In this article we will go back to basics and clarify what LDI actually is, why it is used, and what the recent challenges were.
A refresher on pension scheme liabilities
A DB scheme’s purpose is to pay a retirement income to its members. These payments are the scheme’s liabilities. To value these liabilities an actuary will use a discount rate to decide how much money a scheme needs to hold today to meet them. Essentially, a discount rate is an assumed rate of interest that the scheme can earn based on its assets. For example, if you need to pay a debt of £100,000 in five years you do not need £100,000 in the bank today. You can assume a rate of interest on your money (the discount rate) such that if the discount rate is 5% you only need £78,350 in the bank today.
The present value of a scheme’s liabilities therefore depends on the discount rate. This changes as interest rates change and means that the present value of the liabilities can change independently of changes in the scheme’s asset value, giving rise to interest rate risk. Movements in the discount rate present an unrewarded risk to pension schemes and can have a significant impact on the funding ratio of schemes.
The purpose of Liability Driven Investment funds
The aim of LDI is to hedge this risk, as detailed above, of the discount rate changing as gilt yields fluctuate. In order to achieve the hedge, pension schemes holds assets that move in line with the liabilities. In doing so, the scheme’s funding ratio is protected from changes in the valuation of the scheme’s liabilities.
Pension schemes use LDI funds as their hedging assets because they can do so without sacrificing the returns from their growth portfolios. Of course schemes could invest in gilts to match the value of their assets to their liabilities, but to do so, they would need to raise cash by moving out of growth assets.
How LDI funds work
Leverage is a desirable feature of LDI funds as it allows schemes to reduce liability risk without selling out of growth assets. Leverage arises from the fact that the collateral pool used to back the exposure to discount rates is only a portion of the liabilities being hedged. For example, if we hedge £3M of liabilities we may put £1M up as collateral and invest the remaining £2M in growth assets. In aggregate, we are not leveraged because we have the full £3M to support the hedge.
LDI fund managers monitor leverage on a daily basis and if it reaches certain thresholds, will call additional capital from clients. At Cartwright we advise clients to hold their investments on an investment platform to allow for the efficient transfer of additional collateral to LDI funds, when it is required.
What happened over the recent period?
The speed at which gilt yields rose during this period was unprecedented. As a result, the amount of leverage in LDI funds moved so rapidly that in certain instances it was not possible to get additional collateral to LDI fund managers quickly enough. In these instances, LDI managers reduced the leverage by reducing exposure resulting in a reduction in hedging. In most instances there was no significant issues. For example, in our client base:
· There were no instances where clients ran out of collateral
· No clients were forced sellers of equities to fund collateral calls
· For the majority of our clients all collateral calls were met and hedges were maintained
· For a minority of our clients, hedges were temporarily reduced and have since been re-established
Conclusion
LDI is used so that changes in the value of a scheme’s liabilities due to movements in gilt yields are matched by a gain or loss in the value of LDI funds. The intention is to lock down the value of a scheme’s liabilities and remove unintentional risks, not to generate returns. However, as part of the journey plan for most schemes, their liabilities will not have been 100% hedged. The rise in gilt yields over the recent period will therefore have been beneficial, because the fall in the value of the scheme’s liabilities, will have been greater than the loss on the LDI funds, resulting in improved funding ratios. Claims that pension schemes were in danger of going insolvent were, at best, grossly exaggerated. At worst, dangerously misleading. In actual fact for the majority of schemes their solvency ratios have improved! Where are those headlines?!
Glenn Cameron, Investment Consultant and Head of Digital Assets, Cartwright
