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
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.
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