LDI Debate: Bridging the void
A mixture of accounting issues, demographics, trends in the equity market and a sharp fall in bond yields has revealed the chasm between the assets and liabilities of pension funds in the UK, Europe and the US. Many will be unable to pay their pension promises in full. Most will be pushed into liability-driven investment strategies. But are they a real solution or an expensive act of desperation?
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.
|Alan Stewart, WH Smith:
calling the market at any time is a brave decision
DKA, Merrill Lynch An explanation of the current position is always helpful to trustees. For example, imagine that two years ago you had 100 units of liabilities and you were 20% underfunded, so you had 80 units of assets. Even with a relatively high allocation to equities, say 70%, you’ve only got 70% of 80 – ie, 56 – units of equities working to offset a rise in 100 units of liabilities. If interest rates fall, pushing those 100 liability units to 115, and if inflation expectations rise, pushing those 115 to 130, then even if your equity portfolio goes up by 50%, that only takes 56 units to 84 units against your new liability of 130. That’s why your deficit has gone from where it was two years ago to more now. As Joe Moody says, those dynamics are not always appreciated. AS, WH Smith So the solution is to look at the liability of defeasing excess return assets. But most companies will have to make accelerated payments. The portfolio itself won’t return sufficient to fund that gap.
The LDI solution
AC, SSGM Those are the problems. How does LDI overcome them? Is it a state of mind, a set of questions or can you reduce it to products?
AS, WH Smith Well, in one sense it is a state of mind. People are asking: “How do we meet our liabilities?” rather than: “What do we invest our assets in?”
|Christopher Hitchen, Railpen: hedging at current levels of real yield doesn’t make sense|
RB, UBS There have been two mind-set changes. One, we can no longer assume that the sponsor will make good all the pensions obligations and we must risk manage that. Two, if I hold a pound of equity instead of a pound of bonds, it doesn’t mean my liability is now worth less than before, so now there are capital implications for holding non-matching assets. Pensions are only paid from two sources: investment returns or a sponsor. So if one of them has now become uncertain, I have to ask how much uncertainty and mismatching, I’m prepared to take. MK, Watson Wyatt I believe that LDI is primarily concerned with hedging pension funds’ long-term interest-rate and inflation-rate risk. In many cases, those are not the key risks the fund is facing. There is often a deficit that needs funding or heavy equity risk that swamps any other risks that the fund faces, such as inflation or interest rate risk. So funds need to sort out their priorities in terms of overall risk management before they focus too heavily on LDI.
DB, ICI Well, in my view, LDI is about understanding liabilities and making the right risk immunization trade-offs. My nominal liabilities have no interest-rate element to them but they have real inflation exposure. If RPI goes to 4%, my liabilities will increase significantly. Interest-rate products are a natural risk immunization asset, but LDI doesn’t mean you have to buy a huge portfolio of inflation-linked gilts.
RB, UBS We want to understand the size of the liability problem in today’s money, though, so interest rates have been and continue to be useful reference points.
AS, WH Smith We understand how inflation is portrayed to us from an investment perspective through those two components, the inflation element and the underlying interest rate. So I think we have to look at an interest rate product.
DK, PruM&G That’s true, but you could use a floating-rate asset to defease some of your inflation-linked liabilities, if you accept the way in which monetary policy is conducted. But within the terms of the regulation it doesn’t look like a good matching asset.
|Chris Hatry, LGIM:
schemes can get the benefits of derivatives through pooled funds
AC, SSGM We’ll come back to these strategies later. But before that, people have to choose to move to LDI. Should that decision always be strategic or are there tactical considerations as well? DKA, Merrill Lynch A key consideration is how the risk in the pension scheme compares with risk being run in the corporate. If you view the pension scheme as analogous to a debt that you are running in the company, then a critical question is: “How would I deal with this position if I was running it in the sponsor?” So typically, when trustees ask: “Is now the right time? Will the real yield head back up to 3% at some time soon?” I don’t know, but I would make two points. First, because of the size of risk, you should think very carefully before trying to “call” the market. Second, an increasing number of schemes are heading the same way as WH Smith, Friends Provident and Schroders. It is estimated that there are £1.3 trillion of defined-benefit liabilities and less than £30 billion of long-end supply of government bonds. So if even a small percentage decide to go that way, the price of this instrument – the hedge – will go up. So although real yield levels appear to be unsustainable, from a supply and demand perspective there is every possibility that they will go significantly lower. Is that a bet you want to take, given the non-linear characteristics of the risk you’re running?
JM, SSGA But are trustees taking a strategic market-timing or a risk budgeting decision? First you must identify the risks and their view of the liabilities. Secondly you assess them against the problems they have and the future cashflows from the corporation. Third, they must evaluate what they can tolerate in their solvency and then ask: “What can I get for my money and my risk budget?” Unfortunately, some in the third phase are unrealistic – they say: “Use portable alpha to get me no volatility and a 3% return on top of my swaps.” Well, that’s like saying: “I’d like the equity risk premium, but without paying for it.”
MK, Watson Wyatt It is true that the challenge facing many of our clients is when to switch to a LDI approach. The equity rally hasn’t helped funding levels overall – clients are in the same position or worse than a couple of years ago. In terms of them buying index-linked gilts at negative real yield, some pension funds might want to take long-term interest rate and inflation risk off the table at any cost. Other funds will want to address the deficit risk or the equity risk first.
|Dawid Konotey-Ahulu, ML: implementing a liability-driven hedge can reduce deficit VAR dramatically|
AS, WH Smith Calling the market at any time is always a brave decision. Moving to an LDI structure, you have to be aware of what’s happening, and we wanted that first-mover advantage. We’ll have to assess our decision over the long term, but others will need to assess the market and make a call, as you do in any investment timing decision. RB, UBS Look at Linkers. “First-mover advantage” is a much-used phrase, but if you look at Linker 35 yields, only two years ago they were still above 2% and now they’re at 75 basis points and 60bp on the 55s. And if you look at where 20-year yields will be in 10 years’ time, they’re substantially sub-50bp.
An expensive hedge
AC, SSGM So where are real yields going and what does this mean for the use of this product in LDI?
DK, PruM&G Just because we know that LDI is increasing doesn’t mean that we will see zero or negative real yields. Bond markets have mean-reverting characteristics, and abnormal levels of valuation will not necessarily persist in the same form. We won’t necessarily see real yields back at three, but we shouldn’t dismiss schemes that are prepared to say: “0.6% on an index-linked bond is not an attractive real yield and I’m prepared to sit back and wait for that to normalize.”
DKA, Merrill Lynch I believe the real yield might well go below zero. Why? Companies are saying: “I will put the money into my deficit, because otherwise I can’t run my company properly, but I’m not going to fund it without some kind of protection, so I’ll hedge.” They don’t like these prices, but they’ve got to do it soon because who knows where prices are going? They didn’t think real yield was ever going to go below 2%, then it went to 1%. That didn’t seem sustainable, but now it’s at 60bp. Could it go to zero or below? Yes. And will people buy it there? I think so. There’s a framework in which they have no choice.
CHy, LGIM I agree. It’s a tough decision to hedge completely at these levels but many will be prepared to partially hedge the risks in their scheme. That adds up to a lot of demand and could drive yields even lower. Eventually the supply will come through and the yields will recover to more reasonable levels.
CH, Railpen There’s a psychological barrier to buying at negative real yields. I’d feel a bit exposed, career-wise, as a trustee’s representative, certainly on a 20-year view. If it happens it’s because of imperfections in the implementation, not because you want it to. Hopefully you design your implementation to avoid it.
DKA, Merrill Lynch There seems to be an assumption that if you buy below zero, you’ve done something that inherently makes no sense.
CH, Railpen It doesn’t at current levels.
DKA, Merrill Lynch Agreed, but if I’ve written liabilities that I haven’t hedged and, in common with every type of financial institution, I now have to hedge those liabilities and further, if there is no supply and I have to buy this thing, then I’m going to have to pay a premium for it. The regulator asks: “As a sponsor, what sort of risks are you exposed to? And how do you manage them across your firm? What do you do in the pension fund? And does that in any way deviate from what you do in the main company?” Increasingly we’re seeing CFOs and trustees moving away from the idea that they are seeking relative value from the long-dated debt instrument, towards the idea that they are simply managing risk. At that point, the price becomes almost academic.
SB, Barclays Capital It boils down to risk appetite. Some pension schemes will assess whether they see value in the fixed-income market, form their views and decide to hedge or not. Other schemes might not have the same flexibility. If the trustees are concerned about risk or if the corporate cannot tolerate any downside in the pension scheme, that fund might decide to hedge, regardless of perceived value in the market.
On the topic of whether Linkers have a role to play in LDI solutions, the answer is “absolutely yes”. We suggest schemes consider both linkers and swaps when they design solutions taking into account their relative valuation. In the present market environment, index-linked gilts can offer better value than swap-based solution in certain maturities.
RB, UBS We will see negative real yields, certainly on the Linker 55 this year. I don’t think they will remain negative for too long, but they will range trade between, say, 1% and 0% for the rest of the year. One reason is the PPF’s explicit mandate to invest solely in fixed-income and cash assets when schemes come into the assessment period, and there are already over 30 there, with the credit cycle turning, impacting the willingness and the ability of sponsors to step up to the plate.
Absolute return not the answer
AC, SSGM What strategies – as opposed to asset allocation or specific product choice – are available within the LDI framework. For example, what about absolute return?
|Serkan Bektas, BarCap (r): trustees should pin down the risks
that can be managed
EM, Standard Life Absolute return is not a solution, because the liabilities don’t move in that way. But I think it is a good starting point, because if you have a way of generating a return, say Libor plus 4, you could swap from that onto your liabilities and turn that into liabilities plus 4. The idea of generating absolute return is good, but you also need to manage exposure to movements in long-term interest rates: a return of 10% is pointless if your long-dated liabilities have gone up by 20%. DKA, Merrill Lynch I agree. We look at the value-at-risk (VAR), which we define loosely as the percentage risk of the deficit getting bigger over a one-year period using a 95% level of confidence, and work that out considering the existing asset mix against the liabilities. Let’s say that number was 25% and let’s assume the scheme is 70% invested in equities. As you implement a percentage hedge, we look at how VAR falls. Then we map a decrease in your equity allocation from 70% down to zero, and look at how the VAR falls. Often we will find that implementing a liability-driven hedge reduces VAR fairly dramatically, sometimes by more than a reduction in your equity allocation. Often trustees want to reduce exposure to interest rates and inflation, and then look at where that VAR level is. Say that takes you down to 12%, they’re then happy to look at a different strategic mix of alternative assets, which takes their VAR back up to a level that makes sense. But you start by taking this unrewarded risk off the table and then leg your way back in to a level you’re comfortable with.
AC, SSGM So conceptually at the overall planning level you’re almost creating two portfolios; a defeasing one, and a return-seeking one?
DKA, Merrill Lynch Yes, but you don’t have to take all the interest-rate and inflation risk off the table. You can combine that with the creation of the return-seeking portfolio, and that gets you to where you want to be on the risk surface.
|David Knee, PruM&G:
A lot of schemes still need a large amount of alpha
EM, Standard Life I don’t see it as an aggressive portfolio and a liability-matching one. I would have a Libor-plus portfolio and deal with the liability-matching element as an overlay. That is the most efficient way, because then you have two skill sets: the people trying to make money and the quantitative job of moving from Libor-plus onto liabilities-plus. MK, Watson Wyatt You can have a portable alpha overlay – subject to issues of trustee governance and understanding the arrangements. This may be a more efficient method of spending the risk budget than dividing into liability-matching and return-seeking assets. Both options have merits, depending on the governance budget of the particular trustee group.
AC, SSGM Trustees are going to have to get over their aversion to derivatives, aren’t they?
SB, Barclays Capital The asset-liability position needs to make sense and the risk/reward position that implies needs to be appropriate. But having the ability to utilize derivatives probably opens a greater range of avenues than if you exclude them. Derivatives will not be appropriate in every case. One needs to look at relative pricing, relative overall advantages and disadvantages of matching certain components – derivatives versus bonds, for example. But informed use of derivatives is certainly indispensable.
DK, PruM&G Schemes can go some way without the use of derivatives. If, for instance, you just bought the three longest-dated gilts in order to match yourself from a duration perspective, you’re taking off significant risk.
SB, Barclays Capital It’s useful to measure the liability exposure in both cashflow and valuation terms when assessing the usefulness of swap solutions. I think inflation exposure is well understood in that if inflation increases, liability cashflows will increase. Inflation swaps can match the movement both in cashflow and mark-to-market valuation terms.
Interest rate risk management introduces other considerations. The liability – the amount of cash payable to scheme members over time – isn’t a function of interest rates. You have instruments that match that liability cash flow subject to credit risk, as in bonds. These instruments can match both the cashflow and the valuation risks. But you also have another solution, which is to eliminate long-term interest-rate valuation sensitivity by recasting your long-dated interest-rate exposure into a short-dated interest-rate exposure. Interest rate swaps achieve this and function as a shock absorber, a source of protection from market movements. There is a risk mitigation benefit to interest-rate swaps, but it’s different to bonds.
DB, ICI I think derivatives are a very important piece of optimizing flexibility. There are halfway-house products where you can enter into arrangements using derivatives to give you better cashflow matching, but without the onerous requirements of Isda.
JM, SSGA Embracing derivatives provides the maximum flexibility to deal with liabilities; you’ll certainly get a superior investment solution than if you’re only prepared to buy just a couple of long-dated gilts.
|Mary Kerrigan, Watson Wyatt
LDI is now available to the whole spectrum of smaller schemes
CHy, LGIM Schemes can get the benefits of derivatives without the complexity through pooled funds, for example a fund investing in an actively managed corporate-bond portfolio and incorporating swaps to increase duration, within the pooled wrapper. That can make more sense than investing in, say, an over-15-year corporate bond index, because it gives wider diversification. Derivatives are now an ordinary tool of fund management, and more funds are going to include them. DB, ICI The constraint will be finding trustees who are financially competent and capable of understanding them.
CHy, LGIM That’s true in a segregated environment for a swap overlay. But where the derivatives are within a pooled product, trustees may feel less intimidated.
DKA, Merrill Lynch We often find that our clients are relieved when they realize that whatever swap product we’re pitching is also available from an asset manager off the shelf. Trustees understand the proposition, they know how much risk they want to take off the table, they want to do the transaction, but the collateral and documentation is a lot to ask, and they’re often very happy to be offered a product.
RB, UBS The development of those products has revolutionized everything. There is a tipping point at which the client must fundamentally trust that the fund manager knows what he’s doing, and that’s part of the reason why you’re paying him in the first place.
MK, Watson Wyatt These products have opened up the whole LDI spectrum to the smaller schemes in particular. They couldn’t have considered LDI before because it was just too complex. From a governance perspective and also in many cases too costly.
RB, UBS As well as swaps, there are the nonlinearities – for example, puts or put spreads or collars and spreads, or credit default swaps.
AC, SSGM Is it fair to predict a proliferation of alpha-seeking assets as LDI takes off?
DB, ICI It’s happened with the proliferation of hedge funds already. Clearly, if you’ve de-risked liabilities with derivatives, equity market beta might look very unattractive. That said, delivering 200 to 300 basis points of alpha isn’t going to be feasible for all the pension schemes in the UK.
MK, Watson Wyatt There will be more explicit division of assets into their specific objective for the fund. Are they there to match liabilities or to generate returns relative to those liabilities?
AS, WH Smith Trustees are there to interpret the liabilities. That’s the primary driver that pushes people towards a risk-averse investment approach. The more alpha you see, the more risk you take on, the more chance there is that those assets are significantly less than you thought they were. So you have this balance between near certainty compared with excess return. And that’s a challenge.
|Euan Munro, Standard Life:
We will see money moving out of regulated markets
DB, ICI A trustee should be more comfortable taking alpha risk against the corporate covenant than taking beta risk. If you lose the 3% versus Libor rather than make it, and it costs £20 million, you must believe the corporate sponsor is good for it. If it’s all in equities, you may be asking if the sponsor’s good for £200 million! RB, UBS Plus you’ve got diversification whereas hitherto the industry has relied on hoping the FTSE has risen and beaten the accrued liability.
JM, SSGA This is why investors have recently turned their focus on the global currency markets, extracting what they perceive to be a source of reasonable alpha. Some of the very large funds with depth of resource have turned themselves into “alpha-hunters”, essentially travelling the world actively seeking new diversified sources of return. The other side of the argument is that beta is very cheap and it’s in plentiful supply. Real alpha is very expensive and in very short supply. The issue is one of volatility associated with long-term beta. Investors still believe in the equity risk premium but returns can be up and down 10% to 15% in any one year. The issue for pure “alpha-hunters” is that it must be captured over a long period – 30 years is a long time, so that’s a lot of hunting.
DK, PruM&G If you move down that spectrum of pushing alpha up, trustees will need to broaden the investment opportunity set, because you can’t say: “We’ve got this standard mandate, and you can go long or short gilts and buy international bonds to some moderate extent. We just expect you to take larger risk positions in those particular areas of flexibility, but generate twice the outperformance.” Even if you’re a skilled duration manager, your information ratio will plummet as you seek to do that. In reality, trustees are very reluctant to give fund managers the ability to go short assets and that mind-set is proving quite problematic.
CH, Railpen Some of the long-only managers that moved over to long-short found that their skills weren’t immediately transferable and it doesn’t feel quite the same. But obviously you need to have researched your manager sufficiently to understand that, or you need to have consultants there.
SB, Barclays Capital We’re talking about using the liabilities as the main guide to decide on investment policy and to measure performance. Both alpha and beta strategies represent risk relative to liabilities but an appropriate combination of both is the answer a lot of pension schemes are looking for. The prevalence of large deficits in many pension schemes implies that there will be a need for investment outperformance of liabilities for the foreseeable future. Some schemes will rely on asset class beta and cost-efficient passive products that deliver that. Some schemes will want absolute alpha and strategies that are less dependent on whether an asset class is trending up or down.
EM, Standard Life The distinction between alpha and beta is important in LDI. If I allocate to equities passively, I’ve got some beta and academically, historically, I get rewarded for that. If, instead, I go to an active manager who isn’t taking systematic beta, but picking stocks, that might add value without introducing any material increase in risk relative to liabilities. The risk is that you’re in equities, not that you’re in active equities. I agree, if you discount back management fees it could be a big cost, but fees accrue annually. If the manager’s not delivering, he’s sacked, and you can put a stop to the loss of value to the fund.
DB, ICI If people focus on removing inflation and interest-rate risk with derivatives, perhaps they don’t fully understand that volatility in the equity market is the main risk. Equity beta risk is far more severe than in a typical alpha product. That said, I have a degree of scepticism about alpha products and hedge funds.
|Andrew Capon, SSGM:
a complex mix of issues has pushed asset owners towards LDI
DK, PruM&G But if you say: “I don’t believe that you can generate Libor plus 200. I can see the corporate bond market where I know default-adjusted I can generate Libor plus 50”, do you settle for that? For a lot of schemes it’s not going to be enough. MK, Watson Wyatt For that return-seeking portfolio, you need a diversified source of alpha and beta, such that you’re spreading those risks. It is important also to remember that alpha is not macro-consistent; not everybody can access it.
CHy, LGIM A practical problem with these types of strategies – for example, structured credit – is that the modelling required to fully understand the risk is complex and may be beyond the governance capacity of a smaller scheme. Over time we’ll see greater preparedness to accept more complex strategies, but trustees that really want to understand risks won’t find it simple.
DK, PruM&G For managers like ourselves thinking about the offering we bring to the market, one of the challenges is the liability hedge alongside the alpha proposition. A lot of schemes still need a large amount of alpha. So, how do you deliver that? And how do you give diversified sources of beta, so that the risk/return of the LDI proposition is not just a hedge but genuinely useful to the pension scheme over the next 10 years.
EM, Standard Life That’s where the division of labour is important. Pension fund trustees are well equipped to understand the liabilities, make some assessment of their confidence in the sponsor’s covenant and give a risk budget. But it’s not appropriate to rely on trustees for strategic investment decisions.
The downside of LDI
AC, SSGM We’ve heard the benefits, but what are the dangers of the LDI approach?
CHy, LGIM I think one of the dangers of liability-driven investment is that it can appear to be providing a closer match than is possible. There is an apparent precision to the cashflows and also to the hedging solution. But the liabilities are uncertain. Even if future mortality rates were known with certainly, statistical variations in typical schemes can be considerable.
SB, Barclays Capital I’m in two minds about the level of precision of hedging. I agree with Chris Hatry that extreme precision is not always necessary. On the other hand, it is helpful to recognize that if there are some unknowns, it does not necessarily mean that we should not manage other risks that are capable of being addressed efficiently. If we cannot deal with mortality precisely, we should pin down the risks we can manage: hedge the exposure you’ve identified, while taking a view that it will vary. But at the same time, if you think about LDI as risk/reward targeting in a way that takes into account what the liabilities are, inevitably you’ll leave some risks on the table. We find that if you hedge interest-rate and inflation risk to 75% to 80%, returns diminish unless other risks are being reduced at the same time. In a portfolio with substantial exposures to other investments, the marginal benefit of the hedging programme starts to decline. It’s helpful to look at total volatility, manage equity risks in line with interest-rate-inflation risk management, not necessarily focus on one area and leave large exposures unmatched in other formats.
AC, SSGM There are accounting problems too?
EM, Standard Life Once you’ve got all your cashflows worked out, you have to ask how they will be valued. You could have a perfect economic hedge that would satisfy investment bankers, but if the valuation actuary rounds a break-even in the 2.3 to 2.8 range to 2 1/2, then there’s very little point in going to the inflation-linked bond market to hedge those liabilities. Ultimately you want some protection against the valuation treatment of your liabilities.
DB, ICI Accounting is not the big driver. It’s the economics. Good corporates look at the nature of the liabilities and the immunizing assets that deal with these, just like any other treasury position, and understand it on that basis. So the measurement position of the corporate and the trustee should be aligned. The corporate might think its balance sheet has more risk capacity than the trustees think, but on the basic economics you should agree – you may just want to take different judgements on risk tolerance. To pay all those liabilities, we have to have a common view on risk measurement, and trustees, just like the treasurer, should understand the group balance sheet to allow them to make sensible judgements. However, I think there are very few trustees with that understanding.
AS, WH Smith They are better informed now than two years ago. But actuaries are only now beginning to address the conflicts and gaps in understanding. You can have the same actuary advising the company and the trustees. And it’s unclear who’s acting on whose behalf.
AC, SSGM Finally, what developments in this area will we see in future?
EM, Standard Life We’re all assuming the need for an asset-side solution. But I for one would welcome my company saying: “We’ve valued your pension using inflation-linked yields and we will move it out of the regulated scheme and into a personal pension which you can invest how you like. You don’t need to buy index-linked on negative yield.” I would be delighted. I think we’ll see money moving out of regulated markets, because they’re too tightly regulated.
DK, PruM&G Well the other option is that you just attack the liabilities and, unpleasant as that is for scheme members, there’s a lot of flexibility there that companies have not yet availed themselves of.
DKA, Merrill Lynch We’ll increasingly see companies attacking the benefit structure and using that as a risk-mitigation strategy.
DK, PruM&G The shareholders will demand it because they won’t be prepared for companies to put the 20% shortfall that exists into the scheme and pay no dividends for 10 years.
RB, UBS Companies that are reasonably well funded with a good covenant won’t necessarily want to make those difficult HR decisions. Unfortunately, those that need to are likely to be companies with 50% or 60% funding and a poor covenant.
DB, ICI But many pension schemes might find they are already paying more than they need to on the strict interpretation of the trust deed. In those situations it’s quite right to say: “We should be paying what we’re supposed to and no more.”
DK, PruM&G Changing tack slightly, one thing we will see is more widespread adoption of leverage. Schemes will have to lever up their assets. They will be implementing derivative-overlay-type strategies that will claim to bring benchmark plus 200 basis points, because when the average investment-grade corporate bond yield is, say, 80bp over gilts, you won’t generate 200bp from thin air. Trustees need to appreciate that.
SB, Barclays Capital We will see LDI becoming the norm rather than the exception. Investment management objectives will focus on maximizing the ability to pay the benefits. Covering the FRS17 position is the current objective of many pension schemes and their corporate sponsors, but as we approach that position, some schemes will raise their targets and manage towards buyout solvency. In addition, we will see much more inclusion of options in LDI solutions.
DB, ICI As funding levels improve we will see corporates take risk out. They will be run on a closed scheme basis, heavily matched, but carrying the risk on mortality. I do think it will be a higher standard than FRS17, but it can’t be a buy-out because it implies corporations are prepared to spend 100bp on mortality immunization. They’re not.
DK, PruM&G We’re all assuming that they’re prepared to pay the real yield or negative real yields to immunize.
RB, UBS The worst outcome really would be that you’ve got enough assets to go into the PPF. There is some insolvency event but you don’t have enough assets to buy out. Then suddenly you receive a pension that’s capped at £25,000 a year when it’s paid by the PPF.
CHy, LGIM Pension scheme finances will obviously be influenced by the path of the UK economy. Let’s all hope that we have a good 10 years ahead, because different economic scenarios could lead to very difficult situations for pension schemes.
JM, SSGA People will adopt broader solutions. Some already exist – more sophisticated, dynamically balancing policies using mortgage period optimization frameworks. They work versus liabilities. There are people running money against them, and they produce higher funding ratios over the long term than an interest rate swap hedge. Nobody adopts them in the UK. But the Dutch are more interested, as are people in the US. Compared with, say, buying equity real yields it’s worth looking at.
DKA, Merrill Lynch I share Serkan’s view that LDI will become the norm, but also much more than that. You’ll have the sort of risk management structures in place in pension funds that you now have in banks. But I also suspect that in 10 years your average pension fund will be investing in assets that are simply not available today.
AC, SSGM That’s where we must end. Thank you all very much.
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