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OPDU Report 26 October 2009 Advisory Service Forum The remarkable rally in global stock markets witnessed since early March has doubtless provided pension fund trustees with some succour after the wrenching losses that occurred in the aftermath of the collapse of Lehman Brothers. With the MSCI World index up more than 20% for the year to date, and the FTSE 100 index returning above 5,000 almost a year to the day since the bankruptcy of the US investment bank, the sense that the worst of the financial crisis is over affords some relief. Nevertheless, with recent reports highlighting that Britain’s largest company pension schemes are facing their largest ever collective shortfall, with one actuarial firm putting the aggregate pension fund deficit for the FTSE 100 companies at close to £100 billion, any optimism concerning the health of UK company pension schemes remains in strictly limited supply. What the dramatic events of the past 12 months have done are to remind trustees of the critical role risk management takes in the stewardship of pension scheme assets, particularly in volatile market conditions. Set against this turbulent background, the continued rise in popularity of liability-driven investment (LDI) approaches, which ensure a pension fund’s assets and liabilities are considered in a holistic solution, should come as no surprise. The changing pensions picture At the start of this decade, company pension schemes were rarely discussed and seldom a cause for concern for companies or pension trustees. This was to change. The bear market that started in 2000 was the first in a number of events that not only altered the perception of pension schemes but also led to fundamental changes in how they are structured, regulated and managed today. That bear market was the first serious sell-off in 20 years and meant that the value of pension assets decreased dramatically. At the same time, changes in pension law and the introduction of FRS17 and IAS 19, which meant that pension fund deficits would now be reflected on a company’s balance sheet, increased the focus on pension funding levels. This changing environment was conducive to the growth of LDI solutions. These have been steadily gaining critical mass in the UK pension market as schemes have attempted to address their funding deficits, and as companies and trustees have increasingly had to face up to the looming challenge presented by significant increases in life expectancy and maturing generous defined benefit schemes. Know your true liabilities The management of risk is at the core of the LDI approach. But let us first dispel one important myth about LDI: it does not claim, nor indeed aim, to remove all risk; after all, without risk one cannot expect to generate the capital growth necessary to finance the pensions of today and tomorrow. Instead, LDI provides an effective framework for under-standing and managing risk in relation to the liabilities of a pension scheme. This is a meaningful departure from the traditional approach to pension investment strategy in the UK. Typically, the majority of a scheme’s assets were held in equities, invariably with a heavy bias to UK stocks, and the fund manager was charged with outperforming the market regardless of its direction. However, this approach assumed a number of risks that were historically often misunderstood or underappreciated by trustees. Most were all too aware of the implications of a sustained equity market downturn. But pension schemes are not only exposed to risk on the asset side; the liabilities side of the equation demands equal if not greater consideration. The main risks to funding levels actually come from interest rate, inflation and mortality risk. The traditional asset allocation strategies of defined benefit pension schemes have often resulted in volatility in funding levels due to a mismatch between their assets and liabilities. Why? Pension schemes are required to value their liabilities using discount rates derived from market interest rates. When interest rates change, so does the present value of the liabilities, just as the price of a bond changes. Likewise, if the liabilities are linked to inflation, the present value will also be sensitive to changes in inflation expectations. These two key risks typically went unrewarded and often unacknowledged. Another unrewarded risk relates to mortality; average lifespans have already increased beyond the estimates of many actuaries. Historically, little could be done to mitigate this risk, but recently we have begun to see thinking develop in the area of longevity hedging through the use of longevity swaps and different forms of buy-out. An LDI approach means identifying and implementing bespoke investment solutions to specifically address the threats posed by interest rate movements and inflation. Rather than setting a market benchmark e.g. FTSE All-Share index, an LDI approach will involve creating a benchmark that is based on a scheme’s specific liabilities. Assets that have the same sensitivities to changes in interest rates and inflation as the liabilities can be incorporated into the investment strategy to minimise these risks. Placing liabilities at the heart of the investment strategy process provides trustees with a much better understanding of risks inherent in their scheme and puts them in a much better position to decide how much additional (desired) risk they wish to assume. Beyond bonds LDI is not just about investing in bonds as is sometimes thought to be the case. Most LDI strategies consist of two elements: one that seeks to match liabilities, or, more specifically, better manage the risks associated with liabilities, and one that aims to generate return. The former will indeed normally comprise a combination of bonds and/or interest rate swaps that have the same sensitivities to changes in interest rates and inflation expectations as the scheme’s liabilities. The return-seeking component, however, may invest across a wide range of assets to help target an improved funding level, either to reduce any deficit and ongoing funding costs, or aim for a slight surplus to mitigate the impact of an increase in mortality or other non-financial risks. Pension schemes have traditionally looked to equities to generate this growth, but some are now considering absolute return funds. These funds aim to deliver positive returns on an annual basis, regardless of market conditions. Often with targets of outperforming cash by 2-4%, these funds generally makes use of derivative instruments to hedge out market risk and use manager skill to generate returns. The added value, or alpha, produced by these absolute return strategies can be attached to a scheme’s liability benchmark through the use of swaps (a process known as ‘portable alpha’). Some of the cash that is backing the swaps in the liability-matching component can be replaced with actively managed funds that aim to deliver attractive returns relative to cash. All change please? A common misconception surrounding LDI is that implementing such a strategy involves wholesale changes in the underlying assets. This is not necessarily the case.A scheme’s existing fixed income assets may already fulfil a liability-matching function, given their similarity to liabilities (except in reverse – income instead of outgoings). Incorporating these assets into an LDI strategy is not only cost-effective, but also means they can be actively managed with the aim of generating additional returns. Meanwhile, swaps offer very effective liability matching and can be used in a non-intrusive way, such as via a portfolio overlay, potentially leaving the underlying assets unchanged. This also means that the scheme’s capital can be used to invest in growth-generating instruments. Segregated solutions in particular may make use of their existing inventory of assets and may involve direct ownership of interest rate and inflation swaps. For schemes unable to hold swaps directly or who need a simpler governance structure, pooled LDI funds also provide very effective solutions. Size doesn’t matter When first introduced, LDI was typically a segregated, bespoke solution, largely restricted to very large, more sophisticated schemes. However, as the market has developed, and awareness of the effectiveness of such strategies has increased, the need for more off-the-shelf options has increased. Pooled fund ranges offer a variety of maturities and different protection levels that allow smaller schemes cost-effective access to inflation and interest rate hedging. By taking a building block solution, a scheme can build a portfolio of pooled funds that closely matches its liabilities, not only in terms of maturity but also where those liabilities are fixed or where they are inflation-linked. It may also not be necessary when investing in these funds for a scheme to fully fund them on day one. The remaining capital is therefore free to be invested in return-seeking assets such as equities, cash-plus strategies or property. For example, a pooled fund solution could see £100 million of liabilities hedged through £25 million investment in a mixture of interest rate and inflation-linked pooled funds. The remaining £75 million can be invested in a range of funds targeting various outperformance objectives that can be used to generate excess return. Obviously there are costs associated with implementing an LDI strategy, as there are with any form of investment management. However, an effective implementation strategy can help minimise costs; partnering with an investment manager with the appropriate systems, as well as requisite marketplace access, is essential. Ultimately, though, trustees considering the appropriateness of an LDI strategy for their scheme should focus on the benefits of an approach that significantly reduces volatility in funding levels. This both increases the probability that sufficient assets will be available to meet liabilities and reduces the potentially negative consequences for the sponsor of higher funding costs and balance sheet impact. Andrew Welch Head of Client and Consultant Relationship Management |
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