Right across Europe, changes in accounting methods, the regulatory environment and formerly slap-dash investing strategies are pushing institutional investors to apply the strictures of liability-driven investing (LDI) and gobble up derivative products.
Or at least that’s the official story. Touted often and loudly as the solution to the current pensions’ shortfall, LDI has taken on the profile of a messiah strategy. The reality is that in the UK most LDI strategies involve few derivative products, concentrate on cash-flow and confuse many trustees.
“There is frequently confusion over what LDI means, that there is no unique solution and often it’s down to the parties promoting it for certain approaches,” warns Ralph Frank, an LDI specialist with Mercer Investment Consulting.
What is new is the explosion in asset management companies promising to fulfil an LDI mandate using products once only the playground of investment banks. At the same time, investment banks are stepping on consultants’ toes by offering pensions advice on calculating liabilities and strategies to combat the problem.
Appetite for risk
“The old strategies of benchmarking are falling away, most managers haven’t focused on liabilities and their linked appetite for risk, but there needs to be differing solutions for different clients,”says Joe Moody, head of LDI at State Street Global Investors, (SSgA).
The UK is seen as leading the European markets, in part because of its higher reliance on equity investing than commonly found on the continent and a greater need to sort the problem out, but also because new regulations on liabilities have arrived there first. Interest in the Netherlands has been strong too.
In essence these ‘new’ strategies set out to limit risk on those assets that can be used to cover a fund’s expected liabilities as identified by actuaries. In the case of pension funds these liabilities are the cash that has to be paid out over a period of time to their pension-holders.
For a start, deficits to the pension of company now go to its books as a debt and finance directors are being forced finally to make sure the trustees live up to their jobs of covering liabilities.
The reality in the UK of LDI is that its use of derivatives is all but limited to swaps, with few fund managers having the opportunity to implement strategies across the portfolio
that boost alpha in conjunction with limiting liabilities.
One exception to the full-on LDI strategy is UK retailer WH Smith which sold all of its shares and bonds and invested the £870m (€1.27bn) proceeds in a portfolio of swaps and equity options under the auspices of SSgA. Goldman Sachs acted as consultants.
“We were worried about the liabilities and using an SSgA product, 94 per cent of our assets were put into swaps to guard against inflation and interest risk over a 50 year duration and 6 per cent went into long-dated equity options,” outlines Martin Ashford, group pensions manager for WH Smith.
But the retailer had the luxury of having closed its defined benefit pension to new members in 1995. For younger, developing pension funds such a strategy may be highly undesirable.
For WH Smith and for many in the UK, LDI is the same as de-risking cash-flow. Not the same in the Netherlands, tipped as the next growth hot-spot for LDI, although regulations to force liabilities to be matched have been delayed until 2007. In part the Dutch pension funds have been given a lift by the regulators not demanding that they must match inflation risk.
Match cash-flow
At PME, the €15bn Dutch metal-workers pension fund, Paul van Gent agrees that LDI is useful and that it is a strategy incorporated into the investment policy. “We’ve used the strategy in conjunction with a consultant to match cash-flow risks through the use of swaps and bonds.”
Interestingly, he adds that it needs to be a symmetrical policy since ‘the business we’re in is also to get excess returns’ and while equity options and futures are incorporated, he views the risk profiles over differing durations of other asset classes such as commodities, property and equities as also being core to the strategy. Unlike WH Smith the pension remains open and allocates assets with 53 per cent in fixed-income; 32 per cent equities; 8 per cent direct Dutch real estate; and 7 per cent commodities.
“Apart from the Dutch, some Belgian funds have already taken LDI on-board,” explains Mr Moody. He has also noticed a lot of interest from German corporates on a global basis, but few sales as yet.
Whatever the developments in Europe, the demand by the UK regulators that liabilities are linked to bond returns has created something of a problem for LDI. Firstly, there is the problem of education with the trustees’ life-long suspicion of derivatives. Secondly, it has allowed much of the industry to focus purely on cash-flow matching which in turn has produced the third problem of having to buy over-priced bonds.
“Certainly these moves are going to require more education, the trustees probably weren’t clear over the past few years what their risks were but that’s changing with asset management houses and investment banks, along with consultants doing a good job in education,” observes Steve Goldman, European and Sterling product manager with Pimco.
“Corporate sponsors haven’t been comfortable with liabilities and have been pushing education,” adds Mr Moody. He points out that now corporate financial directors are involved, their experience in raising finance and derivative products has helped.
But as the corporate finance officers have rushed in to stop pension liabilities from haemorrhaging their companies’ asset value, the focus has been purely on cash-flow liabilities. “It’s true there’s a lot of attention now on cash-flow matching, which is often seen as being the LDI solution,” says Mr Frank.
Liabilities can be matched purely by investing in swaps that cover not just the projected outflow of cash over time but also interest rate and inflation factors.
In many cases this is done with a view to eliminating any risk, in others there is a view that there should also be out-performance of the liabilities covered.
“In our case we create a liquid bond benchmark return to match liabilities and as active bond managers we like to add value by performing one to one and half per cent over benchmark,” outlines Mr Goldman.
In most cases, whether seeking to give out-performance on the cash-flow strategy or not, by using over the counter (OTC) products, has led to a few problems. This is purely that the demand for long-dated bonds is outstripping supply and the yields are falling to record lows. This is partly due to UK chancellor Gordon Brown’s much-vaunted prudence, which saw the government issuing much less debt in the early days of the Labour government. It is also due to ever-increasing demand on the hedge fund industry and now the institutions.
Paradoxically, according to Mr Goldman, this increased demand for bonds for underlying derivative products through the growth in the hedge fund market has made such products cheaper to deal in for the pension schemes.
“It’s true that the margins on vanilla envelope swaps are very tight unlike other derivatives which have more opaque pricing,” agrees Dominic Delaforce, co-head of LDI at Aberdeen Asset Managers.
On the other hand, points out Mr Moody, these falling yields continue to increase pension liabilities. If you have £100 of liabilities and invest in a bond with a five per cent yield to cover yourself but the yield falls to 4 per cent, under the regulations that one per cent fall is multiplied by the duration of the scheme. “If that’s 20 years, that means liabilities rise from £100 to £120 and even if you’re equities gained 10 per cent, you’re still negatively correlated,” says Mr Moody.
So has the solution already reached unattractive prices stopping others from following, or are those firms already using this strategy likely to see their deficits continue increasing? The difficulties facing pensions are likely to remain and as asset managers continue to match asset values to liabilities, there remains a future danger.
Expensive Tailor-made solutions leads to flood of new pooled funds
The trouble with drawing up a strategy to match your income to your liabilities is that it is an expensive business. ‘Each client’s needs are unique’, is the mantra, so it should come as no surprise that the sector is being deluged with new pooled liability-driven investment funds.
To put it bluntly their attraction is that they are cheap, at least relatively.
Barclays Global Investors (BGI) has made the biggest noise in the sector following a series of 20 UK domiciled liability-matching funds currently worth about £2bn, with another 16 pooled funds aimed at UK and European pension funds that want to outperform their liabilities.
Similarly State Street Global Advisors (SSgA) has launched a series of euro and sterling-denominated products, with US dollar pooled funds to follow.
“We created them for the smaller- to medium-sized schemes that can’t afford the governance budget or costs of the more complex instruments,” explains Joe Moody, head of LDI with SSgA.
For smaller pension funds, the costs of following LDI can be unattractive. In more precisely assessing liabilities, providing the range of instruments to match them and then assessing counter-party risk and all the legal detail involved, it becomes an expensive matter. Instead firms like Fortis, Insight and Standard Life Investments have joined the ‘pooled club’ offering various choices of interest rate, inflation-linked cash-flow products but in a unitised form.
The products vary, with SSgA’s UK inflation-linked products linked to limited price indexation (LPI) rather than RPI – the level of inflation that UK pensions have to legally match, usually up to 5 per cent per annum. Duration goes up to 40 years.
Fortis launched its first products as euro-denominated LDI funds from Luxembourg saying it could hear the European market calling out for pooled products, in particular the Dutch market as new regulations on liabilities come in next year. It will be going head-to-head with BGI.
Those in the sector admit the limitations of something that was dreamed up to be tailored. “It won’t provide us with a perfect match but it gets some of the way there,” says Mitesh Sheth, responsible for LDI at Henderson Global Investors. By broadly matching the duration of liabilities with specific funds at 10-year intervals can ‘re-budget’ your risk, he asserts.
“It's my expectation that this market is going to grow,” says Steve Goldman at Pimco.
Steve Goldman, Pimco
