestion from our respondents. “Derivatives are a tool to help achieve it, not the driving force,” says one.
Others see the use of derivatives as an enabling device rather than a driver. “It has helped increase awareness of the facility to understand the nature of the risk faced by pension funds and the capacity to hedge against them,” one pension fund manager remarks.
Whether liability driven investment will become the dominant investment strategy in the future remains an open question. Slightly more than half our respondents think it will. One UK manager observes that “liability driven investment is not a single strategy or need not be labelled as such. But funds will undoubtedly be far more aware of the link between assets
and liabilities and the exposure they risk if they deviate from a linked strategy.”
Yet there are doubts about the importance of LDI. The manager of a Dutch pension fund suggests that LDI strategies will matter “only for marked to market business”. Another Dutch manager predicts that LDI will dominate “over the next five years but not over the long run”.
A continuing recovery in the equity markets should, in theory, lead to a diminished interest in liability matching and LDI diminish. Yet only a minority of our respondents believe this is likely to happen. Other factors such as accounting issues, and the huge impact that a reduction in gilt yields has on fund liabilities, will ensure that interest remains high, says one pension fund manager.
Another says interest will not diminish because LDI is not, or should not be, synonymous with the use of bonds.
The EU pensions directive, due to come in force this month, could ensure continued interest in LDI, chiefly because of its requirement for pension funds to cover their technical provisions. Here there is broad agreement. A clear majority of our respondents – four out of five – agree that the directive will encourage interest.
Finally, it has been suggested that the immunisation of liabilities, can only work properly in pension schemes that are closed to new members. A minority agrees. “They definitely work best in closed schemes where the variable of starting pension is taken out of the equation if there are no members in active service,” the manager of a UK pension fund says.
However, a large majority disagrees. “Pension plans with new members have changing liability profiles but the principle still holds,” one respondent observes. “Matching should be a dynamic process. It should not automatically be done in full,” another points out.
One UK pension fund manager sees the key issue as mortality risk rather than fund maturity: “The more mature the fund the more clearly defined are the total liabilities, making matching easier. But even there you cannot get precision, due to mortality risk.”
So there you have it. Ultimately the only truly closed pension fund, and the only one where perfect liability matching is possible, is the one where the mortality of its membership is known.
This is a tall order. As the economist John Maynard Keynes said in the long run, we’re all dead. But how long is the long run?