Investment framework with a buzz

Investment framework with a buzz

By Kate Burgess

Published: November 6 2006 02:00 | Last updated: November 6 2006 02:00

A couple of years ago, it would have been hard to find anyone in the UK's financial services industry muttering "liability driven investment". Now everyone is at it. LDI, as it is known, has become a buzzword for pension fund managers and trustees, investment banks and investment consultancies.

Most companies involved in UK pensions are offering clients access to LDI in some form of product or service.

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In essence, LDI is an investment framework that seeks to match, wholly or in part, pension fund assets to the promises made to employees and pensioners.

In most cases, it involves some use of swaps and derivatives to hedge out the risks such as changes in inflation and interest rates that can eat into a pension scheme's ability to keep these promises.

Exponents of LDI say the need for a new approach became acute after a combination of falling equity markets and changes to the accounting rules on pension funds crystallised big and volatile gaps between equity-dominated portfolios of assets and pension plans' liabilities. The industry, it emerged, had been focusing on matching the performance of peers or a benchmark without close reference to liabilities.

And low inflation and low interest rates meant there was little hope of the value of assets ever catching up - as managers had hoped - with these liabilities. Meanwhile, the UK's new Pension Regulator made it clear he wanted companies to clear these deficits within 10 years.

At first, LDI was a popular term bandied around at conferences with few funds actually adopting it. But a report last month by consultants Hymans Robertson said in the past six months LDI was "beginning to gain traction". It forecast a 20 per cent increase in LDI business by 2010.

Interest is also growing in the US where the Financial Accounting Standards Board now requires companies to value pension fund deficits on balance sheets by December in much the same way that UK companies do. A survey last year by JP Morgan Asset Management found that half of US retirement plans view the need to hedge against swings in liabilities as a reason to change investment strategies.

Leaders in the field of LDI, such as Barclays Global Investors, State Street, Legal & General and Insight, have spent millions developing new products and services, channelling resources to building LDI expertise, recruiting investment consultants and bankers, and bringing in experts on derivatives and alternatives sometimes at the expense of mainstream equityanalysis.

As more product providers enter the fray, the meaning of LDI is expanding and blurring.

At one extreme, LDI is interchangeable with liability-matching, where managers try to replicate the cash flows needed to pay benefits. This involves buying a series of fixed-income bonds or using interest rate and inflation swaps.

The industry argues, though, that LDI is a long-term investment discipline looking at risk in new ways and placing a plan's liabilities at the heart of the investment process.

Things have moved on since WH Smith pension fund - a pioneer of LDI - last year switched almost its entire investment portfolio into swap contracts designed to last 50 years with Goldman Sachs. The company's and trustees' goal was to eliminate all the risks posed by interest rates, inflation and stock markets that might endanger the scheme's ability to pay its pension promises. WH Smith kept only a small proportion of the fund in equity call options.

However, this is too expensive a process for most companies.

Switching to bonds and swaps locks funds into low-return assets that limit funds' flexibility should markets change. They also lock company sponsors into paying higher contributions to make up for the lower-risk/lower-returnprofile of the assets. WH Smith agreed pension contributions of £52m over three years to shore up the pension fund deficit.

Increasingly, therefore, pension fund trustees and sponsoring companies have turned to a model of LDI that has fixed income and swaps on the one side with a high-return portfolio on the other designed to deliver above-market returns to help funds close their pension deficits.

The likes of Schroders and BGI's strategic solutions group claim their aim is to restructure portfolios with a clear risk budget, replacing unintentional risks that are not properly rewarded with a range of risks across different asset classes that are properly rewarded.

Mercer Investment Consulting estimates that "one in 10 UK pension funds will consider introducing some kind of liability benchmarked strategy, split equally between those implementing a passively managed swap strategy (either an overlay strategy or in place of traditional bond mandates) and those implementing actively managed liability benchmarked strategies, or 'LDI plus'-typemandates".

BGI has about 40 clients with about £25bn in assets using LDI strategies and not one of them is the same, says Andy Hunt, senior strategist in LDI at BGI. Last year more than 125 funds made inquiries about LDI.

Inevitably, the explosion of LDI products is fostering a certain level of cynicism with observers who worry that LDI brings with it a new set of risks. Changes to assumptions on longevity, for example, will put tremendous strains on the model. So, too, will a sudden shift in interest rate or inflation expectations. It is important that funds keep some kind of exposure to assets that can deliver some kind of capital appreciation over the longer term, they say.

But despite these anxieties, LDI is here to stay, says Mr Hunt. "LDI is not a cottage industry any more. It has become mainstream."