Liability Driven Investment (LDI): Pension Risk Management in the 21st Century
Liability Driven Investment (LDI): Pension Risk Management in the 21st Century Robert Gardner – Redington Partners: Pensions Management Institute Newsletter (March 2008) Liability Driven Investing (LDI) means different things to different people. To some, it means recognizing that the liability cashflows of a pension scheme are bond like in nature, i.e. they can be matched by investing scheme assets in long term bonds. To others, like Redington Partners, LDI is about pension risk management and using Asset Liability Management (ALM) to model, understand and improve a pension scheme’s investment strategy in order to outperform the scheme’s liabilities. Redington believes that it is important to look at the assets and liabilities of a pension scheme holistically and evaluate all of the risks that a scheme is facing, both together and separately. On the liability side, these risks include interest rates, inflation, and longevity. On the asset side, these risks include equity, property, credit and currency risks etc. It is essential that pension schemes develop a framework to assess these risks individually, and understand how they interact with one another. This is the essence of risk management. Pension schemes have only recently started using LDI strategies. In October 2001, Boots plc Pension Scheme converted all of its equity holdings to long term sterling bonds to match the scheme’s future liabilities. In 2003, Dawid Konotey‐Ahulu and I executed the first ever full LDI hedge (using long‐dated swaps to hedge the scheme’s liability sensitivity to interest rates and inflation) for Friends Provident Pension Scheme. The Boots and Friends Provident transactions helped establish the framework for what Redington calls LDI 1.0. LDI 1.0 The introduction of LDI to the pensions industry was significant because traditional investment strategies used by most pension funds were no longer meeting the needs of Trustees and corporate sponsors. Therefore, pension schemes started implementing LDI strategies to more closely match and offset the liabilities. The first investment vehicles used were LDI pooled funds. LDI pooled funds made it possible for pension schemes to enter into interest rate and inflation swaps (backed by cash) to match the scheme liabilities. While the swaps in the LDI pooled funds performed as intended, matching a pension scheme’s liabilities, a number of problems remain unresolved using this investment strategy. First, if a pension scheme is running a deficit, an investment strategy using LDI pooled funds only generates a return equal to Libor. Simply generating a return equal to Libor is not sufficient to close the gap between the scheme’s assets and liabilities, especially on a buy‐out or solvency basis. Second, ‘recently’ the cash backing a swaps portfolio has underperformed in current markets, with many ‘cash funds’ failing to produce their mandated Libor returns. Finally, the goal of an investment strategy is to meet a given funding target in some point in the future (X years) by maximising the return on scheme assets to achieve the optimal risk adjusted return. At Redington, we refer to this as the fuel efficiency of an investment strategy, i.e. minimizing the volatility for a given excess return over the liabilities.
Figure 1: Portfolio Fuel Efficiency LDI 2.0 The goals of LDI 2.0 are to improve a pension scheme’s risk management framework, reduce the volatility of the scheme’s assets with respect to the liabilities and improve the scheme’s overall fuel efficiency. LDI 2.0 identifies how the scheme’s assets behave both on their own and together i.e. how they are correlated. For example, it can show the portfolio’s risk and return attribution (how the assets and liabilities contribute to the overall risk of a portfolio) on a regular basis e.g. quarter on quarter. As a result, Trustees and corporate sponsors can now understand the portfolio’s total ALM position. A pension scheme that has a traditional asset portfolio consisting of 60% equities, 30% bonds and 10% property has low fuel efficiency similar to that of a Hummer, i.e. the level of risk taken for additional excess return is very high. The Risk Attribution Chart (Figure 2) shows a breakout of the overall risk by portfolio component for a sample pension scheme. In this example, the liabilities are the scheme’s largest risk driver, contributing almost three times as much risk compared to equities. This pension scheme has a Value‐At‐Risk (VaR95) of 17%, meaning that in 1 year’s time there is a 1 in 20 probability that the funding level may fall by more than 17%, or the deficit may get wider by 17% of the liabilities.
Figure 2: Risk Attribution Chart (Un‐Hedged) To make this pension scheme more fuel efficient like the Prius, it is first necessary to hedge unrewarded risk (the risk generated by the liabilities) by crafting a swap overlay to match the scheme’s liabilities. Furthermore, diversification can be used to reduce the risk generated by the assets. This combination allows a pension scheme to create an optimal risk adjusted return, maximizing the scheme’s fuel efficiency. An example portfolio that has implemented an LDI 2.0 framework is shown in Figure 3. In this example, the scheme hedged the unrewarded risk (the liabilities) by executing interest rate and inflation swaps and sold a portion of the scheme’s equity holdings, investing the proceeds in alternative assets. The results are striking. The overall risk (VaR95) of the portfolio has fallen significantly, from 17% to 7.5%, meaning that in one year’s time there is a 1 in 20 probability that the scheme will lose 7.5% of its funding level.
Figure 3: Risk Attribution Chart (Hedged) Once the liabilities have been hedged using a swap overlay, diversification will help to maximize a scheme’s fuel efficiency. Figure 4 shows that while the FTSE100 has fallen recently, other assets like hedge funds and commodities have outperformed in the current market. Figure 4: Historical Returns of Selected Asset Classes As a pension scheme de‐risks and implements an LDI 2.0 framework (using swaps and diversification), other risks like longevity risk (rising life expectancy) begin to have a greater impact on a scheme’s overall risk.
Pension schemes must understand a scheme’s mortality assumptions and exposure to longevity risk, because the fact that people are living longer will have a significant impact on the value of scheme liabilities. By incorporating longevity risk analysis into a robust ALM framework, it is possible to adjust the fuel efficiency of a pension scheme and increase expected return to accommodate increases in life expectancy. Innovation and the Defined Benefit Pension Scheme When defined benefit schemes were first established the benefits were not priced properly. As a result, many defined benefit schemes are now being closed to new members and or adversely recalibrating pensioner agreements: increasing the minimum retirement age, reducing pension payments, or a combination of the two. Replacing defined benefit schemes are defined contribution schemes. This change has shifted the risk from the defined benefit pension scheme to the individual, who usually has neither the time nor resources to make objective prudent investment decisions. At retirement, individuals seek a stable income, and defined benefit pension schemes are the best vehicle to help achieve this goal. Redington believes that, when properly constructed, a defined benefit pension scheme can remain open to new employees while significantly reducing the financial risk and burden to a corporate sponsor. Until recently there has been a lack of innovation in the pension space. However, the defined benefit pension landscape is changing. Financial service providers (investment banks, asset managers, and buy‐out firms) are now providing new strategies and investment vehicles designed specifically for pension funds. The evolution of LDI has been rapid and complex. Those schemes that ignore the innovative approach to asset allocation, funding structure and portfolio hedging are ultimately risking their members’ pensions. LDI 2.0 (Pension Risk Management in the 21st Century) is one of the tools available to help Trustees and corporate sponsors navigate turbulent markets and increase the fuel efficiency of the pension scheme.