Using LDI to set pension fund investment strategy

What is LDI?

LDI is a common acronym for Liability Driven Investment. Globally, corporate-sponsored, defined benefit pension funds have embraced an LDI-framework to setting investment strategy. Adopting an LDI strategy means that investment risk is no longer defined predominantly in relation to the standard deviation of investment returns. Rather, the concept of investment risk is extended to include all risk which could impact the volatility of asset values relative to liability values. In summary, LDI is a framework for setting investment strategy which has, as its end goal, the reduction of volatility in asset values relative to liability values.

Importantly LDI is not limited to consideration of a single asset class, for example, bonds; the LDI framework can (and should) be applied across all asset classes in order to arrive at a holistic view of the volatility of all asset classes relative to the liabilities. The table and diagram below sets out the types of risk that will typically be considered when adopting an LDI approach.

Table 1: Factors influencing asset and liability values

Factors influencing volatility of asset values	Factors influencing volatility of liability values
Systematic (or market) risk (e.g. equity market risk for equities or property market risk for property investments	Interest rate risk
Credit risk	Inflation risk
Liquidity risk	Longevity risk
Active manager risk	Model risk

Chart 1: Risk attribution with liabilities

 

Table 2: Brief description of factors influencing asset and liability values

Factors influencing volatility of asset and liability values	Description
Systematic (or market) risk (e.g. equity market risk for equities or property market risk for property investments	This is risk which characterises the asset class to which an investor is exposed. It cannot be diversified by holding a diversified portfolio of securities within the asset class.
Credit risk	The risk of losing some or all of your investment due to deterioration in the credit-worthiness of your counterparty. While it can be included as part of market risk, for some asset classes, such as corporate bonds, it can make sense to measure this separately due to its importance to the overall risk associated with the asset class. Some quantification of this risk can be made by observing historical, long-term average default rates.
Liquidity risk	The speed and cost at which an investment can be sold for cash.
Active manager risk	The risk that an active manager underperforms its benchmark. When considering its strategic asset allocation, a fund may assume that it can achieve certain market returns, however taking a decision to appoint an active manager means that the manager can underperform the market.
Interest rate risk	The risk that the value of the assets (or liabilities) changes in response to changes in interest rates.  Fixed rate and inflation-linked bonds will typically be the highest contributors towards an asset portfolio’s interest rate risk. Liability cashflows are valued to today’s monetary terms by discounting them to the present day. An increase in the rate of interest used to discount these liabilities will decrease their present value and vice versa. An often quoted, but narrower definition of LDI, is that LDI is about constructing an investment strategy that better aligns the interest rate sensitivity of the assets to those of the liabilities.
Inflation risk	The risk that the value of the assets (or liabilities) changes in response to changes in the market’s expectations for future rates of inflation. Inflation-linked bonds will typically be the highest contributors towards an asset portfolio’s inflation risk.   Liability cashflows are valued to today’s monetary terms by discounting them to the present day. Where future cashflows to be paid increase in line with inflation then an increase  in expectations for future rates of inflation will increase the present value of these cashflows and vice versa. An often quoted, but narrower definition of LDI, is that LDI is about constructing an investment strategy that better aligns the inflation sensitivity of the assets to those of the liabilities.
Longevity risk	This is the risk that the liability cashflows to be paid in the future increases as a result of the recipients of those cashflows living longer than anticipated. Generally, deteriorating longevity (pensioner dying earlier than expected) is considered to be less of an issue as it does not lead to a strain on the finances of the pension fund.
Model risk	This is the risk that the actuary’s projection of future cashflows turns out to be lower than those cashflows that actually materialise. Key demographic assumptions are sometimes embedded in these cashflow estimates, for example, assumptions relating to spouses pensions and early or ill-health retirement experience.  The pension fund’s actual experience is likely to differ from this.

What have been the catalysts for this focus on LDI?

Globally we can point to two main catalysts for extending the definition of risk and hence for the focus on LDI:

1.      Accounting regulations:

During the noughties changes in global accounting regulations resulted in sponsor balance sheets becoming more responsive to recognising changes in pension fund surpluses or deficits (defined as the difference between assets and liabilities) and the latter moving to the use of mark-to-market approaches to value both the assets and liabilities. Together these developments introduced greater volatility in a sponsor’s balance sheet as a result of changes in the pension fund’s surplus or deficit. CFO’s became increasingly concerned that such volatility could materially (and adversely) impact the company’s financial results for reasons that were unrelated to the company’s core business. This was especially true for companies that had pension fund’s whose liabilities were large relative to the company’s market capitalisation – a small, adverse change in a large pension fund liability could swamp any positive performance in the company’s core business.

The poster-children for the adverse impact that these developments could have on a company were two well-known British companies, British Airways and British Telecom. Table 3 below illustrates that the relative size of the pension liabilities and market capitalisations at these two companies are such that a small change in their liability values would have a large impact on their market capitalisation. 

Table 3: Pension liabilities and deficits (Source: Accounting for Pensions 2010; LCP)

Company	Pension liabilities	Pension deficit	Market capitalisation	Liabilities / Market cap	Deficit / Market cap
British Airways	£12.8bn	£0.6bn	£1.6bn	791%	37%
British Telecom	£33.2bn	£4bn	£6bn	551%	66%

2.      Funding regulations:

Following a number of high profile pension fund failures; the result of failure of the sponsor coupled with a poorly funded pension fund, many pensioners were left stranded. Regulators moved to tighten funding regimes for pension funds by emphasising the need for a clear plan to deal with any pension fund deficit and within an acceptable timeframe.  Increasingly, the emergence of deficits in pension funds were at the top of the agenda for company financial managers who could no longer kick the can further down the road. Deficits were having a direct and adverse impact on their cashflows by requiring higher contributions to be injected into the pension fund. All of this was taking place in the midst of the worst financial crisis in history.

In the early part of the noughties these themes played out across Continental Europe and the UK and then, in the latter part of that decade, these changes played out in the US and closer to home in South Africa. Today, corporate pension plans in the US and South Africa are leading the charge to the adoption of LDI strategies with many sponsors in these countries also moving to the “so-called” end-game more swiftly than their UK counterparts, i.e. the transfer of these pension liabilities to an insurance company and, in so doing, entirely eliminating the pension liability from their company balance sheets. But that is a subject for a future article.

LDI in Africa

Defined benefit pension schemes are not as prevalent in Africa as they are in the UK and the US. In South Africa, the continent’s largest pension fund market, defined benefit pension schemes were closed to new entrants in the nineties and their demise was hastened by offering members incentives to transfer out to newly established, defined contribution arrangements. That said, a few large legacy defined benefit pension funds are still in existence and many of these funds have moved towards adopting a LDI strategy, especially for assets backing their pensioner liabilities. The adoption of similar strategies by large pension funds in the rest of the continent is not without challenges due to less developed capital markets but, as discussed, LDI is not about investing in specific assets but rather about the adoption of a framework for the holistic consideration of managing funding level volatility. Adopting such a framework is of paramount importance as a first step towards improved risk management and governance.

Future developments

An LDI framework is not limited in its application and can (and should) be extended to defined contribution arrangements. The absence of a clearly defined or guaranteed liability does not imply the absence of such a liability. In fact, members of defined contribution pension funds are left with no different a challenge – they too need to be sure that they are accumulating sufficient savings in their pension funds on which to ensure a comfortable existence in old age. Arguably, members of these defined contribution arrangements require even greater financial assistance to define clear retirement objectives and goals. LDI can be used to frame such goals by linking savings goals to incomes required in retirement and in this way setting an appropriate long-term investment strategy.

In summary, LDI is a framework for managing investment risk. It has proved to be a useful tool for setting investment strategy especially where there are dual objectives of targeting a long-term savings goal whilst still focusing on the need to ensure acceptable investment outcomes in the short term.  There is an analogy to be drawn between a limited-over cricket game and LDI. In both cases the long-term goal is achieved by the successful achievement of a series of shorter-term goals which when taken together yield the desired end result.