LDI Debate Participants
AC, SSGM What are the most important of the factors that have changed the pension fund landscape and which will remain with us?
RB, UBS The economic problem of falling real yields is the problem and accounting changes have then highlighted it.
JM, SSGA I agree. Real rates of return over the last century have been around 1% in the UK. As people adjust to a return to those levels, they have to risk-manage the effects of previous unrealistic expectations. Nominal yields have recently driven down real yields as inflation expectations have remained largely unchanged. Also, the relationship between traditional bonds and equities during the 1990s was positive relative to liabilities. Since 2000, the relationship between assets and liabilities has become negative. This year consultants report increases in deficits, and that’s largely through still not having a good understanding of the mix of assets and liabilities and how they move relative to each other.
EM, Standard Life While it’s true that real returns on risk-free assets over the past century have been about 1%, I think that is the ex-post outcome. Investors no doubt expected that they’d do better than that, which raises the question: “Do you want to deliberately buy 50-year index-linked gilts yielding 0.6% when you can still buy 30-year Japanese bonds with a real yield of around 2.4%, simply because the Japanese don’t yet have our asset-liability-matching approach to investing?”
 |
David Blackwood, ICI (r):
LDI is about making the right risk immunization trade-offs |
AS, WH Smith The regulations have been key, though. An increasing number of funds are closed to new members, so we’re having to focus on something that was previously a problem for tomorrow.
RB, UBS Exactly; we no longer try to come up with projections for funding a pension at some point in the future; now we have a crystallized debt that needs to be managed as debt. To be fair to the corporate sector, they’ve had to respond to significant regulatory changes. You’ve got a hard guarantee now, and that was not the case in the past, when you were able to either walk away or wind up.
DB, ICI The view that it wasn’t a contractual promise, and it is now, is probably a bit generous to corporates in explaining the mess. It’s clear the FRS17 accounting standard brought transparency, but it shouldn’t have changed the way corporates fundamentally valued their liabilities. The bottom line is that corporates just didn’t understand the promises they made.
SB, Barclays Capital Well, I think the regulatory changes of the [UK] Pensions Act 2004 placed the financial and risk implications of the pension promise on the sponsoring corporate in a much more visible manner. The introduction of the Pensions Protection Fund (PPF) levy and the clearance procedures established by the pensions regulator increased corporate awareness of pension funding and risk implications. So, regulations contributed to growth in LDI implementation.
MK, Watson Wyatt As well as being a key focus for the corporate sponsors, the legislation has meant a shift in the balance of power towards the trustees. They typically want more contributions to the fund, less investment risk and more focus on benefit security.
DKA, Merrill Lynch There have been two other major changes, neither of which was anticipated five years ago. First is the advent of marking to market. Pension funds today need to know what the mark-to-market extremes will look like. Second, pension funds believed that even if FRS17 became the measure of liabilities, they would not have to change their behaviour. That was a miscalculation because the pensions regulator said: ‘Either you fund the deficit or I will put constraints around what you can do in the company’. Now, two years on, companies are injecting huge amounts of money into their pension schemes, the equity market has returned 50% over the past few years, and the deficit has still got bigger. So companies need a solution and have turned to LDI.
Joe Moody, SSGA:
trustees must identify the risks and their view of the liabilities |
 |
JM, SSGA There’s certainly a growing recognition of the cost of the implicit promise and people are now asking how they pay for it. I also don’t think we should forget demographics. People are drawing pensions for much longer and that is a big cost.
CHy, LGIM And that problem has been emphasized by the fall in interest rates. The apparent cost of paying an extra year or two’s pension in 20 years is less when rates are high because of the effect of discounting.
Waking up the trustees
AC, SSGM How do you get trustees to focus on the complexity of underlying issues – rather than just headline numbers, which can mislead?
JM, SSGA It’s worth illustrating to trustees the starting point in terms of risk analysis. This is followed by a forward-looking analysis to evolve different asset allocations in terms of the pension fund’s expected funding ratios. What is the probability of being underfunded in 10 years? Does it improve with the LDI strategy? It is important to look at the distribution of outcomes on the downside and the upside. This is one way of demonstrating the benefits versus conventional strategies. So managing a deficit in terms of risk is not just about setting an expected return target. This is especially acute for an underfunded scheme.
SB, Barclays Capital Many trustee bodies are making the transition from managing “asset performance” to managing the “asset/liability position”. Quantitative measures and illustrations tend to be very useful in forming consensus on the scale of risks and the best ways of dealing with them. Measures of historical asset/liability valuation trends, illustrations of how risk management solutions address the exposures and how the risk/return profile of the scheme might be improved are all useful.
