What now for liability-driven investments, after last year’s crash in the market? Pensions experts Rakesh Girdharlal and Moiz Khan say it should lead to a more balanced approach
Liability-driven investment (LDI) grew in prominence at the turn of the millennium in response to a changing landscape for defined benefit (DB) pension schemes. During the past two decades, it has increased in popularity to become a core investment and risk-management strategy.
More recently, however, LDI attracted negative attention in the press when many schemes experienced severe collateral challenges in their LDI strategies immediately after the September mini-budget. This raised several questions about what LDI actually means, why DB schemes use it and what caused the problems. How can LDI evolve from here?
Asset liability management
DB schemes were widely available within the public and private sectors until a series of scandals in the late 1980s and 1990s (including the infamous Robert Maxwell case) led to boosted regulations, changes in accounting and greater costs to the sponsors funding them. Ultimately, this saw employers closing DB schemes (initially to new members and later to accruals), replacing them with defined contribution schemes and reviewing DB investment strategies.
As the concept of matching assets and liabilities – and the impact of mismatch on funding or solvency levels – became more widely understood (further helped by the case of Equitable Life not being able to meet its guaranteed annuity options as interest rates fell), LDI gained popularity among some investors. To achieve this objective, pension schemes typically invest in a portfolio of government bonds – both conventional and index linked – to match their liability profile.
Many DB schemes are underfunded, which essentially means they cannot fully match their liabilities using bonds.
To narrow, and ultimately close, the funding gap, schemes invest in a range of return-seeking assets, with the aim of outperforming their liability discount rates, which are typically based on bond yields. This leaves fewer assets to invest in bonds to match assets and liabilities. To overcome this issue, LDI portfolios are leveraged through derivative instruments, such as interest-rate and inflation swaps, or through secured funding arrangements, such as repo contracts.
A repo is a repurchase agreement that allows schemes to sell bonds with the agreement to buy these back at a pre-agreed price (which keeps the schemes exposed to the changes in the value of the bonds sold under the repo contract). As the value of the bond on repo falls, schemes need to post collateral to support the repurchase agreement. The funding raised through these contracts allows schemes to purchase more government bonds while remaining economically exposed to bonds sold under repo contracts to better match their liabilities.
‘Mini-budget’ fallout
The value of government bonds fell sharply last September, resulting in higher collateral calls on pension schemes. For some LDI portfolios, in particular pooled funds, the calls were too large to be met via the available collateral. Figure 1 shows how the available collateral in the LDI portfolio would have reduced for a levered pension scheme, despite improved overall funding levels.
This resulted in a unique scenario where some schemes were forced to reduce leverage in their LDI portfolios by selling government bonds and closing out repo contracts to minimise the impact of further collateral calls. As more schemes attempted to sell government bonds, it further fuelled the fall in market values to the point where sales could only happen at depressed prices.
This finally resulted in the Bank of England stepping in to purchase gilts in order to stabilise the market. For schemes, this was a short-term liquidity issue as opposed to a solvency issue.
Figure 2 shows the sharp fall in the value of the 2046 index-linked gilt (broadly matching average scheme liability duration) following the mini-budget, and the recovery following the Bank of England’s intervention.
Cashflow matching
One silver lining in all of this is that 2022’s net increase in yields (or decrease in the value of government bonds) has improved pension schemes’ funding positions, as liabilities have fallen in value more than assets. Going forwards, this should help schemes to reduce their reliance on leverage in their LDI portfolios and ultimately look to invest more like insurance companies, where future expected pension liability cashflows are matched with bond cashflows, to better manage the timing and valuation differences between their assets and liabilities.
Schemes that still rely on leverage will be looking at ways to actively reduce it where possible, add robustness to their overall liquidity and collateral plans, and reduce the correlation between the valuation of their repo contracts versus the assets held in their collateral pools.
Rakesh Girdharlal is head of LDI and liquidity at Aviva Investors
Moiz Khan is head of insurance and pensions solutions at Aviva Investors
Image credit | iStock
