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The Actuary The magazine of the Institute & Faculty of Actuaries

The rise of LDI

When liability driven investment (LDI) first emerged within pension schemes, there was a widespread lack of understanding and, in some cases, suspicion around what these solutions were doing and whether they actually helped. Over time, LDI has become more mainstream, with greater knowledge and acceptance among institutional investors and increasingly of more sophisticated solutions.

In the beginning, was the (buzz)word
LDI can be defined to encompass a broad approach but typically involves hedging the impact on liability values arising from changes in interest rates and inflation, usually through swap contracts. When LDI first emerged in this form, a typical strategy might have been:
>> A large, segregated portfolio
>> Fully cash flow matched
>> A low risk, low return strategy
>> Best for fully funded, closed, mature schemes, or just pensioner liabilities
>> In a very small minority
>> Expensive to implement, both in terms of transaction costs and in terms of the rates that are locked in.

Many of these things may have been true, and they certainly restricted the potential audience. However, they were also reflective of a product in its infancy and a long way from reaching its full potential. Over the past five years, LDI fund managers have set their minds to overcoming some of the drawbacks of early solutions, with far-reaching success. The LDI solution of today is much more applicable to a wider range of situations.

Pools of buckets
The first major breakthrough occurred when fund managers launched pooled funds. The responsibility for negotiating with investment banks over the documentation required for swap contracts was shifted from pension schemes to the fund manager. The need for a segregated account, with associated costs, hassle and minimum size restrictions fell away.

In designing pooled funds, managers adopted a ‘bucketed’ approach (see Figure 1), whereby each fund addresses the risks associated with cash flows in a number of successive years. An LDI strategy was formed by mixing investments in different ‘buckets’ in the right amounts. This is a compromise that produces what appears to be a materially less precise match but, in fact, the residual risk is surprisingly small — and is still a vast improvement on using bonds for this task. This aspect is sometimes misunderstood but greater comfort with LDI in general seems to be bringing greater acceptance of a more pragmatic viewpoint.

Under the bonnet
First generation LDI funds typically contained an interest rate swap contract for each year’s cash flow. These provided a hedge for the interest rate risk in the relevant cash flows. These swaps were fully backed by cash holdings, so a £100 investment was required to hedge a cash flow with a present value of £100. What you ended up with was a cash flow hedge with the right timings, and an average term that was much longer than the bonds that normally provided schemes’ liability matching element but you remained locked into a low rate of return by the high cash exposure. This is fine if you had only assumed low returns (often true for pensioner liabilities) and didn’t want higher returns to help with a deficit or future accrual, but these schemes are in the minority.

Partial funding or (deep breath) leverage
The second generation of funds began to address this by requiring only 50% of the value of the cash flow being hedged to be invested. The swaps themselves do not require an up-front payment but are simply designed to increase or decrease in value in line with the liabilities as interest rates fall or rise. When they do, the LDI funds make or receive a payment from the investment bank. The cash in LDI funds acts as the source for these payments, so we only need enough to cover the potential fall in value. Unless interest rates rise by a large amount, a 50% cash holding should be plenty.

This means that there is cash left over to invest in something a bit more interesting, with the possibility of producing higher returns. This is good news for pension schemes, especially if the funding assumptions imply something more than cash returns. Since this is often the case for non-pensioner liabilities, we suddenly have the prospect of applying an LDI strategy to assets backing actives and deferred pensioners, while still being able to meet the required return assumption.

However, 50% cash is still higher than the average scheme’s existing allocation to bonds, so represents a sacrificing of return potential. More recently, managers have launched funds that squeeze the level of cash required down from 50%. The more they succeed, the higher the return potential, so LDI becomes applicable to a wider range of circumstances and requirements. At some point, sacrificing the potential to capture a risk premium stops being a valid reason not to adopt an LDI strategy.

Moving goalposts
In the early days, moving to an LDI solution meant an implied value of liabilities, based on swap rates, significantly higher than most schemes reported in their actuarial valuations. Many viewed this as suggesting that LDI was an expensive option that meant locking in to low long-term interest rates. However, these are market rates — they contain information about expectations for cash returns into the future. Yes, they may be distorted by supply and demand imbalances. Yes, there is room for strategies that don’t hedge all of the liabilities or tactical positions reflecting shorter term beliefs but these should be adopted consciously with an understanding of the risks that are being left on the table as a result.

An acceptance of this has spread across the industry, reinforced by comparable numbers from other valuations that use (near) risk-free rates. Accounting, PPF and buyout valuations are increasingly important and the high numbers attached to them mean that a swap-based valuation is no longer the outlier. In addition, if the LDI fund is partially funded, there remains the potential for excess return.

Education, education, education
So, we now have a solution available to both small and large schemes, providing a pragmatic but still effective bucketed hedge of their liabilities. It does not overly restrict the return potential, but does reduce the liability risks they face. This sounds applicable to more than just the minority. There is no doubt that this is a complex area, which is a little more challenging than our collective comfort zones of equities and bonds. However, that is not a reason to dismiss the potential benefits; grasping the difficult concepts and communicating them to clients is supposed to be one of the core skills of our profession, after all.

Increasing awareness, understanding, acceptance and belief in LDI is a slow but ongoing process. This has only occurred through patient explanation, education and training, initially within the consulting community and then with clients, and this needs to continue.

The future
So, finally, a little crystal ball-gazing, from which I can promise that some, none, or all the predictions may come true, but offer some insight for each of the key participants in LDI:
>> Fund managers need to continue with the development of more efficient structures. This may not mean just reducing cash requirements, but also finessing the way that exposures are gained. There could be better specification of cash flows — limited price indexation and so on, addressing mortality risk or more sophisticated structured investment-type solutions, using a wider range of derivatives.
>> Investment consultants should grasp the opportunity, and rethink how they set investment strategy in a world where addressing liability risks does not mean placing restrictions on how assets are invested and returns are sought. Theirs is the real requirement to understand the issues that arise with LDI strategies, and be the independent arbiter of what is appropriate for their client base.
>> Scheme actuaries will need to consider using swap-based valuations, reflecting the full-term structure of interest rates, and understand the interaction between the way assumptions are derived and the LDI hedging strategies that are implemented.
>> Trustees and sponsors have the somewhat unenviable task of getting to grips with all of this, ensuring they make the most of the opportunities now available to develop a strategy that is appropriate for their needs without taking their eye off the widget machine.
>> I will watch with interest as the market continues to develop flexible investment approaches, combining liability management and return-seeking assets.

Ross Pritchard is an LDI solutions manager at Schroder Investment Management