Judging by the results of a recent European pension fund survey by JPMorgan Asset Management, they could be in for a long wait, for UK respondents were revealed to be most sceptical about widespread adoption of LDI. While 44 per cent of UK investors polled said they use or intended to use LDI strategies, most believed that LDI would be implemented by no more than half of all pension schemes in the UK between now and 2011.
The survey found that the prevalence of scheme deficits in the UK was no spur to embracing LDI. While 74 per cent of UK respondents reported funding shortfalls, they also showed the greatest resistance to using the derivative instruments required to execute an LDI strategy.
Today there are at least 16 LDI product-providers in the UK, whereas only two years ago there were less than five. Maybe these asset managers who are directing much resource and sales effort at what are still uncertain investors should instead consider intensifying their marketing campaigns in continental Europe. For instance, in the Netherlands, 66 per cent of pension schemes canvassed said they were either using or thinking about adopting LDI, while in Denmark and Sweden the figure was 53 per cent. And these are countries where well over 90 per cent of respondents reported scheme surpluses.
Significantly, the report pointed out that heavy adoption of LDI in continental Europe is driven not by persuasive marketing but by regulation and compulsion. New funding regulation is being introduced in Sweden this year and in the Netherlands in 2007, while it was noted that schemes in Denmark have been obliged to track assets against liabilities for almost five years.
The report said it is surprising that UK schemes claim to experience very little regulatory pressure to adopt LDI, given that the mark to market value of liabilities is now taken into account both to determine a scheme’s minimum funding requirement and the fee it should pay to the new Pension Protection Fund (PPF). This, it added, might be due to the fact that UK schemes are under less time pressure than pension schemes in the Netherlands, Denmark and Sweden to plug a funding gap.
But while liability-matching seems to be the priority in the afore-mentioned countries, the report said “it is clear” that UK trustees also want to be tempted by the carrot of excess return, “which suggests that some form of alpha generation should be integral to any LDI solution”.
More UK schemes, it is claimed, would adopt LDI if they understood that it could help to reduce their deficits.
In light of the reluctance of UK pension funds to use derivatives, it is interesting to note that respondents indicated a somewhat contradictory preference for leverage in an LDI strategy to address a funding shortfall. Could it be that they do not realise that the use of leverage depends on derivatives? If so, consultants and asset managers need to do more to educate UK pension schemes about derivative instruments. Where UK schemes are willing to use derivatives, they prefer an asset manager to execute over-the-counter transactions on their behalf.
The biggest users of derivatives are schemes in Denmark and Sweden. Danish funds recorded the highest use of swaps and swaptions, while Swedish schemes used the most options, futures and forwards. Derivatives are most commonly used for currency hedging, while around one on four schemes are using them for liability matching and one in five to manage equity risk.
But maybe there is hope for the legion of LDI product-providers touting for business in the UK. According to consultants Watson Wyatt, the use of inflation-linked swaps in the UK will more than triple this year to Ł9bn on the back of increased demand by pension funds.
And Robert Hayes, head of strategic advice and solutions at Merrill Lynch tells FT Mandate that the trend towards bespoke bond mandates will lead to increased use and acceptance of derivatives, particularly interest rate swaps and credit default swaps.
JP Morgan’s LDI report anticipated “huge growth” in the swaps market over the next three to five years on account of the lack of sufficient long-duration issues in either government or corporate bond markets.
Asset managers vying for UK institutional business in the alternative investment arena have been playing a waiting game for the last five years. A trickle of mandates has resulted during that period. Are LDI managers prepared to be so patient?
Henry Smith, editor
henry.smith@ft.com
