When WH Smith, the UK newsagent and stationery giant implemented a liability driven investment (LDI) strategy in September 2005, it offered hope that the final salary scheme could remain open for existing members.
But having ended the scheme for new employees in 1996, WH Smith has announced it has started consultations about closing the defined benefit pension fund to existing members as well.
Does this mean LDI does not work? Interestingly, Alan Stewart, finance director of WH Smith, argues that the LDI strategy has been successful.
He says 94 per cent of the £870m (€1.3bn) pension fund bought derivatives in the form of a Libor-linked cash fund in September 2005 to hedge the fund’s interest rate and inflation risk.
Outperformance targets
“The other 6 per cent was invested in equity call options over seven, eight and nine years,” says Mr Stewart. “We did this to profit from any equity market outperformance over bond markets.
“This gave us an effective exposure to equities of £430m. In the worst case scenario, the options would cost us £50m after nine years if equities underperform.
“The LDI strategy has allowed us to focus on our investment policy to try to close the deficit by controlling the level of risk facing the scheme.” The deficit has fallen to around £100m.
He adds that the LDI strategy had quite high set up costs and ongoing fees. By implementing LDI, however, the scheme has saved fees through not using active management. “This has brought a benefit in itself.”
But if LDI has been working well why is the final salary scheme closing? Mr Stewart says: “We decided to close it to existing members because only 11 per cent of employees are in the final salary scheme.
“The other 89 per cent have the same employment terms in all other respects. We thought it fair to have a level playing field.
“There is also no cost-effective way to hedge mortality risk.”
While mortality risk is difficult to hedge, consultants and investment managers generally believe LDI has a role to play for most pension funds. The key is for LDI to be implemented appropriately for each scheme.
It is argued that LDI can help schemes to maximise liability relative returns. This is based on the premise there are three types of risks. Ravi Rastogi, senior investment consultant at Watson Wyatt, says these are unavoidable, unrewarded and rewardable risks.
“Longevity is an example of an unavoidable risk and, until the mortality swap market develops much further, this cannot be hedged cost-effectively,” says Mr Rastogi. “Schemes have to measure and monitor these risks.
“Some pension schemes thought they only faced equity risk but are discovering they have unrewarded risks like interest rate and inflation risks. These are not usually rewarded, or deliberate, in terms of investment returns and can be mitigated, managed or minimised.
“It is arguable that rewardable risks, such as investing in alternatives, credit or equities, should be magnified or enhanced to boost investment returns.”
Simplistically, under LDI, pension funds hedge interest rate and inflation risks, such as through derivatives or bonds, and use the rest of the scheme’s assets to try to generate capital growth to reduce their deficits.
Joe Moody, head of LDI at State Street Global Advisors, says LDI enables investment strategy to be more flexible. This is through derivatives enhancing equity allocations and making interest rate and inflation risks more predictable.
“LDI is an important part of the process in sponsors understanding the risks of their pension fund,” says Mr Moody. “It thus allows the sponsor to make cash payments to reduce the deficit or use capital more efficiently to narrow the deficit.”
Asset managers talk about using the pension fund to try to generate a targeted return in excess of the rate of future liabilities will growth.
“Trustees need to take a holistic view of the pension fund,” says Mark Miller, head of business development of Fidelity’s UK defined benefits business.
“This should involve understanding the liabilities of the pension fund, the return required to outperform the growth in liabilities and the strategies required to generate this return.
“If trustees decide liabilities will grow by ‘X’ then trustees need to aim for a higher targeted return. To achieve this, the pension fund is likely to comprise a diversified mix
of asset classes to enhance returns and reduce risk.”
Simon Chinnery, vice-president at JPMorgan Asset Management, warns that LDI is not an exact science in terms of trying to generate a targeted investment return. A pension schemes still needs to implement a successful investment strategy to reduce its deficit.
Devil in the detail
Mr Rastogi says LDI is an attractive and relatively simple concept but, as always, “the devil is in the detail of how it is applied to a particular situation and executed.
“Investors should be aware there may be a need to compromise on transparency but the extent of the compromise can be managed. Some packaged solutions are not fully transparent on where the assets are invested and therefore what risk they are taking.
“Derivative pricing is not always fully transparent either. Trustees may be quoted a price but have to pay another price when the transaction is completed.”
Trustees also have to look at the price required to achieve the hedging. “There may be a price at which trustees decide it is more cost-effective to postpone the hedge,” says Mr Rastogi.
Nevertheless, Mr Rastogi says LDI can work as long as the strategy is appropriate for each pension fund. “The LDI concept should be viewed as a long-term companion rather than an immediate and instant solution. It must be monitored and tweaked on an ongoing basis.”
