In this edition of Pensions Watch we look at the central role played by Liability Driven Investment in the risk
management of defined benefit pension schemes and consider whether a new economic environment of punchy
inflation numbers and rising bond yields changes anything for this crucial aspect of risk management.
The central role of risk management
Running a defined benefit (DB) pension scheme has never been easy. Indeed, pension fiduciaries have to be
familiar with the laws, vagaries and interconnectivity of economics and financial markets, the intricacies of
investment management, the ramifications of a continuous flow of legislation and regulation, not to mention
the dark arts of actuarial science and accountancy. However, overlaying all of this is the ability to successfully
manage a multitude of risks of different shapes and sizes – some highly visible and quantifiable, others less
so. Indeed, successfully running a DB pension scheme has increasingly become a complex exercise in risk
management. Central to this notion of risk management and critical to the success of DB scheme outcomes,
certainly over the past 10 to 15 years, is running a Liability Driven Investment (LDI) portfolio. Indeed, those DB
schemes which have failed to adopt a formalised LDI policy have seen their deficits spiral skywards.
The science of LDI1
The basis on which LDI operates is very simple. As the scheme’s assets are there to fund the scheme’s
liabilities – effectively a negative asset – the latter becomes the benchmark against which the assets should
be managed. In other words, the assets and liabilities, as two sides of the same coin, must be viewed together
through the same lens to maximise the likelihood that the liabilities, i.e. members’ pensions in payment and
those payable, will be met by the assets in full and on time. After all, constructing an asset portfolio without
a clear understanding of the characteristics of the liabilities would be like a cobbler making a pair of shoes
before measuring the intended recipient’s feet. The chances are the shoes won’t fit! That’s exactly the position
innumerable DB schemes found themselves in, in the early noughties, following the dot.com bust and the
introduction of mark-to-market accounting,2 and in the aftermath of the 2007-08 global financial crisis (GFC),
as the prices of return seeking assets collapsed and the unprecedented declines in nominal and real (inflationadjusted)
bond yields began to unravel.
Getting into the weeds
Interest rate and inflation risk
For the uninitiated, let me explain. The projected liabilities of a DB scheme are analogous to the
projected stream of payments from a bond or, more correctly, from a series of bonds given that each
member’s pension entitlement is unique (and might be taken by the member in a number of ways).3
Just like the price of a bond, the value of a DB scheme’s liabilities is inversely related to changes in bond yields, i.e. as yields fall, liabilities rise.4 They also have a defined sensitivity to small yield changes,
akin to the duration of bonds,5 known as PV01, the present value of a one basis point – or 0.01% –
change in yields.6 Quite simply, a PV01 of, say, £2m, means that the liability value would fall by £2m
given a 0.01% rise in yields and rise £2m for a 0.01% fall in yields. This is the interest rate risk, or rates risk, attaching to a scheme’s liabilities. Then there’s the scheme’s inflation risk which, via its IE01
metric, measures the sensitivity of the liabilities to a 0.01% change in market expectations of inflation.7
Contrary to rates risk, a rise in inflation expectations increases the liability value, given the increased
projected value of both pensions in payment and those to be paid. Depending on the inflation linkage
of a scheme’s liabilities,8 this inflation risk can also be sizeable, with an IE01 often running into in the
hundreds of thousands or millions of pounds.
Long-run unrewarded risks
Given the prospective size of a scheme’s PV01 and IE01, even small declines in interest rates and/
or small increases in inflation expectations, if left unmanaged, can cause a DB scheme’s liabilities to
outpace its assets, to the detriment of its funding level and the security of member benefits. Indeed,
these risks are often described as being long-run unrewarded risks in that, if removed at an acceptable
price,9 they shouldn’t have a material impact on the scheme’s expected, or target, investment return
over the long term.10 In other words, unlike potentially rewarded risks from return seeking assets, there
is no definable risk premium for keeping these unrewarded risks on a scheme’s balance sheet. In so
doing, the scheme’s risk budget is potentially freed up to accommodate greater exposure to potentially
rewarded risks, i.e. to return seeking assets, such as equities and real assets, to improve the scheme’s
funding position in the long run. In this respect, LDI is both a risk management exercise and a risk
reallocation exercise.
Hedging instruments
In managing, or even mitigating, this unrewarded risk, a well run LDI approach should match all or an
agreed percentage (more on this agreed percentage shortly) of the PV01 and IE01 sensitivities of the
liabilities with equivalent bonds or bond-type assets (and it is usually a mix of both), i.e. mirroring the
sensitivity of these liabilities to changes in interest rates and/or to inflation expectations. While LDI
bond assets principally comprise gilts, index-linked gilts11 and, to a lesser extent, other G7 sovereign
bonds and investment grade corporate bonds, bond-type assets overwhelmingly comprise interest rate
and (break even)12 inflation swaps,13 and to a lesser degree gilt total return swaps (gilt TRS)14 and semiilliquid
secure income assets (SIAs). However, SIAs – typically real assets with secure long-term cash
flows, often with an implicit or explicit inflation linkage – are increasingly employed in LDI portfolios.15
Bond or swaps or a combination of each?
Interest rate swaps, in particular, come into their own in matching very long dated, e.g. 50 year,
liabilities, given that there are very few gilts and index-linked gilts that have a sufficiently long duration
to perform this role.16 Additionally, swaps, being synthetic financial instruments, or derivatives, which
overlay the scheme’s asset portfolio, rather than requiring the initial capital outlay of a bond, can
potentially accommodate larger allocations to potentially rewarded return seeking assets. However, this
characteristic is limited by the need to hold sufficient (typically low yielding) collateral assets, variously
in cash, gilts and investment grade bonds,17 to meet counterparty calls on the scheme in the event of rising yields and/or heightened inflation expectations. The size of this collateral pool, or more correctly
the, so-called, rates and inflation headroom the collateral pool provides, will depend upon both the
size of the PV01s and IE01s being hedged and the extent to which the scheme wishes to be protected
against a potential rise in yields and/or inflation expectations beyond the norm, without having to
realise return seeking assets at short notice. However, the continually changing relative value of swaps
and bonds of different maturities, as measured by the, so-called, z-spread,18 adds yet another dimension
to the desired gilt/swap split.
Hedge ratios
Another key decision is the level at which a DB scheme should hedge its PV01 and IE01 risk, or
what percentage of this risk it should manage. One influential survey suggests that DB schemes are
increasingly aligning their LDI hedge ratios with their funding ratios.19 So, if the scheme’s funding ratio
is 85%, then a hedge ratio that manages 85% of PV01 and IE01 risk is targeted.20 This is the same
as having a target hedge ratio equal to 100% of the scheme’s assets. In so doing, these schemes,
which are typically well funded with strong, or tending to strong, sponsor covenants, seek to reduce
the volatility of their funding level, or funding ratio, rather than the absolute value of the scheme’s
deficit, when faced with gyrating yields and/or inflation expectations. However, there are others who
target hedge ratios greater than their funding ratio, or level of assets – some even aligning their hedge
ratios with 100% of the scheme’s liabilities. These schemes, which may not be particularly well funded
and/or have a weak, or tending to weak, sponsor covenant, that might be at odds with the amount
of investment risk being run by the scheme, seek to reduce the volatility of the absolute value of the
deficit, rather than the funding ratio. Of course, there are also those with hedge ratios somewhere
between 100% of assets and 100% of liabilities who, depending on whether the hedge is closer to the
former or latter, principally target reducing the volatility of either the funding ratio or the absolute value
of the deficit – albeit not exclusively.21
Governance considerations
Given the sheer amount of governance and cost entailed in successfully managing a LDI portfolio,
it probably comes as no surprise that, according to investment consultant Mercer, 78% of DB
schemes employ a multi-client pooled LDI fund, run by a LDI portfolio manager, rather than a bespoke
arrangement, run by a portfolio manager on a segregated basis.22
A new LDI paradigm
Against the backdrop of the inexorable decline in nominal yields and the unprecedented transition, since the
GFC, from low positive to deeply negative real yields, it’s perhaps unsurprising that the adoption of LDI policies
among DB schemes has gained considerable momentum over the past decade or so. Indeed, the vast majority
of DB schemes now have a formalised LDI policy.23
However, DB schemes are now faced with a new and, for many pension fiduciaries, unfamiliar LDI paradigm
which, given the seemingly less than transitory nature of recent inflation numbers, has led to sharply rising
inflation expectations, an uptick in nominal yields and even deeper negative real yields. Of course, given that
LDI is very much an exercise in risk management, rather than second guessing the market’s assessment of the
direction of and potential quantum of travel for rates and inflation, the obvious question to ask is, should this
matter? Well, yes, albeit with a qualification.
Why does this matter?
As any DB pension scheme fiduciary will tell you, the number one priority for any DB scheme is to pay pensions
in full and on time. To do so requires a number of key risks to be nailed down, of which rates and inflation
risk are, or should be, at, or near, the top of the risk management agenda. Indeed, as noted earlier, those
DB schemes which, over the past decade or so, have failed to successfully manage these risks, rates risk in
particular, have seen their deficits spiral skywards.
However, when faced with a rising yield environment, the temptation might be to take off, or at least dramatically
reduce a scheme’s hedge ratio, so that a lower value can be assigned to the scheme’s, now unhedged,
liabilities. This would, in turn, cut the deficit and bolster the funding ratio. Alas, this is missing the point of risk
management. In short, what if rising inflation expectations and yields prove short lived and these metrics return
to their former values? This is the qualification.
That said, consideration should be given to the asymmetric effect of rising yields on a scheme’s funding ratio
and deficit, depending on the level of hedge ratio employed. Let me explain. Taking the performance of the
scheme’s return seeking assets out of the equation, a rising nominal yield environment for a 100% assets-level
hedge results in a stable funding ratio but a reduced deficit, whereas for a 100% liabilities hedge, the deficit
should remain the same but the funding ratio will fall. Given this asymmetric trade off, pension fiduciaries might
consider – funding level, sponsor strength and the level of investment risk being run notwithstanding – trimming
a 100%+ assets hedge ratio closer to a 100% assets-level hedge.24 Of course, the opposite applies when yields
are falling.
Equally, the rates and inflation sensitivities of the hedging assets should be regularly assessed to ensure they’re
still performing their matching function, given how dramatically these sensitivities can change with gyrating yields
and inflation expectations in today’s low yield environment. Additionally, it pays to keep a beady eye on the rates
and inflation headroom afforded by the scheme’s collateral pool. After all, the actions of central banks, especially
when inflation expectations are rising,25 can often blindside markets and materially impact yields to a greater
degree than expected.26
To finish where we started, running a DB scheme has never been easy – nowhere more so than in ensuring a
scheme’s rates and inflation risk is being managed appropriately. However, there is an additional consideration,
which adds a degree of complexity to LDI policies for the sheer number of DB schemes that are now cashflow
negative.27 And that is ensuring sufficient liquidity is made available to meet pensions in payment over the
short- to medium-term without overly relying on regular disinvestments from return seeking assets – the very
same assets that ultimately seek to plug deficits and pay pension increases. However, while quite a long and
governance-intensive list, by getting all of the inputs to a LDI policy right, DB schemes should be well on their
way to meeting the number one priority of paying benefits in full and on time.
