Gilt yields have risen materially across the curve (2-2.5% p.a.1) leading to a huge reduction in defined benefit pension scheme liabilities (around 30%2), and for some, a significant improvement in funding position. A raft of additional LDI guidance has ensued.
The LDI industry and advice on its implementation is in a state of flux. Reviews of LDI funds are underway likely leading to changes in solution ranges, operations, client servicing, risk management and fees (potentially higher).
Consequently, it’s a good time to review your arrangements to ensure that they are as good and robust as they can be.
Bad tool, or good tool used badly?
Some commentators have criticised leveraged LDI and questioned its appropriateness as a pension scheme investment.
In our view, leveraged LDI, and indeed the use of leverage in pension scheme portfolios more generally, is a very useful and effective tool for efficient portfolio management. It requires skill, knowledge and proper risk management. It is clear from the events of last year, and some scheme outcomes, that there were significant deficiencies in the management of risk across the sector.
Something’s got to change
For the vast majority of schemes, the use of LDI as it was, is now unlikely to be viable or as cost effective.
The biggest driver of change is the need to reduce leverage and set aside additional liquid assets per the recent guidance from TPR3 and the FCA4. All else being equal, reduced leverage within portfolios means a lower overall expected return from the assets and/or a lower level of liability hedging.
For those schemes where funding improvements have been modest, some adjustment to investment strategy will be needed to either extend the time horizon for achieving funding objectives or restructure return seeking portfolios.
With the fall in revenue driven by reduced LDI AUM (mirroring the liability falls of around 30%) and increased levels of client service (responsiveness/client to staff ratio) and risk monitoring, asset managers will almost certainly look to increase fees. This may be offset by LDI managers trying to manage more of a scheme’s portfolio under the guise of having “access to collateral”, but this raises other potential conflicts of interest considerations.
Trustees and sponsors will need to spend more time on LDI, initially to review and understand what really happened. The next step will then be to effect any changes in governance and managers to improve implementation and oversight of LDI investments.
Best practice
In our view, the best approach to LDI in the future, and the integration of it into wider portfolios, is likely to include some or all of the following:
- Segregated or bespoke approach for LDI – these offer the greatest mix of flexibility, transparency and reasonable cost (even for schemes around £50m)
- ‘Barbell’ approach to investing return seeking assets – combining a large(r) allocation of highly liquid assets with a modest allocation to high conviction, high(er) expected return, illiquid investments
- Synthetic assets as part of the return seeking portfolio – spreading the use of any required leverage across a larger part of the portfolio increases diversification and provides a larger capital base
- Delegation of authority (e.g. to a fiduciary manager, investment consultant, or LDI manager) – so that action can be taken quickly should the need arise
- Enhanced risk management and transparency of reporting – reflecting the relative importance of LDI and high hedge ratios
David Morton FFA, Head of UK Investment Strategy, SECOR Asset Management
1. Based on the increase in 10-30 year nominal and real spot rates reported by the Bank of England between 31 March 2022 and 31 March 2023
2. Based on a liability duration of 15-20 years
3. “You (trustees) must ensure that you have robust and effective operational processes in place to ensure the resilience of your pension scheme to market shocks and reduce the risks to your scheme to acceptable levels... You should make sure the arrangements you invest in operate an appropriate buffer, and that the right processes are in place for drawing on and replenishing the buffer... This buffer should be, at a minimum, 250 bps.” Using leveraged liability-driven investment | The Pensions Regulator 