Roundtable: Liability-driven investment – planning ahead - Special Features - Pensions Week

Tweet By David Rowley | 23 November 2011 |

How do trigger mechanisms work?

Featuring:

• Gerry Degaute, chief executive, Royal Mail Pension Trustees
• Chris Atkins, managing director, Atkins Trustees
• Shalin Bhagwan, head of structuring, Legal & General Investment Management
• Russell Chapman, partner, Hymans Robertson
• Steve Jones, director, Capita Pension Trustees
• Mark Humphreys, head of UK strategic solutions, Schroders
• Peter Drewienkiewicz, head of manager research, Redington

Shalin Bhagwan: We try to impress upon clients that liability-driven investment (LDI) is about setting in place a framework. So if you are not prepared to buy these government bonds today at these prices, are you prepared to buy them at some point in the future at a lower price, to potentially give you a higher yield?
And so we try to have a debate or discussion around ‘If not today, then when? How far forward would you go?’ And actually it is possible to buy bonds on a forward basis, to say ‘Well, if the bond was yielding 4.5% in three or five years’ time, Mr Trustee, would you be prepared to buy the bond?’
‘Oh yes, absolutely, we’d buy the bond then.’
‘Well, did you know you could actually do that today? Let’s not take the risk of us walking out of the room today and coming back in three years’ time and the bond not yielding 4.5% but 4%. If it does yield 4.5% you’ve indicated that you wouldn’t mind buying that if that’s where it was in three years, so you can actually look at entering into those sorts of transactions now.’
That concept we just refer to as forward yields, because actually the yield curve, a 30-year bond, tells us something not just about rates over the next 30 years; it has an implied forward path for interest rates embedded in that. This implied future path suggested that interest rates would be higher in the future, and so you could actually look at that as a neat way of buying into bonds at slightly better yield levels.

Steve Jones: Well, how many trustees are equipped to make that call? I mean, they are dependent on their advisers to a large extent.

Pete Drewienkiewicz: That’s exactly right and that’s exactly why you need to have a good governance make-up and risk management framework in place. But also you’ve got to trust your advisers. When you pick an LDI manager, you’ve got to trust that management team to quarter-back. The only choice for trustees who don’t have an extensive governance budget is to put more in the hands of guys like Mark and Shalin.

Gerry Degaute: I just wondered on your point about buying forward; is that a full legal commitment that is on the books immediately? So you bought forward, and that board of trustees has not fettered a future board of trustees by going into that because it’s actually on the books today, so it’s a today transaction, but at what prices might be three years hence?

Bhagwan: You could turn the problem around and say that when you enter into a 30-year swap, you’ve actually entered into two transactions; a five-year swap and a 25-year swap in five years’ time. And that’s the point – when you buy a 30-year swap, you have locked into the forward yield and arguably by doing a 30-year transaction you have already impinged on the flexibility of the next board of trustees, so this is just about trying to find smarter ways of doing that transaction.

We potentially have a distorted bond market in the developed world because of the massive intervention by central banks

Russell Chapman: Some of it’s a bit semantics and if you as a group of trustees hold a certain view, you should probably go ahead and exercise that rather than leave it for three years and hope that the group in three years have the same understanding that you do, and thus then potentially miss the chance because they’ve forgotten why you decided it was a good idea at the time.

Mark Humphreys: One thing we haven’t talked about so far is, why does LDI exist in the UK? It exists because there is this mark-to-market in UK schemes and we’ve got a focus on yields. We are assuming that yields are entirely marketdriven by the economic outlook and supply and demand. Actually we potentially have a distorted bond market in the developed world because of the massive intervention by central banks.
So the US Fed launches Operation Twist; 30-year Treasury bonds move to the lower end of the range they’ve been in for a while. Is that a true free market or is that a distortion? And obviously that feeds across to gilts and other developed-world bond markets. Are we marking to a market which is actually distorted?

Degaute: So we’re marked to a false market?

Chapman: If the 30-year interest rate is 3%, then reading that literally says that the average interest rate will be 3% over the next 30 years. But if they are currently 3% because external forces are manipulating them to make them very low, then actually rates are going to be much higher than that so you’re better off not buying 3%.

Bhagwan: The external force manipulating the long end of the US Treasury curve today is the Fed. Four or five years ago, pension funds that chose to stay out of LDI on the basis of yields being too low, argued that LDI adopters were manipulating the long end of the UK gilt curve. It kind of feels like you end up in a place where there’s always something that is a rational explanation for why you wouldn’t enter into this investment at this point in time, and that perhaps if the world was slightly different at some point in the future, well, we would do it differently.
My basic point is you’re always faced with extraordinary market forces – or you could potentially always be faced with extraordinary market forces – and you need to navigate through those and not discard them to suit your purpose.

LDI for DC?
Degaute: I was just wondering, we’re sitting here thinking defined benefit (DB) but who’s going to manage this for the defined contribution (DC) members? Who’s got a product that’s going to come out to help them through this?
Jones: There’s no doubt LDI is attractive to DC.
Chapman: It’s going to be 2025 or 2030 when the good bulk of DC money going in today gets invested, so that will probably come out of equities and into annuities. The whole underpin of the lifestyle idea is to switch from growth assets early on to matching assets later on. Typically that’s over a 15-year gilt or corporate bond, or something in the decumulation phase. So if that was an LDI fund that better matched annuity prices, it has a very clear role in DC.

The DC landscape is in some ways an even scarier place than the DB world

Drewienkiewicz: The DC landscape is maybe in some ways almost an even more scarier place than the DB world, because all we’ve done is make it the problem of an even wider group of people who aren’t sufficiently financially educated to make those decisions.
Humphreys: There’s clearly a role for LDI in DC. It is probably currently in the ‘too complex for members’ box but it definitely has a natural role at some point in hedging some of the annuity purchase risks that most DC members face.
However, LDI in general does not yet deal with longevity risk.

Bhagwan: The range of options a DC member will have in the future will be wider than it has been in the past five to 10 years, but I think it’s an open question.

See the previous LDI roundtable discussing performance here.