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The trm
Report - November 2005
Trustee Risk Management – Investment Strategy
What Does Liability Driven Investment Have to Offer?
Tarik Ben-Saud
There is little doubt we are at an inflexion point in terms of investment strategies
pursued by UK pension schemes. During the past decade, we have moved away
from peer group comparisons to scheme specific benchmarks based on market
indices. Now we are seeing a shift towards ‘liability driven’ strategies. This is not
a new era, it is simply an ongoing evolution with each successive shift in
investment philosophy exhibiting a common thread – the tightening of the link
between assets and liabilities.
But what exactly are liability driven strategies?
A liability driven solution is an investment strategy that has, at its core, a ‘transparent linkage’ between pension fund assets and liabilities. Whilst pension
funds have always invested assets to meet their liabilities – that is their primary
purpose – this transparent linkage has hitherto been elusive.
No single catalyst is behind the shift toward liability driven strategies. We have
witnessed a raft of regulatory changes, falling investment markets, declining
funding levels and a reduced expectation of the equity risk premium. Coupled
with this, advances in corporate finance have expanded the investment
opportunities for pension funds. Each of these has contributed to a fundamental
re-examination of contemporary pension fund investment strategy.
Understanding the liabilities
In order to be ‘liability driven’ there is an implied necessity to understand the
liabilities. A pension fund’s liabilities are the benefits paid to a scheme’s members
and consist of a series of cash flows that the scheme must pay out in the future.
The cash flows are usually estimated by an actuary and are based upon the
aggregate forecast of all the benefits for the members. Typically, the expected cash
flows are based on a snapshot of existing members and will not take account of
future joiners.
Pension fund liabilities are long-dated. Their calculation involves forecasting far
into the future (70 years or more) to estimate what payments will be made.
Actuaries also calculate how much money is needed today to be able to meet
these future payments – this is known as the present value.
A typical aggregate cash flow profile is shown in the figure below.
As can be seen, the expected cash flows rise steadily from current levels before
falling away more sharply in later years.
Investment objectives
The underlying desire of most trustees in setting investment objectives is to outperform their liabilities, either to restore full funding or build a cushion against future adverse conditions. However, given the limited information on the nature
of liabilities available historically, naturally the focus fell more on the assets
resulting in a significant and often unappreciated mismatch with the liabilities.
Today the tools are available that permit trustees to define the investment objectives explicitly in terms of the liabilities. For example, a liability driven investment objective might be of the form: match the change in liabilities plus outperformance of x% per annum.
The linkage is transparent and explicit – the assets should outperform the
liabilities by x% each year. The liability investment objective focuses on the
liabilities first and then addresses the desired level of outperformance over the
liabilities, subject to various risk constraints.
The liability driven investment objective should be viewed as a refinement of
existing investment objectives rather than a completely new approach. Existing
investment objectives, which usually consist of a summation of exposures to
various asset classes, can be translated to an expectation of performance relative
to liabilities.
Linking the assets and the liabilities
The key to setting pension fund investment strategy is to understand what
happens to the assets and liabilities when something changes, be it interest rates,
inflation, the level of the equity market, longevity etc.
For many pension schemes the magnitude of risks embedded in existing
investment strategies is not well understood. This is particularly true of interest
rate and inflation risk.
A good place to start is to investigate what happens to both a pension fund’s
assets and liabilities when interest rates fall by 1%. A pension fund’s liabilities are
very sensitive to movements in interest rates. In fact, for the average pension fund
a 1% change in interest rates will change the value of the liabilities by about
20%. So when interest rates fall by 1%, the liabilities increase by 20% (and vice
versa). This is a high level of interest rate sensitivity and stems from the very long-
term nature of the liabilities. Short-term cash flows are not very sensitive to
changes in interest rates, but very long-term cash flows are – the value today of a £100 payment due in 50 years will change by 50% for every 1% change in
interest rates.
Knowing that the liabilities are very sensitive to interest rates is only one half of
the puzzle. What about the assets?
For the average pension fund investing around 60% of assets in equities a 1%
change in interest rates will change the asset value by about 5%. This is markedly
different from the liabilities. The primary reason for the difference is that equities
are not particularly responsive to changes in interest rates – sometimes the FTSE
All-Share Index rises on news of interest rate changes, sometimes it falls. The
bonds held by a pension fund are of course responsive to movements in interest
rates, but generally these constitute only around one-third of total assets.
Linking our assets and liabilities together, in this example if interest rates fall by
1% the liabilities rise by 20% and the assets by 5%. This represents a substantial
mismatch.
The same analysis can be undertaken for inflation and the results are usually
similar. Pension fund liabilities are inextricably linked to changes in inflation, but
the assets of a pension fund generally have low sensitivity to inflation movements.
That brings us to equities. What happens to the value of the liabilities when
equity markets rise and fall? The answer is very little, the level of the equity
market has little bearing on the liabilities. For an average pension fund a 20%
rise in the equity markets will increase asset values by about 15% whilst liabilities
remain virtually unchanged. Again, this is a significant mismatch.
The risks mentioned above – interest rates, inflation and equities – are the three
main investment risks that need to be understood by trustees. Most pension
funds have historically paid too little attention to interest rate and inflation risk in
particular. Adverse interest rate movements can lead to a deterioration in funding
levels even when equity markets are rising, a familiar situation for many pension
funds.
The question trustees are increasingly asking is: how exposed is the pension fund
to changes in interest rates, inflation and other variables? Liability driven
investment strategies usually have their genesis in answering such questions,
which are aimed at understanding the mechanics of how the assets and liabilities
react to various factors.
It must be remembered that there are many non-investment risks, such as
longevity, which also impact funding levels. Liability driven investment only
involves addressing the investment risks within a pension fund.
Managing the risks better
One reason little attention has been paid to interest rate and inflation risk in the
past is that even if the risks were known, little could be done to manage them
effectively as the investment tools were crude at the time. Thankfully that situation
has changed significantly over the past few years.
The very largest pension funds in the UK started addressing interest rate and
inflation risk more than a decade ago. A handful of investment managers with
expertise in derivative markets structured ‘hedges’ to manage these risks. This
door was closed to medium and smaller schemes as it was time consuming from
a trustee perspective and not economically viable unless a pension fund had at
least £400 million or so in assets.
Today, it is possible for almost all UK pension schemes to understand the various
risks and manage accordingly. What has made this possible is the advent of
pooled funds that can isolate interest rate risk or inflation risk. Various pooled
funds, each calibrated to address interest rates or inflation over a specific period,
are combined to manage the assessed risks of a particular scheme’s liabilities
rather than have a one-size-fits-all approach.
This means that a pension fund can have its actuary or investment consultant
calculate the risks associated with interest rates or inflation movements and then
manage these risks to within acceptable tolerances.
The pooled funds offered by investment managers can be thought of as nothing
more than a series of very flexible bond funds. When you buy a bond you know
the cash flows you will receive in the future. Liability driven pooled funds are the
same, you know what you are going to get back in the future.
What a liability driven strategy looks like
The outcome of liability driven investment is typically an investment strategy that
has lower risk versus the liabilities than the existing strategy. This is usually
achieved in two ways:
- Greater attention is paid to interest rate and inflation risk, which generally
results in higher bond weightings.
- Where risk is taken, it is done so in an efficient way.
Let’s expand on the second point. All assets have an expected return and an
expected risk. Bonds might have an expected return of 5% and a risk of 7%
versus liabilities*. Equities might have an expected return of 8% and a risk of 6%
versus liabilities. So greater return means greater risk.
Is it possible to violate the risk reward relationship? Yes. Some managers offer
pooled funds that might have an expected return of 8%, just like equities, but a
risk versus liabilities of only 6%. How can that be? Well there are two types of risk
– market risk and manager risk. Market risk arises from buying assets that are
expected to outperform liabilities in the long term, such as equities. If exposure is
gained via an equity index tracking fund the costs are low, albeit performance
would be volatile versus liabilities. The other way to outperform liabilities is to
rely on the skill of active managers. Their outperformance will cost more in terms
of fees, but entails a lot less risk, especially if the manager is seeking
outperformance from a wide variety of sources.
The future
UK pension funds are beginning to ask fundamental questions as to the
relationship between asset and liability movements with the aim of understanding
and controlling risk.
With so many new avenues opening up to trustees, the future looks encouraging
for those schemes seeking to return to a fully funded position without taking
excessive risk.
Barclays Global Investors has produced a booklet for trustees that explains many
of the aspects surrounding liability driven investment and how it can be
implemented. For copies please contact:
Tarik Ben-Saud
Head of Liability Solutions
Barclays Global Investors
0207 668 8376
tarik.ben-saud@barclaysglobal.com
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