Actuarial valuations often use discount rates equal to the market implied return on gilts plus a margin - usually referred to as “gilts+”, the size of which depends on a number of factors including the investment arrangements in place. While the margin may (but not always) vary from one actuarial valuation to the next to allow for changes in the economic and market environment, there usually remains a high correlation between the movement in gilt yields and “gilts+” discount rates.  

However, to the extent that a scheme’s assets are not exclusively duration-matched gilts, the “gilts+” methodology creates the potential for significant short-term funding level volatility, particularly as the non-gilt assets react differently to interest rate changes. It is no surprise, therefore, that considerable effort has been put into mitigating this perceived unrewarded short-term interest rate “risk” within the context of the typical triennial actuarial valuation cycle. In turn, this provided a platform for the significant growth in leveraged LDI structures, designed to hedge much of a scheme’s interest rate exposure.

The idea that interest rate risk is unrewarded (i.e. is not expected to deliver a financial gain) assumes the market’s assessment of forward cash rates is a fair reflection of what will transpire. However, the movement in interest rates over recent years has confounded market expectations, such that leveraged LDI structures (initially conceived as a risk management tool) have in fact proved extremely beneficial for many schemes. This unexpected outcome suggests to us that the rationale and risks of continuing with leveraged LDI should be revisited, particularly given the current low level of interest rates. 

Funding level volatility considerations are likely to have been a key driver of many pension schemes’ investment strategy design in recent years. However, by shifting the focus towards paying the member benefits (i.e. the actual liabilities for an ongoing scheme), then investment strategies focused on managing funding level volatility may prove sub-optimal and many schemes may question whether day-to-day volatility is really an issue. What has to be managed instead is the volatility of the specific asset when it needs to be realised. We believe that looking at investment risk from this perspective changes the way in which pension scheme portfolios should be constructed.

The above dynamics play to the increasing industry focus on the benefits of cash flow driven investment (CDI). The importance of CDI in developing an understanding of investment risk for a cash-flow negative scheme is illustrated below. 

 

The light green line shows the progression of a hypothetical scheme’s assets assuming contributions and investment returns are exactly in line with expectations - the assets should be just sufficient to cover the final benefit payment. 

Now assume the same return over the lifetime of the scheme, but the performance of the assets falls short in the early years before improving later on to offset the shortfall on a time-weighted basis. In this second scenario, as reflected by the dark green line, the scheme runs out of assets well before the last benefit payment is due to be paid (around year 35). 

The two outcomes differ because the timing (as well as the size) of returns matters. As a result, if assets are disinvested to pay benefits following a period of underperformance, thereby crystallising losses relative to the expected return, the impact can potentially be very damaging by increasing the pressure on the remaining assets to deliver a higher return than initially assumed¹. 

These dynamics have material implications for how we believe a scheme should invest. The return on portfolios with a fixed benchmark comprised of growth and long-duration leveraged LDI assets could be very volatile compared to that needed to deliver each year’s benefit payments. As a result, a scheme may well find itself crystallising short-term profits / losses. 

With the above in mind, we believe there needs to be a fundamental re-think of the way journey plans and ensuing investment strategies are constructed with the aim of delivering returns by the time assets are needed to pay benefits. This requires an assessment of which investments are most likely to deliver the necessary returns over the required timeframe, taking into account the downside risks at the point the assets need to be realised.  

So what does this mean for the future of leveraged LDI structures? First and foremost, the decision to implement or maintain such a structure should take into consideration the particular circumstances of the scheme and its sponsor within the context of the market background. So if balance sheet volatility is a real issue for the corporate sponsor then consideration could be given to introducing an interest rate overlay to help mitigate this risk.

These discussions should however take into account:

a) The potential for yields to vary from that implied by forward curves and what this could mean for the absolute returns needed to deliver member benefits; and

b) How the corporate sponsor’s business might be impacted by the conditions that resulted in a material change in gilt yields.

The overall aim should be to mitigate the risk of increasing pressure on the sponsor for additional funding at a challenging time. 

The above assessment is key to implementing an integrated risk management approach to funding and investment. However, the challenges of doing this should not be underestimated. For example, how do you come up with a good set of alternative outcomes to current market gilts /swaps pricing, and the probabilities attached to them, bearing in mind the market’s poor track record in predicting future cash rates over recent years?

Fundamentally, we believe the use of leverage within a scheme should not be viewed as just a risk management decision but one that can have a material impact on the returns achieved. Indeed, this one decision has the potential to swamp all other investment activity. For an ongoing scheme, the actual liabilities (i.e. the benefit payments) are not affected by changes in interest rates. However, the assets held to deliver the benefits are, and particularly so where large leveraged LDI structures are maintained. Therefore, the key question is whether such leveraged exposures will help or hinder the delivery of member benefits going forward.

Our industry faces a huge conflict of interest in advising on the suitability of leveraged LDI, the complexity of which increases the consulting time cost and introduces an additional layer of management fees. Indeed, freeing up capital that may have been held in gilts creates more mandate opportunities for consultants and investment managers alike. This is not to say that such structures should not be implemented if they are in a scheme’s best interests. However, given their potentially material impact on overall investment returns, we believe it is incumbent on all industry participants to regularly challenge the rationale for introducing or maintaining leveraged arrangements so the risks are clearly understood and any conflicts managed effectively. 

As part of this challenge it is important to avoid confirmation bias. One argument for supporting the “lower for longer” interest rate case (and therefore leveraged LDI) is that, if rates start rising, schemes will step in and buy more gilts thereby putting a cap on the extent to which they rise further. Conversely, you could just as easily argue that if rates do start rising schemes may refrain from hedging in the belief that they may rise even further. Certainly, if more schemes follow the recent example of the BAE pension schemes and utilise the flexibilities within the funding legislation to move away from a “gilts +” approach, the demand for gilts may subside.

Our industry faces many challenges, some of which we have touched on briefly in this article. We do believe that current legislation governing pension schemes should be reviewed given the focus it creates on managing short-term volatility metrics at the expense of longer term strategies aimed at delivering member benefits.  

The direction of interest rates in recent years has led to returns on leveraged LDI structures that we suspect few would have predicted. Whether or not we are in an environment in which such exposures will do well going forward is difficult to tell. However, what trustees do know is the value of the assets they hold, the sponsor contributions that have been promised and the expected benefits to be paid. Using this information alongside CDI principles to construct an investment strategy designed to deliver returns by when they are needed should provide schemes with a clear sense of the trade-off between the shorter term risk management benefits of a leveraged LDI structure and the longer-term absolute return risks to deliver member benefits.  

¹ The reverse dynamics would apply if returns were stronger in the early years.

Stamford Associates Limited

January 2018

The information and opinions contained in this article are intended for general discussion and do not constitute a personal recommendation. Past performance is no guide to future performance and you should seek independent advice before entering into any financial transaction. For professional investors only. 

Stamford Associates Limited

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