| Externalities of the LDI approach are raising some questions |
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| 17/04/2006 | |
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Is the liability driven investment's gospel leading pension funds straight into the wall? LDI solutions, which encourage investments in long-term bonds as well as derivatives in a bid to match assets and liabilities, are being been accused of driving their long yields to historical lows, pushing pension liabilities to higher levels. Fund managers, along with newer pension industry players such as investment banks, are nevertheless betting that there will be no shortage of clients interested in this approach. According to Steve Aukett, senior product specialist at London-based Insight Investment, which began investing heavily in 2003 both in technology and human resources to develop its LDI capability, defined benefit pension funds are getting increasingly interested in LDI solutions. Insight has a total £24bn in assets managed under a LDI approach, £5bn of which is for defined benefit pension funds. Critiques But will the LDI trend last? Just when this concept has become a selling point for many investment service providers, critiques say the externalities of this approach are proving rather costly. The UK's National Association of Pension Funds' (NAPF) conference, held in March in Edinburgh, was the opportunity to gauge the uneasiness of some pension professionals about the unintended consequences of LDI. Some attendees said that government policies such as the Pension Protection Fund risk-based levy, as well as the involvement of investment banks selling high-priced fixed income products to pension trustees were at least partly responsible for pension woes, including the resilience of pension deficits, in which the LDI approach seems to be playing a role. Despite the boom in equity markets, critics point out, pension deficits have remained quite high. According to Mercer Investment Consulting the total pension deficit of the FTSE 350 has increased 24% from £75bn in 2004 to £93bn in 2005. According to critics, this approach has not shielded pension funds against those woes, but could rather have partly contributed to them. Two European central banks have already pointed to the inelasticity of long-dated and index-linked bonds, in part due to pension trustees who disregard bond prices in order to implement LDI solutions at all cost. The Bank of England reported at the end of last year that the pressure on index-linked gilts, which are considered as a prime tool for matching assets and liabilities, had been mounting steadily. The high demand for linkers is driving their yield lower. As this variable influences the discount rate used to assess future liabilities, the result is a reduction in the funding ratio of pension funds. "In turn, this may have reinforced the demand for index-linked gilts and driven their yields even lower", wrote the BoE's analysts last December. They could hardly have been more visionary: the real yield of its 50-year linker issued in the December of last year fell below 0.4% in March. That trend hasn't gone unnoticed by other central banks either. In its latest inflation report, the Norwegian Central Bank said that regulatory changes were prompting pension funds to buy ever more long-term bonds. "With such portfolio adjustments, demand may be relatively price inelastic", said the bank last month. Another indication of the strong interest in the LDI approach is the increase in derivative trading. Given the limited supply of bonds, whose real yields are falling to historical lows, swaps have become a useful alternative. They cost a fraction of an investment in the underlying paper, and offer roughly the same protection: for instance a hedge against inflation, as for an investment in index-linked gilts Protection against interest rate variation is also possible through an interest swap and long-term investors such as pension funds have definitely taken notice of that. According to the Bank of England, the value of swaps traded during the last quarter of 2005 amounted to about £19 billion, about four times more than for the last quarter of 2003 (£5 billion). Absolute return Critics of LDI are also quick to compare this approach to a partial stop-gap strategy rather than a definitive solution to pension deficits, which will have to be filled sooner or later. Reducing the focus on absolute performance and using liabilities as the new benchmark, just when closing the pension gap is necessary, might sound at best counter-intuitive: what is needed, they say, is performance. What is demonstrated by most asset allocation studies is that the reverse is currently going on: low-yielding bonds are gaining ground at the expense of higher-yielding equities. Nevertheless, the LDI approach is usually not applied to all of a portfolio, but rather to a part of it, which leaves open the possibility to invest on higher-return products on the remaining part, as under a core-satellite strategy. "It is important to remember that LDI is not a product, but rather a framework", says Mr Aukett, who highlights the flexibility of this approach, which can be adapted to any given pension scheme, taking into account its funding ratio as well as its return expectations. "Under an LDI framework, we seek to reduce the unintended risk that is due to the interest rate and inflation risk while targeting active risk", he says. "That's a basic investment principle that risk should be rewarded. It is better to remove this unintended risk and rather focus on active risk though diversification of return sources including absolute return funds" The collateral of this re-balancing from equities to bonds has also been a deepening of the diversification of most pension asset allocation into higher-performance assets. Since bonds, which account for an increasing share of a scheme's allocation, return less than pension funds, those returns have to be generated somewhere else. This has become the role of absolute return asset classes such as hedge funds, commodities, real estate and private equity, which are expected to provide the much needed return surplus. Few pension schemes So far, individual indications as to the growth of LDI-labelled products have been few and far between, with only a handful of pension funds making their adoption of the LDI approach public. But this is also due to the fact that many pension funds are only adopting the LDI paradigm, instead of buying the products marketed under the LDI name. The pension fund of WH Smith was reported to have bought a LDI product managed by State Street Global Advisors in 2005. The Pension Protection Fund, which is one of the British drivers behind the LDI trend since its risk-based levy can theoretically be reduced when a pension fund adopts an asset-liability matching strategy, said that it would implement LDI techniques to its own assets. The pension of Xerox UK has awarded a LDI fixed income mandate to PIMCO investment, the bond specialist, which, like many other fund managers, has been developing its LDI expertise lately. J.L. |
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