QE bad for pension funds; bad for the economy too?
14 February 2012 PensionFunds Insider Alexandra Zeevalkink
The Bank of England is to inject another £50bn into the UK economy in order to restore consumer spending levels and increase corporate lending, but many pension funds will be wringing their hands at the decision.
The new round of asset purchasing by the bank, commonly known in the UK as quantitative easing (QE), was expected given the frail state of the UK economy, but the controversial measure will also bring further unwelcome extra liabilities to pension scheme balance sheets. With bond yields dropping as the bank buys up gilts, the schemes will see their incomes drop considerably compared to their liabilities.
The bank started with QE back in 2009 when expected consumer spending stayed out after the government announced cutbacks as a result of the financial crisis. Initially the bank pumped £200bn into the UK economy, which was followed by another £75bn in October 2011. Now, according to the latest reports, the 'Old Lady' of Threadneedle Street is ready to increase the total investments so that the total figure stands at £325bn. With the British economy posting an estimated 0.2% contraction in the last three months of 2011 and an uncertain future due to current Eurozone woes, the move was expected by analysts. But some also warn of the effect QE has not only on pension funds and their members, but on the economy itself, which the Bank is trying to help revive.
"More quantitative easing will worsen inflation and lower long-term interest rates, which will worsen pension fund deficits and lower consumer confidence, thus actually damaging, rather than stimulating sustainable growth", warns Ros Altmann, director-general of the Saga Group and a pensions expert. Altman points out that falling bond yields also make annuities more expensive, giving new retirees much less pension income for their money and leaving them with less spending power. Mark Gull, the Pension Corporation's co-head of asset management told Pension Funds Insider that QE is a method of "transferring wealth from savers to borrowers". According to the Corporation, a new round of quantitative easing this week could soon add another £85 billion to UK pension deficits by lowering gilt yields by another 30 basis points. Another drop in equity markets (by 10%) after a possible Greek default in March is also factored into this gloomy outlook.
Speaking to Pension Funds Insider, Shalin Bhagwan, head of structuring in the Liability Driven Investment Funds unit at Legal & General Investment Management, says that QE puts a strain on schemes "when they can least afford it". "There is a dichotomy going on, cash rich schemes will be fine but others will feel the extra pressure," he says. "Also, is the government really trying to stop schemes from buying bonds and move them to more riskier assets such as equities?"
To the 40% of pension funds in the UK that are due to have their next valuation in March, the move from the Bank of England comes at a particularly important time and many will end up experiencing difficulties, as will their sponsors.
The Pension Corporation previously estimated that pension fund deficits were pushed out by a net £74bn under the first round of QE – the increase in liabilities minus the estimated rise in equities and bonds. "This means sponsors could be forced to pay an additional £7.4bn a year until at least 2020 into their pension fund to cover the additional £74bn hole created by QE1," the Corporation says. "There will be some companies out there that will need to invest more money in their scheme and consequently can not invest that money elsewhere," Bhagwan says.
The Pensions Corporation sees the same problem and recommends that in the interests of UK pension funds QE2 should not buy gilts with a maturity longer than 25 years and should return to the original mandate - which did not target these long dated bonds which are so popular among pension schemes. Though QE is said to be a temporary measure, evidence from the Great Depression and Japan's collapse in the late 1990s suggests otherwise, says Gull. He suggests that depressed gilt rates could stay around for "decades, rather than years", directly affecting schemes' balance sheets over that same period.
The latest figures from the PPF 7800 Index show that the aggregate deficit of the 6,533 schemes in the index is estimated to have increased over the last month to £255.2bn at the end of December 2011, from a deficit of £222.1bn at the end of November. The average funding ratio fell from 81.9% to 80.%, 5,473 schemes found itself to be in deficit and only 1,060 schemes had a surplus. During the last round of QE Ian Tomlinson, the then chairman of the National Association of Pension Funds (NAPF), already warned that around 1000 UK pension funds were at severe risk of a double hit from "the torture of quantitative easing". The NAPF claimed at the time that QE would significantly increase the deficits of UK pension funds and that final salary schemes would be forced to close as a result.
S
o, although strong companies with healthy balance sheets will profit from QE, will the positive effect QE has for them even out the negative effect it has for those schemes, sponsors and retirees who need to be bailed out?
Consultants: Pensions, While Hesitant, Likely to Increase Derivative Use
October 17, 2011 aiCIO
While schemes are still reluctant to use derivatives, pension funds are increasingly using these investment vehicles to hedge against interest-rate risk, consultants say.
While there is still a general concern among institutional investors about effectively using derivatives, schemes are increasingly using these investment vehicles to hedge against interest-rate risk.
"We've seen a growing number of especially corporate pensions using derivatives as they pursue liability-driven investment," Strategic Investment Solutions' Managing Director John Meier told aiCIO. "If you're trying to lower pension surplus interest rate risk, using derivatives is definitely effective in order to maintain a reasonable level of return."
Mercer consultant Gordon Fletcher voiced a similar perspective, noting that he has witnessed a much greater interest in derivatives among corporate funds as they look into derisking strategies amid an environment of frozen legacy liabilities. The perceived growing use of derivatives among institutional investors is supported by a June study that showed that asset owners have retained an appetite for innovation where specific principles are met, fueled by the entrepreneurial culture in the United States. The annual, independent study by CREATE-Research, commissioned by Citi's Global Transaction Services and Principal Global Investors, revealed that schemes have welcomed new asset allocation techniques, such as the use of derivatives, to hedge out unrewarded risks. However, leverage, structured products, portable alpha, and currency funds were perceived as lacking intrinsic value.
Despite the greater use of derivatives, Meier added: "In the US and elsewhere, I think there's a general concern over derivatives, but if there's adequate education about what they do and how they work, schemes can get trustees to sign on," adding that many funds are still hesitant about the extra risks that derivatives introduce, such as basis risk -- when the derivatives used to hedge don't directly hedge with what they're trying to hedge -- and counterparty risk.
Consultants note that with derivative usage comes big challenges in terms of governance. "Investment committees meet once a quarter -- they may not have much time to allocate to running a plan, and using derivatives is quite a big commitment," Fletcher noted.
UK Pensions Mirror America -- or Vice Versa?
UK-based advisers have reiterated a similar perspective of distrust over the use of derivatives, as reported by Reuters. "When the world is concerned about deflation, that is the time for a pension fund to start thinking about inflation risk. Right now, the cost of hedging that over 10 years using inflation-linked government bonds is less than the government target (for inflation)," Shalin Bhagwan, head of structuring in the Liability Driven Investment Funds unit at Legal & General Investment Management, told Reuters, noting that schemes are running out of time to hedge portfolios against inflation.
Schemes in the US and the UK aren't widely using derivatives to effectively hedge against inflation risk, but they could be, Meier told aiCIO. "Inflation risk is a risk that institutional investors are increasingly focused on. With the markets reflecting an expectation that inflation will remain at current levels, the cost for hedging now is pretty low. This could be a good time to hedge against inflation and especially though the effective use of derivatives."
In terms of longevity risk, Meier said that while derivatives haven't been widely and effectively used to hedge against this type of risk, there may be opportunity for derivatives in that area of risk management. While still in its infancy stage, Mercer's Fletcher added that UK schemes are ahead of the US in terms of using derivatives to hedge against longevity risk. "It's certainly on the table in the future for both the US and UK," he said.
In May, Bloomberg reported that banks are now forming death derivatives to help pension funds better manage longevity issues. According to the news service, pensions are purchasing insurance against the risk of their members living for longer than anticipated. Yet, it has become increasingly difficult to find buyers willing to take that risk, packaged in the form of bonds and other securities. JPMorgan and Prudential have set up a trade group to establish a secondary market for longevity risk, while Goldman Sachs and Deutsche Bank have created insurance companies that promise to pay pensions if retirees live beyond a certain age, Bloomberg reported.
Meanwhile, schemes are increasingly transferring risk to insurance companies, driven by merger and acquisition activity, a growing number of closures and part-closures of defined benefit pension schemes, and concerns over longevity risk. A March report by Hymans Robertson showed that UK pension buyouts, in which an entire scheme is passed to a specialist insurer, are becoming more and more prevalent.
Roundtable: Liability-driven investment – planning ahead
| 23 November 2011 |
How do trigger mechanisms work?
Featuring:
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.
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.
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.
- 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
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.
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.
| 08 November 2011 |
How has liability driven investment (LDI) performed over the past five years?
Featuring:
Chris Atkins: I have some difficulties in defining what successful means in terms of LDI because you’re just trying to match your assets and your liabilities in a specific way. If you do that then you’ve succeeded. You tend to measure success via reference to what would have happened if you hadn’t done it.
Degaute: It is a vehicle for buying insurance and at a price. If you look back and say you bought your insurance at something that is far less than today, I guess you feel quite good about it.
Pete Drewienkiewicz: Shouldn’t we try to separate the question of success from the market moves we’ve seen? If we look at the past five years then you’re absolutely right; anyone who was a relatively early adopter of LDI probably feels it’s been extremely successful for them because yields are now a lot lower than they were. But you try to separate it from the way we’ve seen markets move. We try to say, ‘Has that way of thinking been a success?’ And you would probably have to say yes, it has.
Mark Humphreys: That has been its greatest success – making people think about a scheme’s assets and liabilities in their entirety. This is really looking at a scheme in a different way.
Degaute: I agree it is a way of thinking and perhaps what you mean by that is we bought something else in the process. That something else was the management of liability as opposed to assets, so that made us focus more on risk – a risk embedded in what we have to face as opposed to a risk we can take and seek more return.
LDI to a certain extent has been obliged upon us because of the mark-to-market world we’re in, so we have to worry about the volatility far more than we used to, where we could take the return-seeking assets and just smooth them at the point of becoming depressed. In fact they can smooth down the upside as well.
Russell Chapman: The big success has been around understanding and people have acknowledged they’re facing this big risk, which has really woken them up to managing the risk in some sense.
The point about smoothing is quite interesting because if you look at a number of schemes that have got quite developed LDI programmes, it’s actually acted on the investment side to smooth out returns. Typically, when things have gone badly, your LDI portfolio has delivered and that has meant overall investment returns – not in a matching sense but in a total return sense – have been smoothed, which is not what it’s meant to be, but it’s been a by-product of the way markets have gone.
Q If yields were a lot higher than they are now – much higher than they were in 2006 – would you still say LDI had been successful?
Degaute: The answer is yes; the focus was to manage liability, so once that’s agreed by trustee and company, that’s the thing to do because in that sense it’s taken the risk off the books. I’m talking with the benefit of hindsight and so yes, it gave early movers better returns overall but the driver was management of risk, not added return.
Shalin Bhagwan: If yields were higher it would actually be a good thing. Clients haven’t put all their eggs into the LDI basket. By no stretch of the imagination have the majority of UK pension funds reduced all their exposure to interest rate and inflation risk, which are two big risks LDI really tries to manage. Higher yields would actually allow the unhedged liabilities to fall in value and give people the opportunity to take that risk. It’s a phased approach that clients have tended to adopt.
Atkins: Now we have low yields it makes LDI expensive. But anybody who comes into LDI at this point are assured success on the criteria they’ve set because they’ve done it on the basis that they want and need to take risk off the table. Therefore it’s almost self-evident it must be successful because that’s what you’re trying to achieve and you’ve achieved it by doing it. So it’s sort of a silly question.
Chapman: What’s happened for those schemes that haven’t done a lot, or haven’t gone that far down the route, is they are now in a position where the risk is still too big. It’s still disproportionate in relation to anything else they are facing and that gives them a difficult decision – shall we continue to run a risk that’s too big for us or shall we take it out, insuring it at a cost that we think is too expensive?
Atkins: On a risk-valued asset we’re obsessed with capital value and changes in capital value. But in LDI we’re looking at income and putative benefit flows. When you invest in equities it’s all down to the market standing at 5,000, not what’s happening to income from those securities. And we’ve got this imbalance between looking at fixed interest or inflation-linked equities. Maybe we should be moving towards looking at equities the way we looked at cash flows and actuarial valuations years ago, which was on the basis of future cash flows. Now we don’t tend to do it; we’re obsessed with the short-term volatility in equity markets.
Steve Jones: Certainly trustees should be having debates so they understand that if the window is open and it’s an appropriate time, they can go into some of these strategies.
Drewienkiewicz: Yields are of course very low, so maybe the offshoot question is what relevance does LDI have when rates are so low? You might not necessarily want to do something straight away but if you can put in place a sensible risk-management framework that’s going to allow you to take risk systematically off the table at certain levels and at least put in place the governance structure to allow you to act at appropriate times and act rapidly, then that in itself is a massive evolution and a big step forward from where we were five or 10 years ago.
- Gerry Degaute, chief executive, Royal Mail Pension Trustees
- Chris Atkinds, 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
Chris Atkins: I have some difficulties in defining what successful means in terms of LDI because you’re just trying to match your assets and your liabilities in a specific way. If you do that then you’ve succeeded. You tend to measure success via reference to what would have happened if you hadn’t done it.
Degaute: It is a vehicle for buying insurance and at a price. If you look back and say you bought your insurance at something that is far less than today, I guess you feel quite good about it.
Pete Drewienkiewicz: Shouldn’t we try to separate the question of success from the market moves we’ve seen? If we look at the past five years then you’re absolutely right; anyone who was a relatively early adopter of LDI probably feels it’s been extremely successful for them because yields are now a lot lower than they were. But you try to separate it from the way we’ve seen markets move. We try to say, ‘Has that way of thinking been a success?’ And you would probably have to say yes, it has.
Mark Humphreys: That has been its greatest success – making people think about a scheme’s assets and liabilities in their entirety. This is really looking at a scheme in a different way.
Degaute: I agree it is a way of thinking and perhaps what you mean by that is we bought something else in the process. That something else was the management of liability as opposed to assets, so that made us focus more on risk – a risk embedded in what we have to face as opposed to a risk we can take and seek more return.
LDI to a certain extent has been obliged upon us because of the mark-to-market world we’re in, so we have to worry about the volatility far more than we used to, where we could take the return-seeking assets and just smooth them at the point of becoming depressed. In fact they can smooth down the upside as well.
Russell Chapman: The big success has been around understanding and people have acknowledged they’re facing this big risk, which has really woken them up to managing the risk in some sense.
The point about smoothing is quite interesting because if you look at a number of schemes that have got quite developed LDI programmes, it’s actually acted on the investment side to smooth out returns. Typically, when things have gone badly, your LDI portfolio has delivered and that has meant overall investment returns – not in a matching sense but in a total return sense – have been smoothed, which is not what it’s meant to be, but it’s been a by-product of the way markets have gone.
Q If yields were a lot higher than they are now – much higher than they were in 2006 – would you still say LDI had been successful?
Degaute: The answer is yes; the focus was to manage liability, so once that’s agreed by trustee and company, that’s the thing to do because in that sense it’s taken the risk off the books. I’m talking with the benefit of hindsight and so yes, it gave early movers better returns overall but the driver was management of risk, not added return.
Shalin Bhagwan: If yields were higher it would actually be a good thing. Clients haven’t put all their eggs into the LDI basket. By no stretch of the imagination have the majority of UK pension funds reduced all their exposure to interest rate and inflation risk, which are two big risks LDI really tries to manage. Higher yields would actually allow the unhedged liabilities to fall in value and give people the opportunity to take that risk. It’s a phased approach that clients have tended to adopt.
Atkins: Now we have low yields it makes LDI expensive. But anybody who comes into LDI at this point are assured success on the criteria they’ve set because they’ve done it on the basis that they want and need to take risk off the table. Therefore it’s almost self-evident it must be successful because that’s what you’re trying to achieve and you’ve achieved it by doing it. So it’s sort of a silly question.
Chapman: What’s happened for those schemes that haven’t done a lot, or haven’t gone that far down the route, is they are now in a position where the risk is still too big. It’s still disproportionate in relation to anything else they are facing and that gives them a difficult decision – shall we continue to run a risk that’s too big for us or shall we take it out, insuring it at a cost that we think is too expensive?
Atkins: On a risk-valued asset we’re obsessed with capital value and changes in capital value. But in LDI we’re looking at income and putative benefit flows. When you invest in equities it’s all down to the market standing at 5,000, not what’s happening to income from those securities. And we’ve got this imbalance between looking at fixed interest or inflation-linked equities. Maybe we should be moving towards looking at equities the way we looked at cash flows and actuarial valuations years ago, which was on the basis of future cash flows. Now we don’t tend to do it; we’re obsessed with the short-term volatility in equity markets.
Steve Jones: Certainly trustees should be having debates so they understand that if the window is open and it’s an appropriate time, they can go into some of these strategies.
Drewienkiewicz: Yields are of course very low, so maybe the offshoot question is what relevance does LDI have when rates are so low? You might not necessarily want to do something straight away but if you can put in place a sensible risk-management framework that’s going to allow you to take risk systematically off the table at certain levels and at least put in place the governance structure to allow you to act at appropriate times and act rapidly, then that in itself is a massive evolution and a big step forward from where we were five or 10 years ago.
UK pension funds need derivatives rethink
By Sinead Cruise
The return of quantitative easing has reinforced a case for reform in the way some pension funds are managed, with some critics honing in on the infrequency of trustee meetings to approve asset allocation changes. Analysts also highlight trustees' aversion to the use of swap-based tools or hedging to manage risks like inflation or stock market falls. "The big problem is the concept of selling short ... I have met fund trustees who are uncomfortable allowing managers to sell something they do not actually own or making money because a price goes down," said Gordon Ross, global fixed income manager at DB Advisors, part of Deutsche Asset Management. "But investment guidelines will need to be amended to permit such strategies," he said.
The Bank of England has committed to buy 75 billion pounds of government bonds over the next four months which will depress the yield on this pension fund staple investment, making it tougher and more expensive for funds to match income to liabilities unless riskier, higher-yielding assets are added to portfolios. But even if trustees accept they need to raise the proportion of higher-risk assets like equities or corporate bonds in their portfolios to meet obligations, many remain suspicious of complementary hedging strategies designed to offset this risk if bets turn sour.
"Just because you are a good long-only manager it doesn't make you a good absolute return manager ... the ability to protect in a down-market is almost as valuable as being able to identify the trigger point to buy in an up market," Ross said.
Despite being responsible for hundreds of billions of pounds of retirement savings, the UK pension fund sector is broadly seen as less nimble than it should be when dealing with bouts of market volatility, which has recently sent deficits soaring. The aggregate deficit of the 6,533 UK pension schemes in the PPF 7800 index increased to 196.4 billion pounds at the end of September, up from a deficit of 117.5 billion pounds at August 31, government estimates show. "Many pension funds review their asset allocation on a regular but infrequent basis; in some cases this can be only once every three years," Mirko Cardinale, Head of Strategic Asset Allocation Research at Aviva Investors (AV.L), said. To demonstrate the need for more flexible and timely management, Aviva constructed two hypothetical portfolios with the typical asset weights of an average UK pension fund in 2001. Over 10 years, one portfolio was managed dynamically, shifting its exposure to equities, fixed income, cash and property in response to changing returns, risk and correlation each quarter while the second rebalanced its allocations annually, in line with typical industry practice.
The dynamic portfolio outperformed the static one by almost 3.5 percent a year, Aviva said. Moreover, the swift rebalancing helped to its reduce overall volatility and lowered the downside risk, with the maximum quarterly loss about 4 percent.
INFLATION - THE NEXT BIG BATTLE?
Shalin Bhagwan, head of structuring in the Liability Driven Investment Funds unit at Legal & General Investment Management said pension funds are running out of time to hedge portfolios against their biggest foe - inflation.
"Inertia is costing people money, definitely. The equity horse has bolted but inflation risk is what people should now be focused on," he said, referring to missed opportunities to use equity options or variance swaps to minimise hurt caused by recent falls in global stock markets. The reluctance to hedge out the risk of a future spike in inflation contradicts the typical pension fund mantra of investing for the long-term and keeping costs low.
"When the world is concerned about deflation, that is the time for a pension fund to start thinking about inflation risk. Right now, the cost of hedging that over 10 years using inflation-linked government bonds is less than the government target (for inflation)," Bhagwan said.
But Saker Nusseibeh, head of investment at Hermes, the manager owned by the BT Pension scheme, said investors must resist making significant risk management decisions on the back of very short-term market moves. "While this momentum has been building under the heading of greater financial sophistication and risk management techniques, it is now being applied with particular alacrity and vigour in response to unprecedented market conditions," said Nusseibeh, who also chairs the 300 Club, an industry body keen to highlight the dangers of short-term reactions to volatile markets. Even with more meetings and flexible investment guidelines, advisers say most pension funds will always have a natural aversion to synthetic tools in tail-risk management strategies. "If you hedge an asset with a short derivative position, upside is zero and that is something psychologically hard to accept for many people," said Alexander Preininger, head of overlay management at DB Advisors.
(Editing by Greg Mahlich)
Counting the true cost of LDI
17 March 2008
Cost is becoming an important factor in the LDI market,and will mean the difference between success and failure for many providers, says Shalin Bhagwan.
Liability-driven investment (LDI) is being promoted, if not as the solution, then at least as a significant step on the road to recovery for pension schemes. However, the use of the three-letter acronym LDI is being used to describe a variety of investment strategies with vastly different objectives, and there is a surprising lack of information describing the costs of implementation.
That said, there is increasing convergence in using LDI to refer to the reduction of interest rate and inflation risk embedded in a pension scheme’s liabilities (see box one).
BOX ONE: Interest rate and inflation risk
Interest rate risk: The present value (ie the value in today’s monetary terms) of pension fund liabilities is calculated by discounting the expected future benefit payments. Using a lower interest rate to calculate the present value of the liabilities gives a higher liability and is the source of interest rate risk. Reducing (or hedging) interest rate risk creates a more stable liability value – one that does not change as much as interest rates change. An interest rate swap is a financial asset that allows the hedging of interest rate risk.
Inflation risk: Pension schemes’ benefit payments are often linked to future rates of inflation. For example, pensioners may receive a pension that increases each year in line with inflation. Future inflation rates are unknown and the scheme is therefore uncertain about the cost of paying future pensions. Inflation swaps are a type of financial asset that allow the hedging of inflation risk. They increase in value when inflation is higher, thereby compensating the scheme for the higher benefit payments it needs to make.
This brings us to the focus of this article: the costs of implementing a LDI strategy. An understanding of costs is made easier if we recognise that, while the implementation of LDI strategies takes a variety of forms, there are only two basic assets used to reduce interest rate and inflation risk: bonds and swaps. In this article, we focus on the costs associated with investing in swaps, since most trustees are familiar with the cost of investing in bonds.
Over-the-counter market
In contrast to many of the asset classes that trustees have historically encountered, swaps are traded ‘over-the-counter’. This simple difference is at the root of many of the complications that arise under a LDI strategy. Having been used to the comfort of exchange-traded investments, it is perhaps not surprising that trustees and advisers require more time to familiarise themselves with the nuances of over-the-counter markets. A significant feature of these markets is that purchase (and sale) prices and transaction costs (or spread costs) are typically individually agreed between the buyer and vendor. In the main, they are not visible to others not involved with the transaction. These features cloud the true cost associated with a LDI strategy. Help for trustees takes the form of asset managers with the necessary skill and experience to act as a fiduciary on the trustee’s behalf when trading swaps, a point we return to later.
Transaction costs
Transaction costs are paid when a swap is bought (or sold). The cost is often quoted as a percentage of the size of the transaction. Also known as the spread cost, it is paid for each year that the swap is in effect. However, rather than being paid annually over the lifetime of the swap contract, the total transaction cost is paid for upfront. At this point you are thinking, this all sounds pretty obvious. That is until you realise that market convention is to quote this cost as the cost to be paid each year, rather than the total upfront cost. The second subtlety is that a similar transaction cost is charged when you sell the swap. Again, this may be obvious, but what is less obvious is this cost on sale reduces the longer you hold the swap. Total costs are therefore heavily influenced by the period for which the swap is held. For this reason, swaps lend themselves better to longer-term buy-and-hold strategies.
Spreads for buying (and selling) typically range between half and two basis points (0.005%-0.02%), with some common rules of thumb being:
Price discovery
The over-the-counter nature of swaps complicates establishing a fair price to be paid for entering into a swap transaction. This is in contrast to exchange-traded investments, such as bonds and equities, where prices are publicly quoted and transparent. It is for this reason that the astute investor focuses on minimising the total of the price and spread paid when entering into a swap transaction, rather than focusing on one at the expense of the other. In fact, a strategy of minimising spread costs without paying attention to the price being paid for the assets will be to the scheme’s detriment.
Opportunity cost
When the pension scheme is owed money under a swap contract, it will want to receive periodic payments (or collateral) as comfort that the contract will ultimately be honoured at maturity. Of course, the scheme may also need to make such payments in the opposite direction. For this it needs ready access to suitable assets. Typically, suitable assets means cash or high credit-quality bonds. To hold these assets the scheme may need to switch out of other asset classes that offer a higher return, for example equities. This results in an opportunity cost to the scheme, increasing the cost of implementing a LDI strategy. LDI product providers have adapted their product sets to increase flexibility in this regard so that with the exception of the raciest (and riskiest) investment strategies, most providers offer sensible options for reducing opportunity costs.
Asset management and custody fees
In practical terms, implementation often involves the use of an asset manager. The asset manager could fulfil (and charge for) a number of roles, including:
Trustees should understand exactly what services are included in the asset manager’s quoted fee. In particular, any promise of added value from active management against a liability benchmark should be considered separately. Finally, a custody fee will be incurred on the collateral assets and is sometimes not explicitly disclosed.
Slippage costs
This category of costs is probably better described as a risk, but given its potential to negatively impact the scheme’s financial position, it is described as a cost. Simply put, an interest rate hedge exchanges the pension scheme’s exposure to long-term interest rates for an exposure to short-term interest rates (see box two). Far from totally eliminating interest rate risk, the scheme has substituted one risk for another. The scheme is now left with the challenge of investing assets so that they offer a return at least equal to that which the scheme has committed to paying away. This is a non-trivial matter. If, over the term of the swap, the scheme is unable to earn at least this return, then there will be a further cost to a LDI strategy.
Advisory costs
The last category of costs is arguably less significant than the costs we have so far described, but fee-conscious trustees will know advisory costs can be non-trivial. They include the cost of your investment consultant designing and signing off on the strategy, legal advice on any documents to be signed and a more sophisticated governance structure.
The longer-term nature of LDI strategies means guarding against fees that look unreasonably low and are therefore unlikely to be sustained at those levels over the long term. A short-term gain may well turn into long-term pain. As the market for LDI strategies has developed, asset managers have stepped up to offer pooled, off-the-shelf solutions aimed at eliminating the hassle associated with implementing a LDI strategy. The benefit for trustees is the opportunity to benefit from the economies of scale inherent in a pooled approach, so trustees with an eye to cost savings over the long term may be wise to place a premium on those asset managers with a track record of building scaleable pooled funds at low cost.
LDI strategies are primarily about risk reduction. While the cost of implementation should not serve as a distraction to trustees, LDI strategies are becoming more commonplace and their commoditisation is an inevitable consequence. In a commoditised market, cost is a key differentiator, with scale a critical success factor. Trustees and consultants are increasingly responding to these trends and recognising that some solutions and providers will deal better with this challenge than others.
BOX TWO: Scheme liabilities, swaps and interest rates
As described in box one, pension scheme liability values represent the discounting of a series of expected future cash flows, at a particular rate of interest. The choice of interest rate is a key determinant of the liability value. In particular, it is important to recognise that interest rates vary by term. This means the fixed rate of interest the market is prepared to guarantee varies by the term of the guarantee. Pension scheme liability cash flows are, on average, due over long periods. So in choosing a rate of interest to be used for discounting future cash flows, pension scheme liability values are said to be exposed to changes in long-term interest rates.
Interest rate swaps solve the problem of liability values by offering to pay the swap-buyer a fixed rate of interest guaranteed over the long-term. The swap is a payment by the swap-buyer, to the seller, of a floating, short-term rate of interest known as Libor. So that, far from eliminating interest rate risk, interest rate swaps exchange a pension scheme’s liability exposure to changes in long-term interest rates for exposure to changes in short-term interest rates (Libor).
Having entered into an interest rate swap, the key challenge for the pension scheme is then one of generating Libor on the amount on which a fixed rate of interest has been guaranteed. The risk of not generating Libor lies squarely with the trustees. This can be seen by recognising that the fixed rate of interest locked into, is only guaranteed if Libor is generated. The impact of not generating Libor is therefore to effectively reduce the fixed rate of interest the pension scheme can expect to receive, net of paying away its Libor commitment. Investments are, however, available to enable pension scheme trustees to generate Libor consistently and with low risk over the medium to long term.
The trustees then have the choice of investing the scheme’s assets in a portfolio of assets expected to generate a return of Libor, with low volatility around this expected return. Alternatively, trustees in search of higher returns can choose to take on additional risk to generate additional returns above Libor, to fund a deficit, for example.
Finally, a feature of the UK interest rate market is that it typically guarantees a lower fixed rate of interest over longer periods. This reflects the supply/demand imbalance in available investment opportunities offering guaranteed rates of interest over long periods. Interest rate swaps therefore present trustees with a trade-off: locking into relatively low, but guaranteed, rates of interest for the long term, against maintaining higher weightings to asset classes whose return is expected to be greater over long periods, but with no guarantee such higher returns will materialise.
That said, there is increasing convergence in using LDI to refer to the reduction of interest rate and inflation risk embedded in a pension scheme’s liabilities (see box one).
BOX ONE: Interest rate and inflation risk
Interest rate risk: The present value (ie the value in today’s monetary terms) of pension fund liabilities is calculated by discounting the expected future benefit payments. Using a lower interest rate to calculate the present value of the liabilities gives a higher liability and is the source of interest rate risk. Reducing (or hedging) interest rate risk creates a more stable liability value – one that does not change as much as interest rates change. An interest rate swap is a financial asset that allows the hedging of interest rate risk.
Inflation risk: Pension schemes’ benefit payments are often linked to future rates of inflation. For example, pensioners may receive a pension that increases each year in line with inflation. Future inflation rates are unknown and the scheme is therefore uncertain about the cost of paying future pensions. Inflation swaps are a type of financial asset that allow the hedging of inflation risk. They increase in value when inflation is higher, thereby compensating the scheme for the higher benefit payments it needs to make.
This brings us to the focus of this article: the costs of implementing a LDI strategy. An understanding of costs is made easier if we recognise that, while the implementation of LDI strategies takes a variety of forms, there are only two basic assets used to reduce interest rate and inflation risk: bonds and swaps. In this article, we focus on the costs associated with investing in swaps, since most trustees are familiar with the cost of investing in bonds.
Over-the-counter market
In contrast to many of the asset classes that trustees have historically encountered, swaps are traded ‘over-the-counter’. This simple difference is at the root of many of the complications that arise under a LDI strategy. Having been used to the comfort of exchange-traded investments, it is perhaps not surprising that trustees and advisers require more time to familiarise themselves with the nuances of over-the-counter markets. A significant feature of these markets is that purchase (and sale) prices and transaction costs (or spread costs) are typically individually agreed between the buyer and vendor. In the main, they are not visible to others not involved with the transaction. These features cloud the true cost associated with a LDI strategy. Help for trustees takes the form of asset managers with the necessary skill and experience to act as a fiduciary on the trustee’s behalf when trading swaps, a point we return to later.
Transaction costs
Transaction costs are paid when a swap is bought (or sold). The cost is often quoted as a percentage of the size of the transaction. Also known as the spread cost, it is paid for each year that the swap is in effect. However, rather than being paid annually over the lifetime of the swap contract, the total transaction cost is paid for upfront. At this point you are thinking, this all sounds pretty obvious. That is until you realise that market convention is to quote this cost as the cost to be paid each year, rather than the total upfront cost. The second subtlety is that a similar transaction cost is charged when you sell the swap. Again, this may be obvious, but what is less obvious is this cost on sale reduces the longer you hold the swap. Total costs are therefore heavily influenced by the period for which the swap is held. For this reason, swaps lend themselves better to longer-term buy-and-hold strategies.
Spreads for buying (and selling) typically range between half and two basis points (0.005%-0.02%), with some common rules of thumb being:
- spreads increase as the monetary value of the swaps being traded increase, since larger deals mean greater investment risk;
- interest rate swaps have lower spreads than inflation swaps, representing both the premium placed on inflation hedging financial assets and the greater risks to the seller; and
- spreads increase with the term of the swap, for the same reasons outlined above.
Price discovery
The over-the-counter nature of swaps complicates establishing a fair price to be paid for entering into a swap transaction. This is in contrast to exchange-traded investments, such as bonds and equities, where prices are publicly quoted and transparent. It is for this reason that the astute investor focuses on minimising the total of the price and spread paid when entering into a swap transaction, rather than focusing on one at the expense of the other. In fact, a strategy of minimising spread costs without paying attention to the price being paid for the assets will be to the scheme’s detriment.
Opportunity cost
When the pension scheme is owed money under a swap contract, it will want to receive periodic payments (or collateral) as comfort that the contract will ultimately be honoured at maturity. Of course, the scheme may also need to make such payments in the opposite direction. For this it needs ready access to suitable assets. Typically, suitable assets means cash or high credit-quality bonds. To hold these assets the scheme may need to switch out of other asset classes that offer a higher return, for example equities. This results in an opportunity cost to the scheme, increasing the cost of implementing a LDI strategy. LDI product providers have adapted their product sets to increase flexibility in this regard so that with the exception of the raciest (and riskiest) investment strategies, most providers offer sensible options for reducing opportunity costs.
Asset management and custody fees
In practical terms, implementation often involves the use of an asset manager. The asset manager could fulfil (and charge for) a number of roles, including:
- swap execution, including subsequent adjustments to the swap portfolio to allow for updated liability information;
- investment of the collateral assets;
- managing the transfer of collateral; and
- generating additional returns by actively managing the swaps against a liability benchmark.
Trustees should understand exactly what services are included in the asset manager’s quoted fee. In particular, any promise of added value from active management against a liability benchmark should be considered separately. Finally, a custody fee will be incurred on the collateral assets and is sometimes not explicitly disclosed.
Slippage costs
This category of costs is probably better described as a risk, but given its potential to negatively impact the scheme’s financial position, it is described as a cost. Simply put, an interest rate hedge exchanges the pension scheme’s exposure to long-term interest rates for an exposure to short-term interest rates (see box two). Far from totally eliminating interest rate risk, the scheme has substituted one risk for another. The scheme is now left with the challenge of investing assets so that they offer a return at least equal to that which the scheme has committed to paying away. This is a non-trivial matter. If, over the term of the swap, the scheme is unable to earn at least this return, then there will be a further cost to a LDI strategy.
Advisory costs
The last category of costs is arguably less significant than the costs we have so far described, but fee-conscious trustees will know advisory costs can be non-trivial. They include the cost of your investment consultant designing and signing off on the strategy, legal advice on any documents to be signed and a more sophisticated governance structure.
The longer-term nature of LDI strategies means guarding against fees that look unreasonably low and are therefore unlikely to be sustained at those levels over the long term. A short-term gain may well turn into long-term pain. As the market for LDI strategies has developed, asset managers have stepped up to offer pooled, off-the-shelf solutions aimed at eliminating the hassle associated with implementing a LDI strategy. The benefit for trustees is the opportunity to benefit from the economies of scale inherent in a pooled approach, so trustees with an eye to cost savings over the long term may be wise to place a premium on those asset managers with a track record of building scaleable pooled funds at low cost.
LDI strategies are primarily about risk reduction. While the cost of implementation should not serve as a distraction to trustees, LDI strategies are becoming more commonplace and their commoditisation is an inevitable consequence. In a commoditised market, cost is a key differentiator, with scale a critical success factor. Trustees and consultants are increasingly responding to these trends and recognising that some solutions and providers will deal better with this challenge than others.
BOX TWO: Scheme liabilities, swaps and interest rates
As described in box one, pension scheme liability values represent the discounting of a series of expected future cash flows, at a particular rate of interest. The choice of interest rate is a key determinant of the liability value. In particular, it is important to recognise that interest rates vary by term. This means the fixed rate of interest the market is prepared to guarantee varies by the term of the guarantee. Pension scheme liability cash flows are, on average, due over long periods. So in choosing a rate of interest to be used for discounting future cash flows, pension scheme liability values are said to be exposed to changes in long-term interest rates.
Interest rate swaps solve the problem of liability values by offering to pay the swap-buyer a fixed rate of interest guaranteed over the long-term. The swap is a payment by the swap-buyer, to the seller, of a floating, short-term rate of interest known as Libor. So that, far from eliminating interest rate risk, interest rate swaps exchange a pension scheme’s liability exposure to changes in long-term interest rates for exposure to changes in short-term interest rates (Libor).
Having entered into an interest rate swap, the key challenge for the pension scheme is then one of generating Libor on the amount on which a fixed rate of interest has been guaranteed. The risk of not generating Libor lies squarely with the trustees. This can be seen by recognising that the fixed rate of interest locked into, is only guaranteed if Libor is generated. The impact of not generating Libor is therefore to effectively reduce the fixed rate of interest the pension scheme can expect to receive, net of paying away its Libor commitment. Investments are, however, available to enable pension scheme trustees to generate Libor consistently and with low risk over the medium to long term.
The trustees then have the choice of investing the scheme’s assets in a portfolio of assets expected to generate a return of Libor, with low volatility around this expected return. Alternatively, trustees in search of higher returns can choose to take on additional risk to generate additional returns above Libor, to fund a deficit, for example.
Finally, a feature of the UK interest rate market is that it typically guarantees a lower fixed rate of interest over longer periods. This reflects the supply/demand imbalance in available investment opportunities offering guaranteed rates of interest over long periods. Interest rate swaps therefore present trustees with a trade-off: locking into relatively low, but guaranteed, rates of interest for the long term, against maintaining higher weightings to asset classes whose return is expected to be greater over long periods, but with no guarantee such higher returns will materialise.
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