| Liability driven investments 101 |
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| 03/07/2005 | |
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Paul Bourdon, Director Investment Solutions at Threadneedle Investments, answers this week's 101 on liability driven investments. 1-What is the concept of liability driven investments about? People have a number of different things in mind when they talk about LDI, but the general consensus is that fundamentally LDI is simply the practice of investing against a benchmark that reflects projected liabilities. LDI encompasses liability matching and investment strategies that seek to minimise asset and liability volatility dependent upon the particular scheme's appetite for risk or in the case of an insurance company, the amount of capital they have. 2-Why has it only become widespread lately and not ten years ago? New accounting standards such as FRS17 in the UK, and IFRS in Europe, and new pension fund and insurance regulations such as the Financieel Toetsingskader (FTK) in Holland and UK insurance regulations PS04/16 by the FSA have pushed liability-driven solutions to the fore. Essentially all these regulations require that both assets and liabilities will be valued on a market–to–market basis. FRS17 expresses scheme surpluses/deficits on company balance sheets, whilst IFRS does the same but with some smoothing effects to reduce the impact. Consequently there will be an increase in volatility of balance sheets due to movements in the net asset/liability position of the pension fund for quoted companies. With scheme liabilities estimated to amount to around 20% of the average UK company's capitalization, for example, it's not surprising that so many are now looking at ways to reduce the volatility such deficits represent. The FTK and PS04/16 introduce the concept of risk-based capital and essentially penalize insurance companies and Dutch pension funds for holding volatile assets and liabilities. Similar issues apply in Denmark. Other key factors have been the triple falls in equities, mortality rates and interest rates. As interest rates have fallen over the long-term this has had the effect of increasing the size of scheme liabilities. Coming at a time when risk assets such as equities performed poorly and mortality experience did nothing but lengthen, scheme surpluses have either reduced or turned to deficits or deficits grew bigger. Quite sensibly, companies are now looking for approaches that enable them to reduce the volatility of their assets and liabilities. This is where LDI comes in. 3-Which investors are likely to be interested by this approach? For Pension funds, LDI is all about considering the appropriateness of assets relative to a liability benchmark rather than an index unrelated to the liabilities. As such LDI is appropriate for all schemes large or small, strong or weak. The main concern for trustees is to reduce the volatility of the assets versus the liabilities. LDI encourages funds to hedge risks in liabilities that they can avoid like interest rates and inflation – and size or financial strength of scheme is not a barrier to hedging. The amount of risk taken in the choice of assets will depend upon the strength of the scheme. It is the level of volatility of assets (versus liabilities) which will show up in the balance sheet and hence create potential stress to the Corporate sponsor – so the stronger the scheme the riskier (or more volatile) the assets chosen can be and vice versa. Again this decision does not preclude large or small, weak or strong pension funds from adopting a LDI approach. The same can be said for insurance companies except that they have to put up capital to support the assets they hold against the liabilities of their business. This has led insurance companies to be in the vanguard of using LDI techniques to manage their assets and liabilities. |
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Articles of the same Serie : 101 |
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Articles of the same Topic : ALM |
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